The Changing Landscape of EM Small Caps

Jerry Zhang and Prashant Paroda of Berkeley Street Emerging Markets Equity Team at Wells Fargo Asset Management

Changing Landscape of EM Small Caps


Emerging market small caps are increasingly professionalising, attracting more experienced management teams who are able to improve margins, cut costs and allocate capital better. We talk to Jerry Zhang and Prashant Paroda of Wells Fargo about the drivers behind this trend.

Emerging market small caps are increasingly professionalising, attracting more experienced management teams who are able to improve margins, cut costs, negotiate better funding terms and allocate capital better.

This trend is driven by two key aspects, Prashant Paroda, Associate Portfolio Manager with the Berkeley Street Emerging Markets Equity Team at Wells Fargo Asset Management says in an interview with [i3] Insights.

The first driver is a changing of the guards in family businesses. Paroda expects that in the next decade we will see a generational change in management at many of these businesses.

“We see that in the next decade there will be a lot of patriarchs and matriarchs retiring, because they are approaching 60 or 70 years of age,” Paroda says. “For small cap companies, there is often the question of whether you pass it on to the next generation or whether you hire a professional manager?

“These families often control more than 50 per cent of the stock and so it is a big decision for them. But often you will find that the next generation is not interested in running the business. They would rather sit on the board and hire professional management teams.

“We think that is a very interesting theme, because what happens is that a professional management team will look at the business in a new light, they look at broad opportunities, better capital allocations, reduced costs and improved margins,” he says.

Bringing in fresh management with new ideas and deep experience can lead to a positive re-rating of these small cap names, Paroda says.

“Suddenly, you see their growth becoming a little bit faster and their margins are improving so you have an earning acceleration. The stock market usually rewards this with a higher multiple after some period of time,” he says.

“To give you an example, there is a hospital company in our portfolio, which is currently going through this transformation. It was a family-owned business and it was actually suffering from a decline in profits and flagging morale, but when the new management came in they took care of finance and resourcing. They reduced costs across the board and they simplified the governance structure and they helped to improve the relationship with their doctors and vendors.

“They also had a diagnostic business which was underperforming for years and steps were taken to improve that business as well. So our focus is to catch as many of these management change stories early in the cycle,” he says.

End of the Golden Era

A second driver of the increased professionalisation of small cap businesses in emerging markets is the realisation that the Golden Era of 2000 to 2010 is not coming back anytime soon and businesses will need to work harder to create shareholder value and earn their valuations.

The euphoria about the prospects of the emerging markets in the early 2000s coincided with a long period of poor returns for US stocks. Investors sometimes refer to this period as ‘The Lost Decade’ for US stocks.

This is aptly illustrated by the performance of the S&P 500 index, which returned negative 2 per cent over the 10-year period from 1999 to 2009, even with the reinvestment of dividends.

“Emerging markets in 2020 are very different from EM in 2010,” Paroda says. “I remember that in 2010, everyone was talking about the ‘Lost Decade for the US’. People were asking: ‘Should we even invest in the US equities?’. Then, the next 10 years the US massively outperformed,” he says.

“I think now people have been incredibly negative about emerging markets, so we as investors feel a lot of froth is out of the system. If you look at where the EM small cap index is trading versus global or US small cap indices, it is at a historical discount.

“We think we are at a point where a lot of the froth is out of the market, expectations are modest and valuations have reached a very interesting point.

“And when we talk to management teams, they’ve realised that too. When the multiple was a lot higher, everyone thought it was their god-given right to deserve that multiple. But now that multiples have come down massively, they’ve got to work harder to create value.

“What I would say about this management transformation, where a lot of patriarchs and matriarchs are turning 60 and 70 and kind of retiring, they realise that this is not 2010 when investors were really excited about the asset class and that they won’t be gifting their companies [to the next generation] at 40 times price/earning ratios.

“Now, it is more like 14 times PE. They’ve realised the importance of creating value for all shareholders and only then will they be rewarded. It is interesting to see that change,” he says.

Paroda also notices a more proactive approach from small businesses, which actively seek out advice on how to lift up their companies.

“Some seven or eight years ago, we never received calls from management teams, saying: ‘Hey, I’ve got this great business and I see you are rewarding my competitor at 20 times, why am I trading at 15 times? What do I need to do to change that valuation?

“You see a lot of small cap companies professionalise and employ investor relation specialists. The whole landscape is changing,” he says.

Moving Online

Currently, the coronavirus pandemic is still raging around the world, causing massive disruption to businesses and economies as a whole. At the time of writing, the United Kingdom and France experienced record new infection rates, while in the United States the rate was increasing again too.

Yet, despite the uncertain and chaotic period, some companies have benefited from the widescaled lockdowns and the move to working from home.

“Some companies are benefiting significantly from the pandemic, for example online education and there are these software-as-a-service companies,” Jerry Zhang, Managing Director and
Senior Portfolio Manager with the Berkeley Street Emerging Markets Equity Team at Wells Fargo Asset Management tells [i3] Insights.

“With the pandemic, no one is going outside to the stores, so for a lot of the vendors it is mandatory to have a storefront on WeChat, for example. Those are opportunities for the service providers and we invest in these software companies that have seen a huge increase in demand,” Zhang says.

