Posted inEquities

The rising fortunes of Asia’s small-caps

Four important developments should provide momentum for the asset class.

After spending almost a decade in the shadow of their larger counterparts, Asia’s smaller companies are now being viewed in a new light. To understand why investor attention shifted away from smaller companies in the first place, however, we first need to look at the evolving relationship with their larger counterparts.

Between 2006 and 2010, smaller companies led the rally that unfolded in the wake of the global financial crisis. This was in line with expectations, given that smaller names often have healthier balance sheets, higher growth profiles, and greater agility than larger businesses. As a result, they tend to recover first.

Small-caps then moved broadly in line with the wider market until exchange-traded funds (ETFs) began their rise to prominence. From 2015 to 2019, we witnessed significant inflows into passive vehicles, most of which were concentrated in large-cap stocks. As such, smaller companies failed to benefit from the substantial growth of these funds.

The past two years, however, have seen several market developments converge, with previous headwinds now becoming tailwinds for small-caps. Four key drivers underpin this change in sentiment – a shift in focus among ETFs toward smaller companies; changing consumer trends; the advent of the ‘fifth industrial revolution’; and, lastly, a boost from environmental, social and governance (ESG) investors.

Shifting ETF focus

Passive investing has dominated fund flows and led to the outperformance of large-cap names. Yet, given the evolving investment landscape, this trend has arguably reached an equilibrium. It is estimated that around 39% of global assets under management are invested in large-cap-focused passive funds, which contrasts with 33% invested in small-caps. In the emerging market segment – most of which is represented by Asia – this figure drops to a mere 13% invested in smaller companies.

Passive investing has inflated the size of large-caps and made their share prices more volatile due to regular index rebalancing. This polarity creates pressure and intensifies the need for more symmetry, which should prove beneficial for small-cap names.

Meanwhile, the rise of retail investors empowered by social media on commission-free trading platforms underscores the need for active investing and diversification within the ETF space. At the start of 2021, US retail investors saw an opportunity to challenge institutional hedge funds that had been shorting the share price of meme stocks such as GameStop, assuming they would fall further. In GameStop’s case, these market participants, coordinating through social media, propped up its share price, forcing the hedge funds to cover their short positions. The result was a widely publicised price crash.

Indeed, at one point, GameStop represented 20% of the SPDR S&P retail index. Passive investors would have been severely burned if they were invested in the ETF when its price collapsed. This highlights the need for diversification and an active investment strategy. Looking ahead, interest in active investing should increase as investors become more aware of the risks associated with a passive approach. Such a shift would be beneficial for small-caps as they have the potential to trade closer to their intrinsic value with increased coverage.

Pillar of consumption

Being digital natives, millennials and Gen Z (MZ) are expected to be the new driving force of consumption. By 2025, it is estimated they will account for half of the consumers in Asia Pacific. As well as being comfortable with the online consumption of goods and services, the MZ generation is also mindful of social justice and climate change while desiring uniqueness and personalisation. Companies that deliver products that meet this fast-changing demand will succeed.

One example is Clio Cosmetics Co, a $200m (£174.6m) South Korean cosmetic firm focusing on ‘must-have’ products. The company’s management quickly realised online was the primary channel used by the MZ generation and it became one of the first South Korean businesses to close its physical stores in China and focus on internet marketing.

It also responded to evolving trends with innovative products, such as a cleansing foam that removes micro-fine dust – a big issue given pollution levels in some cities. In other developments, Clio identified the demand for vegan skincare and launched its Goodal skincare brand featuring natural ingredients. This product also chimes with the MZ generation’s focus on eco-friendly packaging.

‘Fifth industrial revolution’

Reaching the next stage of industrial development means harnessing evolving technologies surrounding artificial intelligence (AI) and big data. Nowhere are these opportunities more abundant than in China, which accounts for three-quarters of the world’s AI patents. Commercialising these ideas presents smaller companies with a vast opportunity.

At the same time, because the regulatory framework remains pliable – as these new sectors emerge – smaller companies will find themselves on a more even playing field with large caps. They will also have the upper hand because they are not restricted by legacy systems or old technology. This means they can exploit smart tech and deliver innovative products with greater personalisation while incurring lower costs.

As an example, larger companies such as Uniqlo and Zara have historically dominated the apparel space, making it challenging for smaller companies to compete. Newer companies like SHEIN, however, are gaining market share with the emergence of big data and the internet. SHEIN was only founded in 2008 but has grown significantly. The company was originally a platform that sold only clothes, but its founder saw an opportunity whereby the firm could design its own labels and accessories based on big data.

The key differences between SHEIN and its peers are:

* Low cost: The company buys directly from suppliers, which reduces the number of supply-chain layers.

* Influencer marketing: SHEIN leveraged off the internet with Instagram, TikTok and various other platforms to promote its products; and used big data to analyse user interest and demand.

* Real-life user reviews or key opinion customers: The platform encourages users to post pictures of themselves in the clothes they buy, which helps eliminate concerns about the quality and fit of the garments. Having real people with various body shapes model the clothes offers an additional layer of comfort.

These tech developments make it easier for disrupters and agile smaller companies to flourish. The acorns of today could become the oak trees of tomorrow.

Ethical investing’s boost

As demand for sustainable investing rises, it is expected to drive more companies to embrace such principles in their operations. At first glance, this trend seems to favour larger companies, given their ample budgets and greater access to expert guidance. In their rush to establish their ESG credentials, however, some larger names have also come under scrutiny for greenwashing – particularly in areas of their extended business operations that find it challenging to meet the necessary standards.

In contrast, smaller companies have an advantage when adapting to the changing ESG landscape, as they are closer to their customers, have a tighter focus on business lines and can respond more flexibly to new business opportunities.

Benefits of diversification

From an investment perspective, the very nature of being exposed to the small-cap market provides other benefits. First, the size of this universe can help spread a portfolio’s risk while improving its defensiveness through diversification.

At the same time, more than 50% of these companies are not covered by any sell-side analysts. This can give conscientious stockpickers who conduct their own research and due diligence a significant advantage. Finally, the structure of these businesses is also favourable. More than half of Asian small-caps are controlled by their founders and management, who have a personal stake in the success of their businesses. This aligns the interests of the key stakeholders with that of the investor.

These characteristics, coupled with the trends discussed, should support the outperformance of this asset class in the years ahead.

Grace Yan is a senior portfolio manager for Asian equity at Nikko Asset Management.

This story first appeared on our sister publication, Portfolio Adviser.

Part of the Mark Allen Group.