In this episode, we’ll explore the overlooked investment universe of emerging market small-cap equities with Prashant Paroda, Associate Portfolio Manager with the Berkeley Street Emerging Markets Equity Team at Wells Fargo Asset Management.
John Natale: I’m John Natale, and you are listening to the podcast On the Trading Desk®. Joining us today is Prashant Paroda, Associate Portfolio Manager with the Berkeley Street Emerging Markets Equity Team at Wells Fargo Asset Management. In this episode, we’ll explore the universe of emerging markets small-cap equities. Prashant, it’s great to have you with us today. Thanks for joining us.
Prashant Paroda: Great to be here, John. Thank you.
John: So you recently published a paper titled The case for active emerging market small-cap strategies. In it, you note that investors may have too often overlooked dedicated small-cap strategies when building strategic allocations to emerging markets equities.
Can you talk about this overlooked investment universe and describe for our listeners what your team finds so appealing about it?
Prashant: Sure, John. Emerging markets small-cap universe is an inefficient alpha hunting ground for skilled investors—alpha being the excess return one can generate by investing in an actively-managed portfolio relative to the return of the benchmark index, which in this case is the MSCI Emerging Markets Small Cap Index.
There are three important takeaways from our paper that I would like to talk about today.
First, institutional allocators often ignore small caps when allocating to emerging markets. Based on eVestment database, emerging market small-cap strategies account for only 2.2% of the total allocation to emerging market equities at year-end 2019. This is despite the fact that the median manager in the small-cap universe is outperforming its benchmark by nearly 300 basis points over 1-, 3-, 5-, and the 10-year period.
Second, the larger emerging markets benchmark has become very concentrated. The top 10 names in the larger MSCI Emerging Markets Index now account for 28% of the weight of the index. In fact, based on the top 10 holdings, the MSCI EM Index is even more concentrated than the S&P 500. Alibaba and Tencent together account for more than 12% of the index.
As the MSCI EM Index becomes more concentrated, it becomes harder for active managers to outperform it. The median EM All Cap core and EM Large Cap core managers are finding it very difficult to justify their fees over the last 5 years. The data clearly shows that a median EM small-cap manager is clearly outperforming compared to the median all cap and large cap core managers.
The question now becomes how has the EM small-cap index done relative to the larger EM index? Surely, it must have done worse than the larger EM index for investors to ignore allocating to small-cap strategies. The answer to that is clearly no. In fact, the small-cap index has done much better than the larger index more that 71% of the time. If you look at rolling 5-year returns over the last 20 years rolled monthly, investors in MSCI Small Cap Emerging Markets Index come out ahead 71% of the time versus the larger MSCI EM Index.
The most important takeaway for us is that by allocating only 2% to small-cap strategies, investors may be missing out on considerable alpha and total return in their portfolios.
John: That’s really interesting. Now Prashant, you’ve noted that it’s not only investors in general who may be overlooking the EM small-cap space, EM of course being emerging markets. There’s also very little coverage of this space among sell-side research analysts. Can you discuss how could this dearth of sell-side research could be a positive factor for those investors who are interested in gaining emerging markets small-cap exposure?
Prashant: Sure, John. The answer may be due to the abundant universe and the lack of analyst coverage. The MSCI Emerging Markets Small Cap Index itself has more than 1,600 names and is a much larger universe than several of the other global indices. We also find that the average analyst coverage is much less than that in the global indices. The average number of sell-side analysts covering a stock included in the small-cap index is less than 40% of the average number of analysts covering a stock in the larger MSCI EM Index and less than 25% of the analysts covering stocks in the S&P 500. There are many stocks in the universe that have little to no coverage.
I would also like to say that regulations such as Markets in Financial Instruments Directive, popularly known as MiFID, will only lead to less analyst coverage for small caps in the future as sell-side firms globally cut their research budgets.
So the opportunity to generate alpha for a skilled investor, in our view, will only expand in the future.
