A case for emerging markets small cap equities Emerging Markets Small Cap An underserved asset class Spread across 24 countries and representing 80% of the world s population, the emerging markets small cap universe is broad, diverse, and full of opportunity. Historically, operational hurdles and lack of investment vehicles have presented obstacles for institutional investment in this space. In recent years, these barriers have diminished considerably as capital markets have matured. Even so, emerging markets small cap remains a widely underrepresented asset class among investors portfolios. According to FactSet, over 80% of the 5,200 publically-traded emerging markets stocks are considered small cap with market capitalizations between $100 million and $3 billion. Despite EM small cap stocks outnumbering EM large cap stocks 7:1, the number of investment strategies dedicated to the space remains limited. There are nearly 600 emerging markets equity products in the evestment database, and only 65 are actively-managed small cap products. This suggests that institutional managers are under-exposed to a huge subset of the universe. In this paper, we highlight the benefits of a dedicated allocation to emerging markets small cap. We discuss the asset class historical outperformance relative to emerging markets large cap, diversification benefits, compelling growth fundamentals, and importantly the substantial value added by active management in this fertile asset class. Further, we suggest that the recent dislocation in performance may point to an opportunistic time to introduce an allocation to emerging markets small cap.
Evidence of a Small Cap Premium Modern portfolio theory suggests small cap stocks can be expected to deliver higher returns in compensation for higher volatility and lower liquidity levels relative to large cap. Indeed, evidence of a small cap premium has been persistent in the US, developed non-us, and emerging markets. Within emerging markets for example, looking at data going back to June 1994, shows the MSCI Emerging Markets Small Cap Index outperforming its large cap counterpart 70% of the time over rolling 10-year periods by an average of 86 basis points. Figure 1 illustrates the longterm outperformance of small cap in emerging markets, developed ex-us, and in the US. FIGURE 1: small cap equities have outperformed developed market and large cap equities on average over time Long-Term Returns of Global Stocks by Asset Class Rolling 10-Year Returns, Annualized (%) Source: Investments and MSCI. Data as of 9/30/2017. Performance is calculated using monthly total returns of the identified indices annualized over rolling 10-year periods since 7/31/1996. It is not possible to invest directly in an index. Past performance does not guarantee future results. A common misperception is that emerging markets small cap s historical outperformance relative to emerging markets large cap comes at the expense of higher volatility. In fact, over longer time periods, volatility (standard deviation) in emerging markets small cap has been the same, if not lower than in large cap! The table below shows emerging markets small cap has generated superior returns with less risk (volatility) than large cap, which is reflected in its higher Sharpe Ratios over the last 5-, 10- and 20-year periods. FIGURE 2: small cap equities have historically higher risk-adjusted returns and Sharpe Ratios to emerging markets large cap equities Risk-Return Profile of Emerging Markets Equities Return 3 Year 5 Year 10 Year 20 Year St. Dev. (%) Sharpe Ratio Return St. Dev. (%) Sharpe Ratio Return St. Dev. (%) Sharpe Ratio Return St. Dev. (%) Small Cap 3.14% 14.58 0.195 4.60% 13.28 0.332 1.74% 24.72 0.054 5.82% 23.63 0.161 Large Cap 5.36% 15.86 0.320 4.24% 14.53 0.279 1.51% 23.01 0.048 5.15% 24.22 0.129 Source: MSCI. Data as of 9/30/2017. Small Cap and Large Cap are representative of the MSCI Emerging Markets Small Cap Index and MSCI Emerging Markets Large Cap Index, respectively. It is not possible to invest directly in an index. Past performance does not guarantee future results. Sharpe Ratio EAM Investors, LLC Institutional Investor Use Only 2
