At Templeton Emerging Markets Group, we believe emerging market (EM) small-capitalization (small-cap) stocks represent an attractive proposition in the current investment climate. However, there are some common misconceptions regarding the asset class that conceal key strengths we believe an active manager could capitalize on. Here, I join my colleagues Stephen Dover, chief investment officer of Templeton Emerging Markets Group, and Chetan Sehgal, director of Global Emerging Markets/Small-Cap Strategies, to talk about investing in this space.

Overall, we believe small-cap stocks in emerging markets offer attractive prospects for active managers. A multitude of mispriced securities, market inefficiencies and a paucity of research provide considerable investment opportunities, in our view.

The Current Market Backdrop

So far in 2017, EM small-cap performance has been buoyant, with many countries and industries in the asset class advancing. Confidence in the market backdrop, economic environment and corporate earnings have improved across EMs. That confidence has come despite challenges such as actual and potential US interest-rate increases, uncertainty brought about by the new US administration and global geopolitical issues.

Addressing Some Common Misconceptions Surrounding EM Small Caps

It Is Not a “Niche” Asset Class. Despite broad perceptions, in our view, EM small caps are far from being a niche investment. The asset class represents more than 20,000 companies with an aggregate market capitalization of over US$5 trillion and daily turnover of over US$40 billion, as the chart below demonstrates.1 Liquidity within EM small-cap markets is comparable to that of EM large caps.

Accordingly, we think the sheer size of the EM small-cap investment universe is a key advantage for active managers, providing abundant opportunities to uncover companies we think represent value. Ownership of EM small caps disproportionately sits with retail investors. Retail investors tend to trade more frequently than foreign institutional investors because the former usually have a far shorter investment horizon—boosting liquidity as a result. A good example of this is India, where investors have a vast number of smaller companies to choose from, and the skew of ownership is toward local investors.

A key difference between developed-market small caps and EM small caps is that EM small caps in many markets are often still significantly important locally. A market capitalization of close to US$2 billion could represent a leading company in a certain country, index or sector—perhaps a well-established business with a long and successful track record. Many of these companies are family owned or controlled, and many have stable profiles when compared with developed-market small caps.

It Is Not Necessarily a More Volatile Investment

Another key misconception about investing in EM small caps is that volatility is higher than their larger-cap counterparts. Like all investments, EM small caps come with real and perceived risks. These include greater price volatility (particularly over the short term), relatively small revenues, limited product lines and a small market share. However, many of these risks are those associated with the EM equity universe overall, such as increased volatility relative to developed markets.

An analysis of standard deviations illustrates the assumption that EM small caps are much more volatile than larger-cap EM stocks does not always hold true. (See chart below)

Although individual stocks can indeed be very volatile, the correlations2 between different EM small-cap companies are often lower, which we believe in is due in part to the expansiveness and diversity of businesses within this investment space. The same factors that might impact a South Korean television and online shopping company’s stock, for example, would not likely impact an Indian cement company. This can help reduce correlation risk at the asset-class level.

Small-Cap Opportunities for Active Investors

Overlooked and Under-researched. Not only do many investment managers overlook EM small caps, they are also notably under-researched on the sell side. This reflects not only the vast number of companies to cover, but also the relative lack of information available. Unsurprisingly, the result is that the average number of stock research recommendations for EM small caps is much lower than for larger-cap stocks.1

Also, many small-cap stocks have little or no research coverage. For a large number of EM small-cap stocks outside of the benchmark MSCI index, research availability is even more limited. This can give a critical advantage to an active manager who can directly research such companies, especially if they have people on the ground in the region to evaluate them first hand. The probability of finding a relatively unknown off-index EM small-cap stock being mispriced is far greater than for a large company with many analysts producing research recommendations on it.

Recapturing Access to Local Exposure to Complement Existing EM Portfolios

Reflecting on the general long-term success of emerging markets, as global economies and as an equity asset class, most of these countries have become ever-more integrated into the world economy. Consequently, the largest and most successful EM companies have often expanded beyond their domestic markets to export and invest globally. Accordingly, domestic factors are no longer the primary drivers of the share prices of many of these stocks. Examples of such companies can include electronics, auto-industry or consumer-related names that derive a substantial portion of their revenues from developed economies rather than those in which they are based.

In contrast, EM small caps generally offer the very exposures that originally enticed many investors to emerging markets in general. Domestic demand, favorable demographics, local reform initiatives and innovative niche products are often the primary determinants of growth.

Consequently, the sectors to which EM small-cap investors are exposed differ notably from those of larger-cap stocks. The MSCI Emerging Markets Index is disproportionately dominated by exposures in information technology and financials, as indicated in the chart below. These sectors are typically more closely impacted by global or country-level macroeconomic trends.

In addition, state-owned enterprises are often more prevalent among larger-cap stocks. While we find many such state-owned companies to be well managed, the interests of the top owners are not always entirely aligned with those of minority investors.