Smaller and mid-sized companies offer the best way to take advantage of the next stage of the emerging market growth story, according to Batterymarch, a subsidiary of Legg Mason.

Not only do smaller companies generally rebound faster than larger businesses, but the shift to domestic demand-driven economies in the developing world will favour those down the market cap scale, says Nathalie Wallace, senior portfolio manager in the emerging markets team.

“Rising consumption, coupled with the demands of massive infrastructure development, has been responsible for increasing growth,” she said.

“Although some large caps are involved in infrastructure-related activities, smaller companies are generally best positioned to benefit from growth in domestic-driven areas.”

Wallace claims that this means increased opportunities for stock-picking investors, who will be able to exploit market inefficiencies in these lesser-known areas.

She explains that government and corporate debt to GDP has fallen in emerging markets over the last decade and consumer leverage is low relative to international standards.

Given that personal and corporate tax rates are also expected to drop further, higher domestic consumption and investment is likely, she continues.

Data from FE Analytics shows that the smaller companies fund of emerging market specialist Aberdeen Asset Management has outperformed the fund house’s other vehicles in the region.

Performance of funds over 5yrs



Source: FE Analytics

Aberdeen Global Asian Smaller Companies has returned 110.01 per cent over five years, while Aberdeen Asia Pacific has returned 66.65 per cent.

Wallace says valuations support the long-term growth story for mid and small caps in emerging markets, which have higher two-year earnings-per-share growth figures than larger stocks. Smaller-cap growth is also cheaper, with lower price-to-book ratios, she says.

“Smaller stocks expand the opportunity set for emerging market investors,” she said. “This is illustrated by the MSCI benchmarks, with over 2,200 stocks in the Emerging Markets SMID Cap Index versus 820 in the EM Standard.

“Emerging markets eclipsed developed countries in terms of initial public offerings (IPOs) in 2010, including hundreds of smaller-cap issues, and while this dipped for 2011 amid higher risk aversion, the overall growth trend in emerging market IPOs is expected to continue over the longer term.”

“Emerging markets eclipsed developed countries in terms of initial public offerings (IPOs) in 2010, including hundreds of smaller-cap issues, and while this dipped for 2011 amid higher risk aversion, the overall growth trend in emerging market IPOs is expected to continue over the longer term.”

Wallace says that there is a clear shift in the internal dynamics of the developing world’s economies.

“Growth in emerging markets has historically been driven by large exporters and commodity producers operating in the global economy, but this has been shifting as a result of economic progress over the past decade,” she explained.

“During the second half of the 1990s, as the US outperformed developing countries, smaller stocks in emerging markets lagged larger, export-oriented securities. Since then, sustainable improvements in emerging economies, such as fiscal and monetary disciplines, have been instrumental in the development of local demand as well as more private and public investment.”