More recent performance points to a potential dislocation within emerging markets. Emerging markets small cap has underperformed large cap by over -850 basis points over the trailing 1-year ending 9/30/2017, as larger companies have benefitted from global growth and a weaker dollar. If you believe in mean-reversion, this suggests small cap may have some catching up to do. Potential Diversification Benefits The characteristics of small cap stocks can lead them to behave differently than their large cap counterparts. Small cap stocks tend to be more influenced by company-specific factors than broad market shifts since company profitability is often determined by a focused product set. Emerging markets small caps also offer more pure, country-specific diversification since large caps typically have a sizable mix of their sales outside of their home country. Sales of emerging markets small caps are often more tied to regional trends such as an expanding middle class, an infrastructure build-out, or a change in government policy. As an example, the largest holding in the MSCI Emerging Markets Small Cap Index at the time of writing is Kingboard Chemical at approximately 50 basis points. Kingboard has expanded from laminates into upstream production of chemicals, glass yarn and bleached kraft paper, in addition to being downstream-integrated into PCB manufacturing. The group became the largest PCB manufacturer in China after it acquired Elec & Eltek in December 2004. Kinboard Chemical is directly exposed to some of the fastest growing industries and economies in emerging markets with nearly ~90% of its revenue come from emerging markets according to Factset. In contrast, some emerging markets large cap companies, like Samsung which is a nearly a 6% weight in the MSCI Emerging Markets Index, generates less than 32% of its revenue from emerging markets. These characteristics result in emerging markets small cap s lower correlations with other equity asset classes, and therefore provide diversification benefits when added to a portfolio. Figure 3 illustrates that emerging markets small cap stocks have had a meaningfully lower correlation to other global equity segments, particularly in the US. The segment s lower correlations and higher Sharpe Ratios relative to emerging markets large cap suggest it should be risk-reward enhancing for a portfolio. FIGURE 3: small cap equities behave differently than their large cap counterparts Correlations by Asset Class Source: FactSet, Investments, and MSCI. Data as of 9/30/2017. Correlations are calculated using monthly total returns of the identified indexes since September 1996. EAM Investors, LLC Institutional Investor Use Only 3
Compelling Underlying Fundamentals The emerging consumer, urbanization, and population expansion are oft-cited growth drivers and attractions to emerging markets. With increased wealth, emerging markets consumers will use expanding incomes to purchase goods previously out of reach. As urbanization transpires, new labor enters the talent pool and creates demand for infrastructure and consumer goods. As seen in the charts below, the MSCI Emerging Markets Large Cap Index is less exposed to these trends as it is dominated by Financials (25%) and Information Technology (30%). Meanwhile, the MSCI Emerging Markets Small Cap Index would be a direct beneficiary of these trends with larger weights in Consumer Discretionary (17% vs. 9%) and Industrials (14% vs. 4%). Not only is the MSCI Emerging Markets Large Cap Index underexposed to consumer trends, it lacks any holdings to certain industries that one would expect to directly benefit from the urbanization trend. For example as of 9/30/2017, Building Products and Textiles Apparel & Luxury Goods have no exposure in the large cap index, and 25 and 58 names respectively in the small cap index. Additionally, corporate governance has been a point of concern amongst emerging markets investors. Specifically, investors often focus on the significant local government influence on large enterprises in the Energy, Telecommunications, and Financial sectors. These three sectors make up 40% of the MSCI Emerging Markets Large Cap Index vs. 12% of the MSCI Emerging Markets Small Cap Index. In contrast, smaller companies tend to be owned by entrepreneurs or families, and therefore more aligned with shareholders. FIGURE 4: small caps benefit from urbanization trends Sector Exposure MSCI Emerging Markets Large Cap Index MSCI Emerging Markets Small Cap Index Source: FactSet. Data as of 9/30/2017. EAM Investors, LLC Institutional Investor Use Only 4
Additionally, forward-looking EPS growth rates in emerging markets small cap outpace all other equity asset classes. While emerging markets small cap does trade at a slight premium to emerging markets large cap on an absolute P/E basis, small cap companies in the index are expected to grow EPS by approximately 18% next year, compared to emerging markets large cap at around 13%. Thus, as seen in Figure 6 below, emerging markets small cap trades at a significant discount on a growth-adjusted basis. FIGURE 6: small caps trade at a significant discount to emerging markets large caps on a growth-adjusted basis Key Index Statistics Emerging Markets Small Cap MSCI Emerging Markets Small Cap Emerging Markets Large Cap MSCI Emerging Markets Large Cap Developed ex Developed ex US Large US Small Cap Cap 2000 1000 MSCI ACWI IMI P/E 2018 