It's been a difficult few years, but emerging markets are back. A supply glut that has been weighing on oil prices since late 2014 appears to be easing, emerging-market currencies are cheap on a purchasing power parity basis, and economic growth momentum is recovering relative to developed markets. Investors have taken notice: The MSCI Emerging Market Index rose 32 percent between a January trough and mid-August.
Think Small or Medium
If that sounds like a missed opportunity, it should. But according to Credit Suisse Asset Management's Industrial Life Cycle (ILC) Equity Investment team, there's another one right behind it. With 97 percent of the MSCI EM Index comprised of large-cap equities, investors have given the majority of their love to big company stocks. Looking out into the future, the most compelling emerging market opportunities are where most investors are not currently looking, and that is with small- and mid-cap (SMID) companies.
SMID companies in emerging markets have outperformed large caps in 12 of the last 15 calendar years. More importantly, they have done so with less risk, not more: since 2001, the MSCI Emerging Markets Small Cap Index has seen higher annualized returns compared to the MSCI EM Index (8.2 percent vs. 6 percent) but with similar volatility (16.5 percent vs. 19.5 percent). Valuations also remain in their favor: Small and mid-cap companies have a lower median price-to-book value than large caps, with a higher estimated five-year earnings growth rate.
Global economic crosscurrents are also working for them. Smaller emerging-market companies tend to be more domestically oriented than larger companies at a time when global growth is sluggish and developing economies are shifting from an export-driven model to a consumption-led one, due largely to the rise of the global middle class. Credit Suisse's 2015 Global Wealth Report shows that the number of middle class adults has grown 27 percent since 2000 to 664 million. Forty-three millions of those new middle-class citizens are in China alone, with another 7.7 million in India, and 6 million each in South Korea and Mexico.
Small and mid-cap companies are well positioned to take advantage of this expanding middle class and the tastes of young, emerging market consumers. More than 70 percent of SMID revenues in the emerging markets come from domestic sources, and SMID companies have as much as 10 percent more exposure to the fast-growing and locally focused sectors of consumer discretionary and capital goods than large ones.
Is Global Exposure Good for You?
Meanwhile, the MSCI Emerging Markets Index is saturated with banking, energy, telecommunications, and utilities firms, which are highly sensitive to global and national macroeconomic trends. At a time when growth is sluggish in the developed markets and Brexit looms over Europe and the United Kingdom, international exposure no longer seems like the advantage it did in the late 1990s and early 2000s, when commodity prices were soaring and developing countries competed to manufacture goods for developed markets.
With historical outperformance and similar volatility to large caps, attractive valuations and the potential to capture the rise of domestic consumption, emerging-market small and mid-caps make for a compelling investment opportunity. There is, however, a caveat: the Industrial Life Cycle investment team does not recommend investing in index funds or ETFs to gain exposure to the asset class. Small-cap indices are shuffled frequently, which can have a large effect on the value of the component stocks. What's more, with relatively little analyst research on SMID stocks, stock picking offers an opportunity to take advantage of market inefficiencies. Active management, in other words, can be a benefit when investing in emerging-market SMID equities. In fact, research from Credit Suisse's equities team has shown that stock selection is the main driver of returns within small cap emerging-market equities, and has historically been a more consistent source of returns than country, industry or sector selection. This indicates that a bottom-up investment approach like ILC uses, which focuses on generating returns from its stock selection, is beneficial in generating alpha over the index.