Considering small and mid-cap and emerging and frontier market equities

By Channel Capital | More Articles by Channel Capital

Large cap developed market stocks often comprise the lion’s share of a global equities portfolio allocation. But the shifting international landscape, and the stunning performance of certain parts of the market over the past decade, mean it’s time to reflect on optimum allocations for this asset class.

This was the focus for the global equities discussion held as part of Channel Capital’s Asset Allocation virtual series, with the session exploring the opportunities in global small and mid-caps and emerging and frontier markets.

To set the scene, large-cap US equities have outperformed for 10 years, with the US S&P 500 Index returning more than 250 per cent – almost double the performance of the MSCI World Index, which returned 130 per cent – over this time. Large-cap US equities have also beaten the Russell 2000 small cap index, which produced a return of 150 per cent over the same period. Emerging markets have delivered investors a return of 77 per cent over the past decade, also below the return from large-cap US equities. Additionally, the tech-heavy Nasdaq index has risen by more than 500 per cent over the past decade.

This has led to market concentration in technology stocks and US equities, which now represent two thirds of the MSCI World Index.

AGAINST THIS BACKDROP, THE QUESTION FOR INVESTORS IS, HOW CAN GLOBAL EQUITY ALLOCATIONS BE OPTIMISED GIVEN CURRENT MARKET CONDITIONS?

The potential in emerging markets

“Having benefited from a strong US tech allocation in our portfolios, over the past few months we’ve broadened our exposure to global equities, adding global small- and mid-caps and emerging markets, which have the highest 10-year forecasts of every asset class we’ve modelled. These are specialist asset classes where active management can add significant value,” panellist Tom Schubert, Drummond Capital Partners’ Managing Partner explained at the top of the session.

Although US equities have outperformed since 2010, the same cannot be said for emerging markets. Emerging markets delivered above-average returns before the GFC thanks to globalisation and the emergence of China. Since then however, although emerging economies have continued to grow, their equities haven’t matched this performance.

Panellist John Malloy, RWC Partners’ Co-head Emerging and Frontier Markets, explained there were a number of reasons for this, including slower global growth, the US and Europe’s uneven recovery path post GFC, overvaluation of some emerging markets currencies, faltering US trade relations and, more recently, the pandemic. “Those issues held back emerging markets. But I would say we’re coming out of that.”

The low interest rate environment is one reason why there are opportunities in emerging markets, says Malloy. “Central banks have contributed US$7 trillion to markets in quantitative easing in the past year. Interest rates are going to be at very low levels for some time. But there’s potential to pick up yield in emerging market local fixed-income assets. The value of the Brazilian real is down by 25 per cent year to date, the Russian rubble is down by about 20 per cent year-to-date, the South African rand is down by 15 per cent and the Mexican peso is down by seven per cent. These currencies are becoming very, very competitive. That’s a big opportunity.”

Malloy says there is also growth opportunities in emerging markets in sectors such as technology and e-commerce. Latin American online marketplace and digital payments leader Mercado Libre is an example. “Ecommerce in Latin America, which has a population of 600 million people, makes up just two to three per cent of total commerce, which is a huge growth runway for Mercado Libre.”

Commodities have traditionally been central to emerging markets’ economies and this is likely to continue.

Says Malloy: “We are big believers in the reflationary environment, albeit not straight away given some countries are still in COVID lockdown. But fiscal stimulus is going to continue and likely accelerate, which will impact real assets, buildings, roads, rail, 5G technologies and electric vehicles. Commodity values will benefit from this. Steel and cement prices are increasing globally and residential building is driving demand for lumber. We think copper is very interesting, which benefits Andean and African producers. There are also opportunities in soft commodities like soybeans. The entire global commodity complex is going really well.”

It’s a small world

Turning to opportunities in global small and mid-cap investments, panellist Ned Bell, Bell Asset Management Chief Investment Officer, noted there have been a number of structural headwinds that have dampened the performance of small cap stocks. These include the rise of passive investment, requiring fund managers to allocate to large stocks, as well as the strong performance of tech stocks through COVID.

“Over 20 years, the MSCI World Small Cap Index has outperformed by a couple of per cent a year. But over the last three years it’s lagged by about 3.5 per cent. The question is whether there are fundamental reasons for this or whether this is due to lack of fund flows,” says Bell.

“From a revenue perspective, smaller company revenue has grown at about 8.8 per cent a year over the last five years, versus the MSCI World Index’s revenue growth of about 8.2 per cent. COVID has also had an impact on small cap stocks,” he adds.

Bell expects smaller companies in sectors such as healthcare and consumer discretionary to do well in the near-term, given the current focus on health and the pause on international travel.

“Companies like outdoor goods firm Yeti are benefiting from people camping and going on road trips. Businesses like US rural lifestyle retailer Tractor Supply are benefiting as people try to get out of the city. There’s a lot of interesting sub-themes emerging from the way consumers are behaving that you can more easily access via small- and mid-caps.”

The outcome of the US election should also benefit emerging markets and small and mid-caps as a result of strengthened global trade relationships. It’s also expected companies in these markets will be more willing to invest into 2021 and beyond as we come out of the pandemic, which should also benefit assets.