A trend that has been longer in the making is the rise of small scaled property management companies in China, Zhang says.

“In the last 12 to 15 years, China has built huge apartment complexes, whole new districts, but who is going to manage these new properties? So suddenly, it is a great opportunity for entrepreneurs. These management companies tend to be small, but in the future there will likely be a lot of consolidation,” he says.

The team also plays into the rise of the Chinese middle classes and the increased domestic consumption that has resulted from this. They have been long term owners of sports apparel company Li-Ning.

“They have Adidas and Nike in China too, but the reason we stuck with this company is because it is such a huge market and the position that they have in it,” Zhang says. “We talked to the chairman and the reason why he was willing to invest and had the patience to invest is because he saw the future of the Chinese market to be as big as the US plus Europe. We think he is right.”

Often when discussing China, the topic of investing in state-owned enterprised (SOEs) is unavoidable, but in the small cap space this is different considering the size of business they invest in. “There are not many SOE small caps, SOEs tend to be huge utility companies,” Zhang says.

Yet, even at the larger end of town he says an increased professionalisation of management structures and incentives.

“At some point, the government will have to decide whether they will have a lot of interference or whether it is more a Singapore-Temasek model, where, as the owner, you just set the ROI and let the manager to achieve that,” he says.

“China is going through this and in the last couple of years we’ve seen progress where they are willing to give options to the management and incentivise them to align interests. China Mobile and Tsingtao Brewery, for example, have implemented stock option programs for the first time.

“But this is not for small caps, this is for the large companies. Small caps are generally privately owned companies where the entrepreneurs incentive is alligned with the minority shareholders to create value,” Zhang says.

Supply Chain Diversification

The disruption caused by the pandemic has made many businesses realise they need to diversify their supply chain as the dependence on one source has proved to be a key weakness during lockdowns.

But Paroda says that the trend towards a more diversified supply chain, which often means moving away from production in China, was already underway before the start of the pandemic.

“Prior to COVID, there was the trade war and there was talk about diversifying your supply chain, especially if you were overexposed to one country,” he says. “But I think that the supply disruption that happened under COVID-19 has definitely underscored the need for firms to diversify their sourcing of products.

“We believe that there will be several hosts of winners and losers and this will be a multi-decade trend. Some of them will be low-cost labour countries, such as India and others in Southeast Asia,” he says.

In fact, the Indian government has been actively seeking to boost domestic manufacturing and protect small and medium-sized businesses from foreign competition, which has helped small caps. For example, only suppliers in sectors that have sufficient local capacity and local competition will be allowed to bid for government contracts.

“There are several industries in India where the government is encouraging them to make it in India. One of them is the consumer electronics space,” Paroda says.

“If you take something like smartphones, for example, if you look at the Chinese manufacturing companies and Samsung they together have more than 80 plus per cent market share in India. The government has recognised that and started to impose duties on phones being imported from China.

“This has given a boost to several local industries, for example the local manufacturing and assembly companies in India. The local mobile phone manufacturing industry in India has grown from 50 million units to over 250 million units a year in the last five years.

“What is happening is that these Chinese brand owners are making [phones] in India, rather than importing stuff from China. So they are teaming up with local assembly and manufacturers and creating a whole supply chain in India, so they can manufacture in India.

“We think this is a great opportunity for some of these companies to expand. And not only will there be a manufacturing hub within India, but these Chinese manufacturers can use them as an export hub to export out of India to other parts of the world,” he says.

This is a thematic that can’t be exploited through large companies, Paroda says. It is really a small caps play.

“You can’t really benefit from this opportunity by investing in Samsung or Xiaomi, because Samsung and Xiaomi is are diversifying their supply chain too. But there are several companies in the small cap space that will benefit from this. We think this is something that will be a big trend over the next decade,” he says.

The Recovery

The pandemic has not yet lost any of its momentum in spreading around the world, and in many places the situation looks very dire. India, for example, has recorded 90,000 deaths and has well over 5 million infections. This number is only dwarfed by the US, which has passed the macabre milestone of 200,000 deaths.

But at some point the pandemic will be brought under control and economies will recover. If history is a guide then small caps tend to be among the first beneficiaries of a recovery.

“If you look at any downturn, and you can take 2008 as an example, investors typically position for domestic consumption recovery plays post any major financial crisis,” Paroda says.

“One of the interesting parts of the MSCI EM Small Cap index, which determines our investment universe, is that if you add consumer discretionary, consumer staples, industrials, health care and real estate together, all of those sectors that typically do well in a recovery, they make up nearly 51 per cent of the index. But for the large cap index it is only 36 – 37 per cent,” he says.

“What we find is that if you want to have this domestic consumption recovery play, people position themselves into small caps. Now, small caps are also from a valuation standpoint trading at a discount to the large caps. If you look at price to book ratios, or a forward price to earnings ratio.

“So we think they are positioned in a way that they will outperform and if you look at 2008, for example, small caps underperformed in 2008 by 5 per cent, but the outperformance in 2009 was more than 35 per cent versus the large cap index.

“We think history might repeat itself here,” Paroda says.

This article is paid for by Wells Fargo Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.


[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.