SMALL CAPS: the fastest growing companies in the world

The creation in March 2008 of the MSCI Emerging Markets Small Cap index helped cast a light on some of the fastest growing companies in the world. The separate smaller companies index has helped emerging market smaller companies to be recognised as a dedicated asset class in their own right, creating new opportunities for institutional investors.

The small cap index comprises roughly 1,700 stocks. This represents a significant expansion compared to the existing large-cap dominated standard index, and provides the potential for higher returns from companies that are under-researched and undervalued by the market. The typical market capitalisation range in the MSCI Emerging Markets Small Cap Index is between US$50m (€33.35m) and $1.5bn.

Companies in this range represent a very different investment proposition compared with standard index companies such as Brazilian oil giant Petrobras with a market cap closer to $170bn.

The emerging markets small cap universe is more evenly balanced across a variety of sectors than the standard MSCI Emerging Markets Index, which is dominated by energy and financial stocks. With no single company or sector having a dominant weighting, success in this segment of the market requires the services of experienced research-driven stockpickers to identify winners among less familiar names.

Brazilian small cap Estacio is one such company that could easily be overlooked by mainstream investors. Estacio is Brazil’s largest post-secondary education provider with over 200,000 students enrolled across its 80 campuses. Although it is the country’s largest provider it has only 4% market share in what is a highly fragmented market. With ample cash on its balance sheet and the shareholder backing of private equity group GP Investments, Estacio can be expected to play its part in the industry’s consolidation.

The attraction of Estacio is not confined to its role as a consolidator, however, as it is also operating in a growth market. Student enrollment has grown strongly in recent years and we expect it to grow further as more Brazilians see the earnings improvement potential of further education. There is plenty of room for growth, with only 24% of young adults receiving post-secondary education. This is below the Latin American average of 30% and a long way behind the equivalent US figure of almost 80%.

Smaller companies often focus in niche product areas or operate in a single country. This means they can display some element of decoupling, to prosper even at times when the broader economic environment is difficult. Against that, however, small cap emerging market companies are subject to potentially higher price volatility and illiquidity – another factor which calls for the skills of experienced stockpickers.

Up to a couple of years ago, the theory of ‘decoupling’ was a fashionable one – the notion that because of rapid economic progress, the world was no longer dependent on the US and other developed markets for growth. Emerging markets in particular, said supporters, could continue to grow rapidly, immune from slowdown elsewhere.

That theory was beginning to look a little threadbare as the world recession began to bite in the second half of 2008, and risk-averse investors flooded out of emerging markets for the perceived relative safety of government debt. However, this rush to exit emerging markets largely overlooked the fact that companies, governments and consumers in emerging markets were generally much less burdened by high levels of debt than their developed market counterparts. Now decoupling as a concept is making a comeback. In past global recoveries, the US consumer has been the main driver of growth; this time, the catalyst could well come from infrastructure spending by emerging market governments.

Infrastructure represents the necessities of life – facilities without which no modern country can function. Roads, water and sewage, power stations, railways, ports and airports, housing and schools – all are crucial as a backdrop for the production of capital and consumer goods and, indeed, the efficient and ongoing development of a country.

The sheer scale of investment into infrastructure in emerging economies gives us confidence that smaller companies will prosper – despite the external backdrop of slowing global growth. The financing of such large scale investment will be backed by government funding and, having prospered in recent years, the largest emerging market economies are in a strong position to invest. As a result, I firmly believe emerging markets are in a strong position to weather the storm caused by the turmoil in external credit markets.

Estimates by Merrill Lynch indicate that governments in the world’s developing nations will spend more than $2.2 trillion over the next three years as they build and upgrade roads, rail, power and water to sustain the growth of their economies and we are already seeing signs that this spend is taking place.

Take, for example, China, which earlier this year embarked upon a massive ($585bn) fiscal stimulation package in an effort to ward off recessionary conditions, largely focusing on infrastructure and consumer spending.  This is exactly the type of investment that will propel sales growth at China Automation, a small company that designs and installs safety control systems.

China Automation has already seen its sales expand from £13m (€14.1m) in 2004 to £75m last year as it has become the supplier of choice to the government-owned giants operating in China’s fast-growing petrochemical and railway sectors. Both of these sectors have been earmarked as focus industries by the Chinese government and will receive substantial investment in the years ahead. Every petrochemical plant or railway built in China will require control systems to ensure their safe operation and given China Automation’s dominance of this space, we expect it will more than double its sales over the next three years.

The Brazilian government, too, continues to provide stimulus in infrastructure spending. The country’s 2007-2010 ‘Growth Acceleration Project’ is a $200bn plan to modernise the road network, power plants and ports.

Infrastructure and consumer spending are highly likely to play a central role in the next phase of emerging market growth. So while the global trade that accompanied the developed world’s consumer boom has slowed down, smaller companies – with their focus on domestic demand – should continue to benefit from increased consumer spending and government-financed investment in infrastructure projects.

Emerging market small caps stand to be the biggest beneficiaries of government stimulus spending because it is typically directed towards local businesses. The domestic bias of the small cap sector is evident in the industry weightings of the small cap index, with a 30% weighting in the consumer sector compared with only 11% in the standard emerging markets index and a 19% weighting in infrastructure compared with only 8% in the standard index (MSCI March 2009).

While the majority of emerging market share prices are well below the highs reached in 2007, the factors underpinning profit growth have brought the small cap asset class right back into focus. As of end July the MSCI Emerging Markets Small Cap Index had risen by 51%, outperforming most other asset classes so far in 2008, yet the combination of lower valuation and higher growth prospects means it remains a stock picker’s paradise for those with the experience and ability to identify tomorrow’s winners in emerging markets.

• Alastair Reynolds is investment director global emerging markets at Swip

©2009 Funds Europe