John: That’s fascinating. Now Prashant, can we talk about your team and its approach to uncovering opportunities in the emerging markets small-cap space? Could you please describe that approach from how ideas are generated to your focus on quality?
Prashant: Sure, John. Berkeley Street process is a sequential process where quality comes first and then valuation.
The Berkeley Street team has been utilizing the same process to identify small-caps within our portfolios since 2006. In any economy or sector, only a small minority of companies generate most of the value. We seek to identify these companies.
In small caps, we pay a lot of attention to capable management teams, ideally with high insider ownership. When we meet or call the management team, we attempt to answer the following questions: Is the management team happy with status quo or driven to achieve more? Are there corporate governance issues related to cross-holdings or related party transactions? Does the management team acknowledge their mistakes or hide them under the rug?
Bad management can destroy value in so many ways that is very hard for people to fathom. So we automatically exclude management teams where we have doubts of their integrity.
The second thing we tend to identify is whether the business has favorable growth prospects supported by major secular trends. We attempt to answer the question, how big can the size of the business become in 5 to 10 years?
Throughout the history of Berkeley Street team, focusing on this question has allowed us to identify ecommerce opportunities in Brazil and online education companies in China. The idea is to catch these companies early and generate considerable alpha for our clients.
We also look for a scalable business model with ample financial resources and strong competitive position and capability. Environmental, social, and governance (ESG) consideration is ingrained in our process. We believe that focus on ESG factors helps us avoid permanent loss of capital.
In this digital age, it is very hard to for companies to hide behind bad corporate governance, labor issues, or environmental negligence. For example, we all know that the air quality index in China, Hong Kong, and India is becoming a political hotbed issue for all governments. We stay away from sectors that are polluting the environment where change in public policy could dramatically impact our downside. Our small-cap portfolio’s carbon footprint is considerably lower than that of the benchmark.
Looking for quality in our small-cap universe allows us to distill the universe of small-cap names into a quality pool of around 300 companies. We then do a valuation analysis on the quality pool where we value intrinsic value of each business using base and bear cases.
For our small-cap strategy that launched in February 2018, we then built a portfolio of between 60 to 90 companies. This portfolio is a subset of the quality pool.
We control for risk using a strict valuation discipline. The idea is to build a high active share portfolio by focusing on companies that will ideally generate the most value in our universe.
John: Now Prashant, there’s one element of your new paper that I found particularly fascinating and would like to learn more about, and that’s the changing nature of family-owned businesses and the opportunities that could potentially arise from those changes. Can you please talk about this and perhaps tell us a story of a family-owned business whose journey embodies this type of change?
Prashant: A large portion of small-cap companies in emerging markets are privately-owned with families owning more than 50% of the float.
We believe that the next decade will see a generational change in management with a lots of head of families approaching retirement age. While some families will still be involved in running the business and pass on responsibilities to the next generation, others will hire professional management and oversee their interests through the board as majority investors.
A new management team with fresh ideas and more professional outlook should lead to better execution of growth opportunities, capital allocation, cost efficiencies, and improvement in margins. A more professional, results-driven management team could lead to a positive re-rating of several small-cap names in the emerging market stock universe.
Let me give you an example. A hospital company in our quality pool is currently going through this transition. When the new management team took over from the family-controlled business, the company was facing a decline in profits and flagging morale.
The new team has made changes to its finance and sourcing teams with a focus on reducing costs. It has simplified the governance structure. It has worked to improve the management relationship with its doctors and vendors. The company’s diagnostics business, which had been underperforming its peers under the previous leadership team, has also been changed, and steps are being taken to infuse confidence in that business, as well.
We focus a lot on catching this management change early within our small-cap universe.
John: Thank you for taking us behind the scenes there, Prashant. That was really interesting. So, no doubt we’ve seen some volatility that has tested emerging markets recently, as well as global markets, overall. Some of this is coronavirus-related, of course, but some of it also is related to the ongoing trade tensions that have been in the headlines for the past couple years and appear to be intensifying.
