Emerging Markets Gain $318 Billion From Small-Cap Stock Takeoff

As we approach the final quarter of 2023, a discernible winning strategy in emerging markets is coming into focus: investing in smaller companies. This approach has yielded an additional 12 percentage points in gains over the MSCI large-cap index for the year, positioning it for the second-best relative returns in the past 14 years. A significant contributing factor to this trend is that larger-cap companies are more susceptible to the economic challenges faced by China.

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Conversely, small-cap companies are reaping the benefits of local growth narratives, such as India's economic expansion, and the fervor surrounding investments in young enterprises engaged in artificial intelligence and electric vehicles.

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Jitania Kandhari, Deputy Chief Investment Officer at Morgan Stanley Investment Management, which oversees assets exceeding $1 trillion, remarked, "Small caps in emerging markets have demonstrated relative strength compared to large caps since the conclusion of the Covid-induced downturn. This mirrors historical instances where smaller companies have outperformed larger ones during post-recession recoveries. Robust domestic recovery cycles initially fueled this outperformance, and the subsequent underperformance of mega-cap stocks has further reinforced this trend."

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The MSCI Emerging Markets Small Cap Index, comprising 1,905 stocks with an average market capitalization of $583 million, has surged by 14.7% this year. In stark contrast, its large-cap counterpart, characterized by an average market size of $7.9 billion, has registered a modest gain of 2.5%.

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Several individual small-cap stocks have delivered impressive returns, exemplified by Taiwan's Wistron Corp. and Global Unichip Corp., which have soared by 255% and 131%, respectively, owing to their involvement in artificial intelligence development. Companies like Jindal Stainless Ltd. and Rail Vikas Nigam Ltd. have seen their valuations rise by at least 100%, capitalizing on India's robust economic growth, which is the fastest among major economies.

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South Korea's Ecopro BM Co. has achieved the most significant gains in the Bloomberg Electric Vehicles Index, surging by 204%. Brazilian education company Yduqs Participacoes SA has also seen a remarkable increase of 103%, rewarding investors who placed their bets on its post-Covid recovery and emphasis on digital revenue.

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The dominance of large Chinese companies, with 375 entries, in the large-cap index has resulted in pronounced negative effects when these firms face declines. For instance, Meituan, down 29% this year, and JD.com Inc., down 43%, have dragged down the entire index. Similarly, India's Adani Group companies faced scrutiny and negatively impacted the index following allegations of governance and transparency issues raised by a short seller's report.

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Ashish Chugh, a money manager at Loomis Sayles & Co., highlights that the outperformance of small caps in emerging markets over large caps can be attributed, in part, to the country bias. Portfolios that reduced exposure to China while prioritizing investments in India, Taiwan, and Korea would have performed well in either category.

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However, it's important to note that while these small-cap investments offer high returns, they also carry increased risk. Emerging-market small caps are known for their volatility and tend to be the first to experience sell-offs when risk sentiment deteriorates. They have historically incurred substantial losses during events such as the dot-com bubble burst in 2000, the 2008 financial crisis, and the 2018 US-China trade war, with the MSCI small-cap index consistently underperforming its large-cap counterpart by around 30% during each of these downturns.

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Furthermore, the small-cap sector faces challenges related to lower levels of regulation, political interference, and governance issues. Even in larger economies like India, such stocks can be susceptible to market manipulation, leaving retail shareholders with underperforming investments.

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For small-cap stocks with sound management and a solid business plan, the next catalyst for growth could come from central banks preparing to lower interest rates. This new growth cycle may prolong their outperformance and alleviate concerns among investors regarding the impact of China's economic slowdown on larger stocks, as noted by Nenad Dinic, an equities strategist at Bank Julius Baer in Zurich. Dinic emphasizes that the backdrop of lower borrowing costs is particularly beneficial for small caps, as they often rely more heavily on debt financing compared to their large-cap counterparts.

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