Most investment advisors understand the benefits of diversifying outside the United States, and many have added emerging markets to their asset allocation. This has likely paid off with emerging markets outpacing the American market over the last several years. However, some now wonder if these markets have become overvalued.
While the valuation of many emerging market companies has risen significantly over this period, we still see significant upside, particularly in the smaller companies of these markets. Such stocks have exceptional growth prospects, but they have been all but ignored and are therefore trading at very reasonable valuations.
Emerging market small cap funds are a relative rarity, with less than a handful in existence. Most emerging market funds are all-cap or large-cap, investing in companies such as the big commodity producers, utilities and banks in their respective economies. However, it is the smaller companies in these emerging markets that we believe offer the most growth potential and greatest upside valuation opportunity.
More than half of the world's population resides in these markets. And as technology spreads, these countries are developing quickly. Investment opportunities arise in companies that benefit from the domestic demand created as emerging economies develop stronger financial systems and as they gain broader access to private capital to finance construction. In fact, the most rapidly growing companies are often infrastructure and consumerrelated. Many of these companies are not the large, well-known names that populate most emerging market funds.
In addition to the tremendous growth potential of small cap companies, there is also a valuation opportunity. Emerging market small caps are an undiscovered asset class. This is one of the few frontiers where you can still find unappreciated stocks -- and the list of small publicly traded companies continues to expand as emerging markets develop.
Investing in these markets requires significant due diligence. We think the most interesting companies are those with a sustainable competitive advantage, strong and experienced management, increasing demand for their products or services, sound financial controls, high returns on capital and high levels of inside ownership. It is also clearly important to gauge the stability of the investment environment.
A tough question is how an investment advisor can effectively complete this level of due diligence on so many companies across so many emerging markets. In reality, no one can possibly cover every company in this universe, so some sort of an initial screening mechanism is a must. Our team uses quantitative screens to identify companies with the kinds of fundamental characteristics that meet our criteria (roughly 300). Each company is then individually analyzed by our team of analysts who are, divided up by sector and/or region. We travel to the markets, visit companies, and we always look to talk directly with management -- in doing so we continue to be surprised at just how little analyst coverage these companies currently have. This due diligence helps us narrow the field to a shorter list of companies in which we have the most confidence.
Even with an exhaustive research process, investing in emerging market small caps carries significant risk. To help alleviate some of that risk, we believe emerging markets small cap investors should be diversified across both countries and investment sectors. It is also critical that research due diligence is not a one-time event for each company. With change happening so quickly in these markets, each investment needs be closely followed on an on-going basis.
As emerging markets continue to participate more broadly in world markets, there will undoubtedly be an emerging class of new consumers and significant spending on infrastructure. A well-crafted portfolio of the smaller companies in these emerging markets may offer one of the most appealing prospects for the years ahead.