12.51 12.05 11.91 11.82 15.34 14.67 18.33 17.56 15.66 P/E 2019 10.98 10.49 10.65 10.62 13.86 13.60 16.74 16.05 14.35 2018/2017 Growth 17.55 18.14 13.86 13.50 11.10 8.34 13.59 10.76 9.96 2019/2018 Growth 14.03 14.70 12.76 12.76 9.30 8.19 11.44 10.08 9.66 PEG 2018 0.71 0.66 0.86 0.88 1.38 1.76 1.35 1.63 1.57 PEG 2019 0.78 0.71 0.83 0.83 1.49 1.66 1.46 1.59 1.49 Source: FactSet. Data as of 9/30/2017. It is not possible to invest directly in an index. Past performance does not guarantee future results. Fertile Ground for Active Management While the aforementioned reasons alone make a compelling case for emerging markets small cap, we believe the strongest argument stems from the inherent dynamics of the asset class. A vast opportunity set, low research coverage and high cross-sectional volatility all point to market inefficiencies which creates opportunity for alpha. Figure 7 shows the breadth of the universe with more than 80% of investible emerging markets stocks less than $3 billion in market cap. This even excludes stocks with less than $100 million in market cap as they likely wouldn t have the liquidity for an institutional portfolio. FIGURE 7: The number of investable emerging markets small cap names is 7x that of emerging markets large/mid caps Emerging Markets Investable Universe Source: FactSet. Data as of March 2017. Emerging Markets Small Cap universe is defined as stocks with market capitalization between $100 million and $3 billion. Emerging Markets Large/Mid Cap universe is defined as stocks with market capitalization of $3 billion and above. EAM Investors, LLC Institutional Investor Use Only 5
Furthermore, we believe that stocks with thin sell-side analyst coverage have a higher tendency to be mispriced. Under-covered stocks have less readily available information and wider estimate confidence intervals. As seen in Figure 8 below, analyst coverage in emerging markets small cap is considerably lower than in the emerging markets mid or large cap space. In fact, more than half of all emerging markets small cap companies are not covered at all. FIGURE 8: small cap has considerably lower research coverage Research Coverage Source: FactSet. Data as of March 2017. This relative lack of coverage could be symptomatic of the segment s lower trading volumes as larger asset managers are less motivated to invest in the segment due to liquidity constraints. Consequently, sell-side coverage remains focused elsewhere and competition is limited to boutiques focused on this niche. Further fueling opportunity for active managers is the disparate nature in which these stocks behave. Figure 9 illustrates the high cross-sectional volatility exhibited by emerging markets small caps, which translates into a much wider range of individual stock quintile returns. The high level of crosssectional volatility highlights the size of the active management opportunity. FIGURE 9: Emerging markets small cap stocks maintain some of the highest cross sectional volatility of any equity market globally Cross-Sectional Volatility Source: FactSet. Last 5 years ending March 2017. EAM Investors, LLC Institutional Investor Use Only 6
Skilled, active managers can exploit opportunistic valuations to more consistently capture the full potential of the asset class. We believe an all-cap approach risks significantly diluting this possible alpha and an indexed approach misses it altogether. Figure 10 illustrates the impressive alpha that emerging markets small cap active managers have added over the long-term compared to their large cap and developed market peers. FIGURE 10: Active managers specializing in emerging markets small caps have added impressive alpha over the long-term versus their large cap and developed market peers Median Manager Annualized Alpha 4.5 1Year 3 Year 5 Year 7 Year 10 Year 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5 EM Small Cap Developed ex-us Small Cap US Small Cap EM Large Cap Developed ex-us Large Cap US Large Cap Source: evestment. Data as of 9/30/2017 shows median manager alpha within each universe. Alpha is calculated using the following benchmarks within each universe: US Small Cap ( 2000), US Large Cap ( 1000), Developed ex-us Small Cap (MSCI EAFE Small Cap), Developed ex-us Large Cap (MSCI EAFE), Emerging Markets Small Cap (MSCI Emerging Markets Small Cap), and Emerging Markets Large Cap (MSCI Emerging Markets Index). As cited earlier, emerging markets small cap as an asset class has underperformed recently. Considering the excess return generated by active managers, however, emerging markets small cap outperforms its large cap counterpart over the trailing 3, 5, 7 and 10 years, and by an average of 170 basis points. FIGURE 11: Considering added value from active managers, emerging markets small cap outperforms over the long-term Annualized Returns of Active Managers Source: evestment. Data as of 9/30/2017. Emerging Markets Small Cap and Emerging Markets Large Cap use the MSCI Emerging Markets Small Cap Index and MSCI Emerging Markets Index, respectively. Active manager returns are of the median manager in the evestment EM Small Cap and EM Large Cap universes. EAM Investors, LLC Institutional Investor Use Only 7
