We continue to monitor the market impact as the coronavirus, originating from Wuhan, China, spreads to other parts of the world. While the number of new cases has slowed in mainland China, neighboring governments in Asia have closed borders and shut down large parts of the economy in an unprecedented move to curb the outbreak. Meanwhile, the rate of infections continues to rise in the West.
One thing is clear: Given the seriousness of the health issues surrounding COVID-19, most, if not all governments in general have prioritized health over the near-term economic impact the shutdowns taking place in many countries has caused. This was clearly not the assumption even as far as a few weeks ago.
It’s a stark reminder of how quickly things can change. We believe emerging market small-capitalization (cap) stocks can offer fertile ground for active managers like us who focus on risk management and long-term growth drivers.
Market Challenges for Small Caps
Emerging market small-cap stocks have had some performance challenges in the first quarter of 2020. Based on earlier experience with China and South Korea, most of the coronavirus lockdowns in other countries or regions are likely to be in place for at least a month.
But when we consider Asia and the investment opportunities therein, it broadly follows a “first-in, first-out” situation. China’s economy is starting to recover; businesses are finally coming back to 80%-90% from their normal utilization levels, be it in information technology (IT), consumer, e-commerce or manufacturing.
The second wave of the virus in South Korea was dealt with swiftly and brought under control, which meant we saw companies in manufacturing come back online quite quickly. In our view, part of this has come from the recovery we’ve seen in China, which is one of the main importers for some major Korean companies. Meanwhile, India was a bit late to react, and is currently in the midst of a lockdown.
We’ve seen knee-jerk reactions from investors, who have pulled out of stocks in an effort to avoid risk. Consumer discretionary stocks, such as movie theater chains and restaurants, have generally seen the most impact, as expected.
While it’s a challenging time for investors, we remain sharply focused on small caps within the emerging market space that we believe are more agile, better prepared and well-managed to weather the storm. On a company level, we are concentrating on those that can survive under new economic scenarios and are avoiding those where business impairment could turn permanent in nature.
The current crisis will impact most, if not all, companies to some extent. The question is whether they are viable or significantly impaired. In our view, risk management during this period is very important. Heading into this crisis, we had an aversion to companies with a lot of debt, or those companies in what we’d consider to be challenged countries, such as Turkey, Argentina, Pakistan, South Africa or Nigeria, to name a few.
Compelling Growth Opportunities
Our core philosophy remains unchanged. We look for good-quality companies with sustainable earnings power. As active managers, we think there are significant opportunities in emerging market small-cap stocks that investors won’t find in larger-cap stocks. In our view, emerging market small caps can offer the type of exposure that draws many investors to emerging markets in the first place, including domestic demand, favorable demographics, local reform initiatives and innovative, niche products.
The sheer size of the emerging market small-cap investment universe is something to consider. We have found that a disproportionate number of domestic retail investors with shorter investment horizons hold these stocks than foreign institutional investors. As a result, emerging market small caps are traded more frequently and are generally liquid.
With the current environment taken into consideration, we’re focused on finding stocks at a discount to their intrinsic value. For us, an ideal small-cap investment opportunity is a company which has a defendable competitive position. Times like these emphasize the importance of determining long-term trends; we are looking for companies with low levels of financial leverage and debt that can survive shocks like the one we are experiencing.
Environmental, Social and Governance (ESG) Steers Investors
The world is changing in a few rapid clicks, and is one of the many reasons why we incorporate ESG issues into our investment process. While the coronavirus provides an example of an ESG risk in regard to issues such as supply-chain disruptions and disaster preparedness, there are other long-term factors we also are considering, including climate change.
An increasing number of investors realize climate change issues will likely have long-term implications, especially for the business community. We’re particularly interested in companies that produce goods or services that meet the changing needs of environmentally conscious consumers. For example, companies involved in solar and related materials for green energy construction.
We also favor companies that meet the demands of emerging market consumers, who now have more disposable income than before. For example, fitness-tracking products, particularly during this time, are becoming more popular as consumers become more health conscious. Some even measure quality of sleep and heart function.
At the end of the day, the case for emerging market small caps has always been about the domestic exposure, growth opportunity, and the sector exposure that aren’t always as readily available with large caps. In our view, some investment themes such as premiumization, technology, the under penetration of e-commerce and health care stand to become even more popular as the emerging market middle glass grows.
With no end-date in sight some countries’ lockdown periods, we’ll be keeping our eyes peeled for any permanent consumer behavioral changes as social distancing becomes more normalized.
To get insights from Franklin Templeton delivered to your inbox, subscribe to the Investment Adventures in Emerging Markets blog.
Important Legal Information
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
What Are the Risks?
All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. The technology industry can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants as well as general economic conditions. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile.