Advisory Research in Chicago has been investing in the international small and SMid-cap market for around eight years now, but until last November, had few emerging market names in its portfolios.  That all changed last November.

 “We started seeing much more diversity on the emerging market side in terms of what we could include in our portfolios and from a price point, the market had become much more attractive,” said Marco Priani, portfolio manager.

The firm decided to launch a dedicated emerging markets fund, the Emerging Markets Opportunities Value Management fund, to take advantage of those small and SMid-cap opportunities,  of which, Priani said, there are many throughout the emerging markets.

Advisory Research finds the best ones by employing a extremely disciplined, value-driven strategy that’s focused on downside protection.

“We look for companies that are trading at or below the liquidation value of their assets. In other words, we like companies that have enough assets that can be liquidated in case things go wrong, and where we won’t lose money below the level at which we invested,” Priani said.

After the team is convinced that their downside is protected through their analysis of the tangible net asset value of a company, their next step is to find a catalyst within a particular company that will improve the profitability and return on its assets.

“This stage of our process is both quantitative and qualitative, time consuming, and centers around our interaction with management, which has to have a clear and credible plan to unlock value,” Priani said.

Once they apply these criteria, the team drills a universe of around 3,500 emerging market small- and SMID-cap securities down to about 500 or 600 names from which they can choose.

Overall, the category allows for a more targeted and nuanced approach to the emerging market, one that can capitalize better on the opportunities it offers.

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“The large cap emerging market index tends to be dominated by more globalized companies with government influence, in a lot of cases, like South Korea’s [Samsung Electronics, which really is developed market stock, and Chinese banks, which are not very shareholder friendly,” said Kevin Ross, associate and research analyst at Advisory Research. “Also, looking at historical returns and correlations, the small-and SMID-cap universe is less correlated to the S&P 500 and other indices, and returns are quite a bit higher, even adjusting for standard deviation.”

Investing in the small- and SMID-cap emerging market space also gives the fund a high exposure to the growing middle class in different emerging market countries.

“We are very overweight consumer discretionary and staple stocks, for example, whereas in the benchmark—given its large cap focus—those companies tend to fall into the materials and energy sectors, so we are underweight those and more weighted toward locally driven stocks in the consumer sector,” Ross said.

Currently, Advisory Research manages around $14 million in its Emerging Markets Opportunities Fund, compared to $400 million in its developed market small- and SMID-cap strategies.

“But I see potential going forward,” said Priani, since in the emerging markets, value has outperformed growth and small cap value has outperformed the broader universe.

Emerging market equities have also had higher risk adjusted returns, he said, and inefficiencies in the asset class point to the potential for continued outperformance.