The Benefit of a Dedicated Small Cap Manager Many investors will readily accept the benefits of emerging markets small cap, but assume they have sufficient exposure through a single all-cap strategy. The most common benchmark among emerging markets managers is the MSCI Emerging Markets Index, which has less than 5% in stocks with market caps under $3 billion. This discrepancy results in a natural large cap bias in most emerging markets strategies missing out on what we believe is the most vibrant sector of the market. Further, placing one s entire emerging markets allocation with an emerging markets all-cap manager limits the investor s ability to monitor and control risk. The emerging markets small cap exposure is better benchmarked against its associated small cap index. This should ensure the investor s management fee is paid for outperformance, not simply beta. The investor should only pay for successful stock selection, not for an all-cap manager that is simply participating with broad emerging markets exposure. The Optimal Balance between Depth and Breadth The sheer size and rapidly changing dynamic of the emerging markets small cap universe can make it difficult for active managers to research each and every stock thoroughly. Thus, we believe a systematic and timely approach to screening the universe is paramount in helping managers identify and capitalize on those opportunities with the most potential. Behavioral investment research suggests that investors tend to discount new information and fundamental developments because of inherent conservative and representative biases. We believe this behavior typically follows a predictable anchor-and-adjust process, as illustrated in Figure 12. FIGURE 12: Investor behavior can create mispricings ATTRACTIVE ENTRY Fundamental value shows signs of acceleration Fundamental value shows signs of deterioration ATTRACTIVE EXIT Market lags fundamental value, price still high TIME» Market slow to respond to new information, price still low TIME» FUNDAMENTAL VALUE ACTUAL STOCK PRICE NEW INFORMATION Compared to the larger cap equities of the emerging markets arena, the relatively slow dissemination of information in the small cap subset can further magnify this effect. Coupled with lower sell-side coverage and dramatically fewer active managers in the space, the lags between when changes in fundamental value occur and when those changes are accurately reflected in market prices we believe are both notable and exploitable. We believe capitalizing on these attractive entry and exit points requires an investment process that can focus research efforts on the strongest investment candidates: companies undergoing positive fundamental change. The disparity between when there is a change in fundamental value to when that change is reflected in the stock price is often greatest after the release of new information. Knowing the key indicators of fundamental change and efficiently screening for those factors, we believe is essential to distilling the investment universe to a list of candidates with the highest likelihood of being mispriced. We believe that deeper, hands-on analysis of those opportunities in a disciplined and timely manner ultimately allows for the effective management of an emerging markets small cap portfolio.. EAM Investors, LLC Institutional Investor Use Only 8
Advantages of EAM Investors in Emerging Markets Small Cap Specialist in Inefficient Markets - Every aspect of our firm from team composition, to our investment philosophy and process, to our technology platform, was purpose-built to exploit the structural inefficiencies that exist in small cap and micro cap equity markets. Philosophy - Positive change-based investment philosophy has the flexibility to consider the entire universe of small and micro cap stocks across all sectors/industries. Process - Objective, disciplined, daily investment process is optimally designed to consider the full breadth of the opportunity set. Focused and timely fundamental research is essential in small and micro cap equity markets where change is dynamic and constant. Investment Team - Experienced, cohesive portfolio management and generalist research team allows for informed decisions to be made consistently, effectively, efficiently, and without sector/industry biases. Trading Team - Equity traders have an average of 20 years of experience transacting