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Graham Macdonald MBMG International Ltd.


Small cap emerging markets favour the brave

So why should investors invest in small cap shares, especially those in the riskier area of the market, namely emerging markets?

Have we not forgotten the lessons of 2008 in which liquidity became so scarce and small cap shares collapsed as investors ran for the exits?

Investors need to be aware of this as liquidity remains an issue - especially in smaller emerging markets. However, this also creates an opportunity as investors shy away from these shares leading them to sometimes trade on lower multiples, or not be researched at all.

Small Cap Performance

Source: Schroders, April 2012

By now most market participants are terribly familiar with why emerging markets offer long term investment opportunities, be it strong growth, lack of debt, resources, rich economies, etc.

What many investors may not be aware of is that small cap investing might be the better way to achieve returns from this long term economic growth story.

In a recent meeting with Matthew Dobbs of Schroders, this point was made incredibly clear. Just to give the meeting some colour, Matthew Dobbs is quite easily one of the most impressive fund managers around; an out the box thinker, who truly sees life from a different perspective.

S&P Breakdown - Emerging markets

Source: Schroders, April 2012

It was largely due his passion and knowledge on small cap companies that he piqued my interest in emerging market small cap investing. Matthew is the Head of Global and International Small Cap Equities at Schroders and runs a number of successful funds.
In a well diversified equity portfolio, small cap shares deserve a place, especially if one has a longer term view (as can be seen by the huge outperformance over the long run in the Small Cap Performance chart this page).

Small cap shares concentrated in emerging markets also offer the investors a more balanced approach to investing in these economies, as they tend to cover a greater mix of sectors, unlike the indices which tend to be dominated by a few large players.

To illustrate this point, the Russian index is dominated by five companies which make up about 45% of the market, with three of the largest being state owned, namely Gazprom, the world’s largest gas producer, Sberbank, the largest Russian bank, and Rosneft.

China is a little less concentrated, with its top five companies making up a bit less than 30% of the market, four of them being PetroChina, Bank of China, China Construction Bank and the Agricultural Bank of China.

It is not only the concentration of a few large companies that dominate emerging stock markets, but it is also the fact that the top end of the markets is predominantly in either finance or commodities, usually oil. The S&P Breakdown shows how much more heterogeneous the small cap sectors are in emerging markets.

A very important point to note for those wanting to invest in emerging markets is that small cap shares tend to be more domestically focused and 80% are less directly impacted by currencies and global trade.

Furthermore, if one considers the rise of the middle class in emerging markets, with predictions showing that by 2030 over 90% of the world’s middle class consumers will reside in the developing markets, relative to 50% today, the case for emerging market small cap becomes even stronger.

There is also a huge choice, some of 2,894 potential investee companies, 1,747 of which have market capitalisations in excess of $300m (including Developed Asia).

Small cap shares offer investors an earlier stage in their growth path. Remember, Microsoft and Apple were not always the behemoths they are today. Small caps also offer a purer exposure to new technologies, products and market segments. What is also important is that this sector of the equity space also offers the ability to buy focused and directly incentivised management, as many would have been born out of private companies.

Looking at all the positives for investing in emerging market small cap stocks, one would be inclined to have a fairly large portion of one’s portfolio allocated to this segment of the market. However, valuations relative to large cap stocks are not as cheap as they used to be and hence one needs to be aware that the margin of safety is less than it used to be.
Investors need to be aware that when investing in small caps stocks there is risk and, what is more, emerging market stocks also offer risk and here you have a scenario of small cap emerging market stocks! So please be careful.

But if we are going into a world of slower growth for developed economies then it is more than conceivable that most of the growth will be harnessed in emerging markets. So, taking a bit of a risk, provided it is part of a well diversified equity portfolio should reward investors.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]


Holland(ais)e Sauce

Most anthropological research data and psychological or behavioural studies tend to reinforce the idea that human activity always has resulted and probably always will result in there being leaders and followers or hunters and gatherers or Alphas and the rest of the pack. These universal human instincts can be seen everywhere from the rough and tumble of school playgrounds to the benches of the House of Commons or the Senate to the stock market trading floor (although all too often those environments can sometimes resemble each other).

