Surprisingly modest historical volatility and excellent diversification benefits: Rob Feldman, Chris Steward and Yogesh Borkar explore the under-analysed world of emerging market small-caps

Emerging market (EM) small-cap stocks are an important, yet overlooked, asset class. Recent Pyramis research reports highlight potential opportunities presented by international small-cap and emerging market equities. Compelling arguments for these asset classes individually also make a forceful case for investing in EM small-cap stocks. We consider the case from three points of view: historical performance; a deep alpha opportunity set; and diversification benefits.

Historical performance
Over most medium to long-term time periods ending 31 March 2010, EM small-cap stocks outperformed the majority of other asset classes.

Pyramis analysis shows that EM small-cap stocks are not meaningfully more volatile than large caps, yet they present more opportunities to find companies with significant growth potential that are undercovered and, hence, overlooked by many investors.Consider that the volatility over the past 10 years of the largest representation of global equities - the MSCI All Country World Investable Market index (ACMI IMI) (ex-frontier markets) - is only marginally higher than both the MSCI World (developed markets) and S&P500 indices and slightly lower than the MSCI Europe, Australasia, Far East (EAFE) Standard index.

In developed markets, small-cap stocks have historically been more volatile than large and mid-cap stocks. In the US, small-cap stocks were about 30% more volatile than large-cap stocks over the 10-year period ended 31 March 2010. Small-cap stocks in the MSCI World index were approximately 18% more volatile than large-cap stocks and 12% more volatile than large caps in the MSCI EAFE index. By comparison, EM small-cap stocks exhibit marginally higher volatility than the MSCI Emerging Markets Standard (EM) index, comprising large and mid-cap stocks, with relatively higher returns. The standard deviation of return for the EM index is 24.9%. The MSCI Emerging Markets Small Cap (EMSC) index standard deviation of return is only slightly higher at 25.8% for that period.

Over the last 10 years, the return per unit of risk for global markets is higher than that for the S&P500 index. Adding small-caps and emerging markets, both of which are in the MSCI ACWI IMI benchmark, marginally enhanced the risk-adjusted returns for US dollar-based investors.

Alpha opportunities
There are roughly 1,800 stocks in the MSCI EMSC index, compared with 770 in the MSCI EM index, which is dominated by large companies. The MSCI EMSC index was launched in March 2008, however, the majority of investment industry databases have not established a separate category for EM small-cap managers. As of 31 March 2010, the eVestment Alliance database showed nine out of 162 EM funds identified themselves as investing in small-cap stocks. As in the developed markets, the average number of analysts covering each small-cap stock is far fewer than for large-cap stocks.With a high number of potential investment opportunities and fewer research analysts and portfolio managers focusing on emerging market small-cap stocks, emerging small-cap stocks offer an opportunity for alpha capture.

The anticipated creation and growth of a middle class in many EM countries should benefit small-cap companies with a local focus. It is worth noting that the emergence of a middle class historically results in a boost to material consumption and is typically accompanied by increased entrepreneurship, innovation, and growth. As countries develop to the point at which a significant portion of the population is above the subsistence level, they begin to invest in housing, education, and leisure pursuits that spur increased consumption.

Many emerging economies appear to be nearing this stage of development, which could significantly boost growth and consumption in these economies. For example, although only 12% of the population, China's middle class numbers 157 million people. This is second in size only to the US. And China is already the largest cell phone market with 700 million subscribers.

Pyramis' analysis shows that while EM small-cap stocks have a 0.94 correlation with large-cap EM stocks, they have marginally lower correlations with other equity markets compared with large-cap EM stocks. For example, the 0.64 correlation of EM small-cap stocks with the S&P 500 is 12% lower than the 0.72 correlation with EM large-cap stocks.

Added diversification potential reflects the fact that EM small-cap stocks tend to be local in nature. The 10 largest stocks in the MSCI EM index include multi-nationals with global operations. For example, the 10 largest stocks compose 19.4% of the MSCI EM index compared with only 3.2% for the 10 largest stocks in the MSCI EMSC index. In fact, the weight of the single largest stock in the MSCI EM index, the Brazilian oil giant Petrobras, with a market cap of $238bn (as of 11 January 2011, €183bn) is larger than the weight of the top 10 largest stocks in the MSCI EMSC index. More than 80% of sales for many of the larger companies are outside their home country. Smaller companies are often narrower in their geographic and product focus, often enabling them to prosper even when in a challenging global business environment.

Stronger reliance on domestic markets of EM small-caps is also seen in variations in the sector composition of the MSCI EMSC index. The MSCI EMS index is more weighted towards financials, energy, and telecoms than the MSCI EMSC index, which is biased to consumer discretionary and industrials.

The emerging middle class in the developing world is a key reason economic growth there is expected to remain robust compared with more modest growth expectations for the developed world. EM small-caps may provide exceptional return opportunities in such an environment.

Rob Feldman is portfolio manager, Chris Steward institutional portfolio manager, and Yogesh Borkar research analyst/associate portfolio manager in the international/global small-cap portfolio management team at Pyramis Global Advisors