in small and micro cap equity markets using state of the art technology, and personal relationships to source liquidity and avoid eroding alpha with transaction costs. Risk Management - Risk-aware portfolio construction is designed to protect clients capital in difficult markets. Performance - Historically consistent investment performance characteristics have enabled our Emerging Markets Small Cap strategy to add +637 basis points of excess annualized return since inception, net of fees 1. EAM Emerging Markets Small Cap Composite: Growth of $10 Million Since Inception Source: Investments and EAM Investors. Inception of the EAM Emerging Markets Small Cap Strategy was 4/1/2012. Performance for the EAM Emerging Markets Small Cap strategy is shown net of fees. EAM Investors, LLC Institutional Investor Use Only 9
About EAM Investors, LLC EAM Investors, LLC specializes in active small and micro cap equity strategies in inefficient global markets. By using a time-tested philosophy and a disciplined, focused, and objective investment process, EAM believes they can add consistent alpha to their portfolios. The firm s culture is focused on teamwork, with all team members conducting research and an open office architecture promoting effective communication, debate, and real-time decision making. Portfolio managers have a long-standing working relationships and a strong dedication to each other and the investment process. Joshua Moss Joshua serves as a Managing Director and Portfolio Manager of EAM Investors, a firm he cofounded in 2007. Prior to founding EAM, he was a Vice President and Equity Analyst at Nicholas- Applegate Capital Management where he served on the firm s US Micro/Emerging Growth Team with primary research responsibilities for the Micro Cap and Ultra Micro Cap investment strategies. Prior to joining the US Micro/Emerging team, Josh was assigned to the firms Global Select team. During his tenure with the Global Select strategy, his duties included co-portfolio management and research head of the Global Consumer Discretionary Sector. Previously, Mr. Moss was with Credit Suisse First Boston as a Vice President in equity sales and investment banking. Mr. Moss has 18 years of direct investment experience. He holds an M.B.A. from the Anderson School of Management at the University of California, Los Angeles and a B.A. from the University of California, San Diego. John Scripp John serves as Director and Portfolio Manager at EAM Investors. Before joining the firm in 2007, Mr. Scripp served on the U.S. Micro/Emerging Growth investment team at Nicholas-Applegate Capital Management. Mr. Scripp brings 11 years of financial analysis experience to EAM Investors. Mr. Scripp holds a B.A. in Economics from the University of Wisconsin, Madison. Disclosures 1 The excess annualized return is calculated as the annualized net return of the EAM Emerging Markets Small Cap Composite less the annualized return of the MSCI Emerging Markets Small Cap Index for the period April 1, 2012 through September 30, 2017. The net returns of the EAM Emerging Markets Small Cap Composite are presented net of brokerage commissions and include income from interest and dividends as well as capital gains. The returns do not reflect the deduction of taxes a typical investor may accrue or custodial fees. Net returns are net of the maximum annual management fees of 1.25%. The MSCI Emerging Markets Small Cap Index includes small cap representation across 23 Emerging Markets countries and is designed to measure small cap equity market performance in the global emerging markets. The MSCI Emerging Markets Small Cap Index has been chosen as a benchmark to the EAM Emerging Markets Small Cap strategy because the Advisor believes that it is the most appropriate broad-based securities index available to be used for comparative purposes given the investment strategy of the portfolios. The information provided does not constitute investment advice and no investment decision should be made based on any information provided. Information provided reflects the views EAM Investors, LLC as of a particular time. Such views are subject to change without notice. This information is not a recommendation to purchase or sell a security or follow any strategy or allocation. Any forward- looking statements or forecasts are based upon assumptions and actual results may vary from any statements or forecasts. While EAM has used reasonable efforts to obtain information from reliable sources, no representations or warranties are made as to the accuracy, reliability, or completeness of third-party information presented in this material. It is possible to lose money by investing in the strategies. Past performance does not guarantee future results. EAM Investors, LLC Institutional Investor Use Only 10