June 18 (Bloomberg) -- Emerging-market small-cap stocks seem reminiscent of those old Miller Lite commercials that claimed the beer not only tasted great but was less filling.
According to financial research firm MSCI, emerging-market small-cap stocks delivered better long-term performance than their large-cap brethren, with less volatility. That amounted to a 14.1 percent annualized return during the past decade, among the best of any asset class. They've also provided better portfolio diversification in recent years. While price movements of emerging-market large-cap stocks were in line with those of the Standard & Poor's 500-stock index 84 percent of the time in the past three years, that figure was only 69 percent for small caps.
It’s no surprise that a flock of money managers want in on the game. Some 12 mutual and exchange-traded funds now invest in emerging-market stocks with market caps of less than $2 billion, and seven of them opened in the past year. Todd McClone, manager of the William Blair Emerging Markets Small Cap Growth Fund, highlights the sector’s diversification benefits: “If you look at the broad large-cap emerging-markets index, a lot of the stocks in it are exposed to the developed world, which is in crisis or slow-growth mode,” he says. “Small caps are more exposed to domestic consumption.” That means they're less sensitive to problems in Europe and the U.S.
McClone wants to invest in companies selling goods to the expanding middle class in Asia and Latin America. His analysis of the top 10 stocks in MSCI’s emerging-market small-cap index shows that 91 percent of their revenue come from their home economies. By contrast, 58 percent of revenue from the top 10 large-cap stocks are from domestic sources. Samsung, the largest emerging-market stock, derives just 17 percent of its revenue from Korea -- much of its sales occur in the U.S., Japan and Europe.
Perhaps more surprising is that during the past 17 years the average emerging-market small-cap stock has been less volatile than the average emerging-market large-cap stock. It's just the opposite in the U.S., where small caps have much bigger price swings than large caps.
Having more return with less risk is at odds with modern portfolio theory, which posits that the level of investment risks are commensurate with rewards. “The small- and mid-cap index is more exposed to the domestic economy, so there is a higher weighting of stable consumer sectors,” explains Ashish Swarup, manager of the new Fidelity Emerging Markets Discovery Fund. “Also, there are a lot of fund flows coming in and going out of large-cap emerging-market stocks from ETFs and mutual funds, which makes them more volatile.”
Therein lies a conundrum. If hot money makes conventional emerging-market stocks volatile, what will happen as more small-cap funds join the fray? Since small stocks are illiquid to begin with, their advantages may disappear as they get more attention and fund managers exploit any pricing inefficiencies. That hot money can make them volatile. During a serious downturn, the sector has proven itself vulnerable to a liquidity squeeze. The three emerging-market small-cap funds that existed prior to 2008 lost more than the Vanguard Emerging Markets Stock Index Fund’s 52 percent decline that year.
As a first line of defense against such risks, manager Fritz Kaegi of the Columbia Acorn Emerging Markets Fund says he owns a well-diversified portfolio of high-quality growth and dividend-paying companies with low debt and reasonable valuations. He also tries to avoid some of the volatile fund flows from ETFs and mutual funds into emerging markets by "owning stocks in emerging markets but also owning stocks listed in developed markets that have emerging-markets exposure,” he says. “Those developed stocks have more liquidity because they’re not driven by hot money ETF fund flows like emerging-market stocks.”
Kaegi calls these investments "orphan stocks" because he says analysts often ignore them and have trouble understanding them. That, he says, means they can be bought at a reasonable price. One example he cites is Switzerland’s Dufry Group, which owns duty-free shops throughout Latin America.
For Fidelity’s Swarup, finding companies with good corporate governance is the key to downside protection. “The main focus of our research is looking at the company’s principal shareholder or founder and seeing how the company got its assets and how the principal shareholder got his wealth," he says. "Is he linked to politicians? Is he an honest guy? Our experience has been if there’s any sort of political linkage or acquiring assets not through traditional, transparent means, we steer clear because politics in emerging markets can change very quickly.”
Swarup also looks for companies with truly independent boards of directors and executive compensation plans aligned with shareholder interests.
Perhaps the easiest way to play defense is, perversely, to have the flexibility to invest in larger, more liquid stocks. Although Baron Emerging Markets Fund's Michael Kass -- like other emerging-market small-cap managers -- seeks companies that profit off domestic growth, he typically keeps about a quarter of his portfolio in large caps.
For example, Kass owns $50 billion Internet giant Tencent Holdings, which is about as far from a small cap as you can get. The Chinese company has 700 million users in one of the world’s fastest-growing nations. “There is no other company that has the kind of market dominance and the ability to create new products in the Internet space and monetize them in China,” he says. For Kass, it makes no sense to pass up that big of an opportunity.