So my question to you: How are emerging markets small caps responding to that?
Prashant: One of the key distinguishing factors of the MSCI Emerging Markets Small Cap Index versus the larger MSCI Emerging Markets Index is its lower exposure to China. Chinese companies account for around 13% of the small-cap index versus more than 40% of the MSCI EM Index.
Post COVID-19 and a result on the ongoing trade war, there is an increasing likelihood that global supply chains will diversify away from China. Within emerging markets, the beneficiaries of this supply shift will be Southeast Asian countries and India, primarily due to cheaper labor costs.
Exposure to small-cap strategies will reduce country-specific risk to China and add exposure to countries that might benefit from this trend.
Longer term, we believe that asset allocators should give some thought to the secular shifts in global supply chains that may happen over the next decade. This will likely lead to a new host of winners and losers.
Let me explain further. The trade deficit is not only an issue between the United States and China, but also an issue between India and China. India runs more than a $53 billion trade deficit annually with China. To encourage make in India, the government of India has raised custom duties on consumer electronics being imported from China.
Chinese companies and Samsung have around 84% market share in the Indian smartphone market. Now it has become beneficial for these Chinese or Korean manufacturers to assemble their phones in India rather than export them from China.
The opportunity has given birth to local manufacturing and assembly companies in India. The overall industry for the local manufactured and assembled phones in India has grown from around 50 million units to more than 250 million units in last 5 years. Now, these local assembly companies are being used by Chinese and Korean manufacturers to sell within India mainly. But these companies can also become an export hub for these same Chinese and Korean manufacturers in the future to export to other countries.
We are finding interesting opportunities that will benefit from this trend in our portfolio.
John: So going back to your paper, you talked about how the MSCI EM Small Cap Index underperformed the flagship MSCI EM Index in 2008 and then, it did so again most recently in the first quarter of 2020. Is now potentially a good time to be looking at small-caps in the emerging markets space?
Prashant: Although the long-term returns of the MSCI EM Index and the MSCI EM Small Cap Index are quite similar, it has been true that in large drawdowns, emerging market small-cap stocks have historically underperformed the larger EM index, but they’ve also snapped back pretty hard in a recovery. In 2009 alone, the small-cap benchmark outperformed the larger benchmark by 35%.
We are still in the midst of coronavirus pandemic. While small caps underperformed during the large drawdown in first quarter, small caps have started to outperform again in the second quarter.
Then there’s the valuation argument. Emerging market small-cap stocks look very attractive as emerging market small-cap index trades at a very low valuation and historic discount to other global indices.
We believe investors can potentially generate considerable alpha by focusing on companies that will grow their market share in emerging markets over the next decade.
We find that downturns allow quality companies to expand their market share as weaker companies typically get restructured and die a slow death. The current COVID-19 situation could be an opportunity for long-term investors to look at dedicated active emerging markets small-cap strategies to potentially add alpha to their portfolios.
John: That’s also very interesting. A lot about the emerging markets small-cap space that I certainly didn’t know and I have a feeling was interesting for our listeners. Well, that wraps up this edition of the On the Trading Desk podcast. Prashant, thank you for joining us and, of course, we appreciate your time and your insights.
Prashant: You’re welcome, John. Thank you for having me here.
John: Now for our listeners who would like to read Prashant’s new paper, again it’s titled The case for active emerging market small-cap strategies, you can find it on our website, wellsfargoassetmanagement.com. Until next time, I’m John Natale; be well.
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Disclosure: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index. The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure equity market performance of emerging markets. You cannot invest directly in an index. The Morgan Stanley Capital International (MSCI) ex USA Small Cap Index captures small-cap representation across 22 of 23 developed market countries (excluding the United States). With 2,557 constituents, the index covers approximately 14% of the free-float-adjusted market capitalization in each country. You cannot invest directly in an index. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy.