Despite this, EM equities remain underrepresented in global indices by market cap. Many investors are structurally underweight due to index composition and a bias towards domestic markets. There’s also a belief that EMs are a ‘risky’ asset class. This is particularly true for EM small caps, which rarely feature in asset allocators’ portfolios.

We believe investors who overlook EM small caps are missing out. Here, we explain why.

EMs at an inflection point

EM equities, especially small caps, offer diversification away from developed markets (DMs). The latter is heavily skewed to the US economy and an increasingly narrow band of technology stocks.

Over the last decade, US earnings have driven DM outperformance. We believe this is changing. We are seeing indications that the US economy is starting to wane. At the same time, EM economies and capital markets are at a macro and micro inflection point. Following 10 years of underperformance, fresh drivers are revitalising equity markets.

One area to highlight is global capital expenditure (capex). A substantial part of this spending goes towards purchasing tangible assets produced by EM countries, including computer chips and car engines. After years of underinvestment, capex spending is set to ramp up. This will be driven by ‘nearshoring’, the green transition and a technology revolution.

EMs also look relatively attractive from a macroeconomic perspective. In the US, years of unorthodox policy have left its debt-to-GDP ratio at an eyewatering 112%. This compares with 65% for EMs. In the corporate world, US net debt-to-equity is 77%, while it’s 24% in EMs (2). Many US companies used this debt to fund share buybacks, which helped sustain the US market performance over the past decade. It is unclear what will drive the next leg-up in US performance.

EMs, by contrast, have delivered a prolonged period of fiscal discipline and high real rates. Company balance sheets are robust, and inflation is under control in many nations. Notably, EM central banks are poised to cut rates ahead of their DM counterparts. Brazil and Chile have already pulled the trigger.

Together, we think these divergent factors will end a decade of consistent US market strength and spur a marked increase in EM earnings.

Reasons to consider EM smaller companies

The EM small-cap universe is broad, boasting over 2,500 companies with a market cap of under US$5 billion (3). That’s nearly twice as many companies as the MSCI EM large-cap Index. Small caps are also more diverse by sector and country. Despite this, they represent only 1% of total client allocations, according to eVestment. So, why should investors consider a small-cap allocation?

Outperformance potential

Source: Bloomberg, January 2024

As Chart 1 and Table 1 show, EM small caps have an impressive long-term track record, outperforming EM large caps, global small caps, and numerous DM markets. Since 2021, they’ve delivered twice the return of EM large caps. And, while past performance doesn’t guarantee future returns, we think the economic tailwinds set to blow through EMs should continue to propel this outperformance.

Risk reduction

There’s a widely held misconception that EM small caps are highly volatile. However, the universe has lower volatility than DM smaller companies, and other regions (4).

Source: abrdn, October 2023. 

This makes sense. Global ownership of EM small caps is low, while the market is relatively difficult to access. Then there are index weightings. The top 10 large-cap stocks represent 23.2% of the EM large-cap index. This compares with 3.2% of the small-cap top 10 (5). As a result, the small-cap index is more resilient to swings in global liquidity.

Diversification benefits

As for country weightings, while China dominates the MSCI EM Index, India features prominently on the small-cap index. With China and the US at loggerheads, India is benefiting from shifting supply chains and renewed internal investment. This creates good long-term opportunities with less geopolitical risk. On a sector basis, financials make up a large portion of the EM large-cap index. By contrast, industrials and real estate firms have the heaviest weightings in the small-cap index. These sectors are likely to benefit from increased capex spending.

Exposure to EM small caps helps EM large-cap investors diversify their portfolios and spread investment risk across sectors and the market-cap spectrum. For global small-cap investors, EM small caps offer exposure to fast-growing markets such as India, Taiwan and South Korea.    

Source: MSCI, September 2023

Major themes driving EMs

Several structural themes are igniting EM small caps. Chief among them is ‘nearshoring’. This involves companies moving their supply chains closer to their end-consumers. Indeed, US firms are increasingly shifting operations from China to Mexico. Smaller companies like real-estate developer Vesta are set to benefit from this trend. The firm expects to deliver double-digit growth over the next three years, as US businesses snap-up industrial warehousing.

A technology revolution is also boosting EM earnings. Large-cap names like chipmaker TSMC are well-known, but there are also numerous small-cap firms with niche, world-class expertise. Alchip, for example, designs the essential circuits that power the high-performance computers required to operate AI platforms like ChatGPT.

Monumental changes are underway to combat the effects of climate change. Industries old and new are being transformed. Many EM small caps are leading the fight in areas like electric vehicles (EV) and carbon capture. A name to highlight is KSOE, the world’s largest shipbuilder by capacity and the leader in green shipping. Its future looks bright, as regulations force shipping companies to lower emissions and use the kind of alternative propulsion systems in which KSOE specialises. China’s ZS Driveline is another exciting green transition name. The vehicle component company plays a key role in the EV supply chain, with a 70% share of China’s ‘neighbourhood’ EV market (smaller, short-trip vehicles that attract government subsidies).

Lastly, small caps are exposed to EMs’ rapidly growing and increasingly affluent middle class. This cohort has money to spend, bolstering property ownership and consumption. Potential beneficiaries include Prestige Estates, which is helping reach unmet housing demand in India’s expanding cities. Crucially, EM small caps offer unique exposure to these themes not found in the large cap index.

Final thoughts…

After a decade of underperformance, we believe the time for EM equities has arrived. The economic landscape is improving and compares favourably with DMs. EMs are also at the forefront of the major themes that will shape the future, from the energy transition to the technology revolution. EM small caps offer unique exposure to these themes not found in the large cap index.

Of course, not all companies are equal, so we’d advocate an active approach to EM small-cap investing. In the world of EM small cap, company information can be patchy or of poorer quality. A fifth of companies have no or only one sell-side analyst coverage. We believe investors on the ground can help solve this issue. That’s why, at abrdn, we have over 50 EM equity investors based across seven offices, from Sao Paolo to Shanghai. They provide the kind of firsthand insights that we believe can help us successfully navigate this fascinating asset class.

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.

MSCI

The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI” Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com)