Since the time of ancient Greek Cycle theory, history has taught us that if the Alphas become too dominant, too bullying or too self-serving, leaving too great a proportion of the pack excluded, disenfranchised or simply left hungry then things tend to turn very ugly.
Recent thinking has tended to view such occurrences as being almost exclusively within the domain of under-developed or still developing democratic systems rather than in open or seemingly functional democracies in which the opportunities exist for the majority to regularly exercise their rights to representation.

Such complacency can be dangerous. Germany is today the epitome of pragmatic stability but a generation, some of whom are still alive today, witnessed the aftermath of World War I when the establishment of a Soviet regime in Berlin seemed likelier than not as Germans descended into a class struggle that fell only marginally short of full scale civil war.

The dissatisfaction that was unleashed was exacerbated by hyperinflation which neither a national hero nor a socialistic government could prevent leading to the overthrow of the democratic machinery of state by fascism - although as Martin Wolf has pointed out in the FT, it was only when the concerted foreign powers imposed austerity that Hitler was able to seize power.

At that same time, the Alpha-dog battle for global supremacy was actually being fought in the economic war zone of the new world rather than the bloody trenches of Europe: no-one knew whether it would be the USA or Argentina which would dominate the future. Whilst that argument might seem ridiculous to us now, the outcome was largely shaped by Argentina’s retreat into government by self-interested despotic military regimes which restricted the economic potential of the educated population and resource rich country. Meanwhile in America, the democratic system sustained despite scares such as the attempted Du Pont coup attempt to overthrow the government.

As Sir Winston Churchill once said, “Democracy is the worst form of government except all the others that have been tried,” especially, in conjunction with its close relative, capitalism. However, participation of the masses in the selection of government is the most sustainable way of allowing individuals to achieve their creative, productive and economic potential.

To that end, notwithstanding that we do not have a single political bone in the entire MBMG body, we were heartened by the recent European election results which we had both hoped for and expected. The inevitability with which the French electorate rejected the morally bankrupt policies of le Napoleon Sarkozy and the desperation which drove the Greek people to extremes of both right and left should surprise no-one. Greece, the cradle of democracy spent the 20th century seemingly in perpetual default under a series of authoritarian junta before being subjected to an inept government imposed upon it by the joint will of the ECB and Goldman Sachs.

The markets have not taken this change so well - after all it threatens to destroy their ability to continue indefinitely extending and pretending. Our concerns are rather different than those of the market.

Despite his rhetoric or the assurances of Chancellor Merkel, we doubt whether Monsieur Hollande will have the fortitude to implement the necessary transfer of wealth, which his election celebrations seemed promise, back from the German elite to the EuroZone rank and file.

We are also not sure that the Greek protest vote will release enough adequately focused pent-up frustration to prevent a serious blow-up sometime down the track. Nor is this just a specifically Greek, GIPSI (Greece, Ireland, Portugal, Spain or Italy) or even European problem.

Globally, the last three decades has witnessed a transfer of wealth to too small a minority who are not spending enough. This has left an embittered and angry majority whose voices need to be heard if we are to escape a protracted national, regional or global conflict. Both democracy and capitalism will almost certainly survive but how badly will they be damaged? How bloody will be the resolution of current day imbalances?

The one thing that capitalism needs right now is the injection of a modicum of socialism - a transfer mechanism to get us back to a more balanced global socio-economy where a much larger portion of the population is spending and borrowing (within capabilities) again. Without it, fascist or communist regimes may well be at each other’s throats again. The next step is nations staring at each other down the barrels of millions of guns and this being seen as the only alternative.

Au revoir, M. Le Petit and good riddance! Let’s just hope that Francois Hollande is not just too little, too late. But do not hold your breath!

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]