Investors who focus exclusively on large-cap equities within emerging markets (EM) may fail to capture the long-term growth potential offered by small- and mid-cap companies in developing markets. With nearly 5,000 companies above $500 million in market cap, investors have many choices among innovative up-and-coming businesses that have strong long-term growth prospects. That compares with only about 300 EM companies above $10 billion in market cap, which does not leave a lot of room for potential growth.
Further, investors whose exposure to EM comes through U.S., European and Japanese companies that sell products to consumers and businesses in developing markets are failing to maximize the potential of the EM opportunity. They are missing out on the advantages offered by innovative local entrepreneurs who may have a better understanding of the best ways to meet the needs of their home markets and customers.
Small- and Mid-Cap Companies May Offer a Smoother Ride
For investors concerned about volatility, we believe there are two viable options for potentially avoiding the boom-bust cycles that have characterized EM equities in the past. The first is to avoid passive index strategies because they are tied to benchmarks that more heavily weighted historically volatile sectors, such as commodities and financials. What’s more, passive strategies devoted to small- and mid-cap emerging market stocks are almost impossible to find. Those that do focus on small- and mid-cap emerging market companies generally lack liquidity and a deep understanding of local market context. This is something that we can acquire by spending time on the ground in those markets and with those companies.
The second option for navigating EM volatility is for investors to position themselves to take advantage of what we believe is the next wave of growth. In our view, sectors such as healthcare, consumer discretionary and technology will drive future EM growth and are less subject to the boom-bust cycles that we tend to see in commodities and banks. As such, these sectors may provide investors with a smoother long-term ride.
Investing in Future Growth Drivers
When it comes to investing in emerging markets—particularly in the small- and mid-cap space—where you’re allocated matters. The benchmarks tend to focus on areas that used to drive EM growth, not the areas that we believe will be the future growth drivers. Investing with an active manager with on-the-ground experience and an understanding of the local context makes it possible to allocate capital in a way that we believe is more forward-looking.
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