Investment Adventures in Emerging Markets

When Small is Big

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There’s a popular saying in the US, “good things come in small packages,” which is generally a statement about gifts of jewelry. My team and I find this saying can apply to the investment world, too, as we often find companies that are small in size, but which may have big long-term potential.

Emerging-market country indices are often dominated by a handful of large businesses, typically from the energy, banking, telecommunications, heavy industry and mining sectors. Political or global macroeconomic factors often influence such businesses more than their local economies. Our team doesn’t base its decisions on benchmarks—we take a bottom-up approach to investing. As such, we often find attractive opportunities in individual smaller and mid-sized companies, which tend to be found in more entrepreneurial sectors such as consumer discretionary and light industrials. Many of these companies are more domestically oriented than their larger counterparts, and thus can be better aligned with the factors driving economic growth in the individual country or market in which they operate.

Middle-Class Influence

Typically, such companies are also more consumer-focused than their larger peers, exposing them to what we see as a key potential driver of emerging-market company profitability—the ongoing pivot in a number of emerging markets away from export- and investment-oriented growth toward growth based on rising consumer demand. The middle class around the world is growing, and it’s having a dramatic impact on consumer behavior in emerging markets. With more money to spend, many people in emerging markets are clamoring for consumer goods, from beer to clothing to cell phones. Additionally, as people gain more status, they often gain more clout to influence politics and policy—for the better.

The definition of “middle class” may differ from country to country, and according to whether the country is an emerging or a developed market. In the case of Africa in particular, the African Development Bank defines “middle class” largely in terms of higher income relative to the average; that average is, of course, lower in Africa than in developed countries. The bank estimates that more than 34% of the African population (nearly 350 million people) fit the description of middle class in 2011, up from 27% in 20001. It’s clear the consumer culture is growing there, along with discretionary income—something I’ve witnessed first-hand.

Filling a Niche

Many smaller companies are also often at an earlier stage in their life cycle, and thus can offer the potential to experience faster growth than the broader equity market. For example, we have identified several relatively small companies in markets such as South Korea and Hong Kong that have come to dominate a number of local consumer sector niches through strong manufacturing, marketing and management systems, but they remain small in a global context. As these businesses use skills honed in their local market to expand into neighboring emerging markets, they have often enjoyed accelerating growth.  

Exploration of the smaller-companies segment is an important part of our overall research effort as some small-capitalization stocks can potentially grow to be the giants of the future. Some businesses first identified within our smaller-companies research, for example in pharmaceuticals and consumer staples, have evolved into large-capitalization companies. Furthermore, data uncovered by research into smaller companies can add significantly to our understanding of underlying conditions in emerging-market economies.

We feel the potentially negative aspects of smaller-company investment are manageable. These include a costlier research effort, information shortfalls, increased volatility (particularly over the short-term) and limited liquidity. Investing can sometimes require patience, but we think our long-term focus helps to manage these risk factors.

Moreover, the sheer number and variety of opportunities permits diversification2; our research team (as of September 2013) has identified approximately 21,500 companies within our emerging-markets, smaller-company universe. We see the information deficit as more of a potential advantage than a problem. When knowledge is scarce and hard to access, valuation anomalies can arise, and we believe our research methodology leaves us well placed to uncover such opportunities. We think the strong local presence of our emerging-markets team is also a big asset, with members currently located in 18 cities across Asia, Central and South America, Europe, the Middle East and Africa.

With these factors in mind, we believe investors concentrating only on larger-market constituents may miss out on some of the most dynamic areas of emerging-market economies. Detailed, stock-focused research aimed at identifying the drivers of company performance and profitability is a crucial investment process in this environment, in our view. Thus, we believe smaller companies represent a distinct investment opportunity, particularly for long-term investors seeking to capitalize on the dynamic growth in many emerging markets.

1. Source: African Development Bank, “The Middle of the Pyramid, Dynamics of the Middle Class in Africa,” April, 2011.

2. Diversification does not guarantee profit or protect against loss.

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