Thinking Emerging Markets? Think Small.

Disclosure: Outside the USA for Professional Clients/Qualified Investors use only. Capital at risk.

Rick Bisignano: Hi, I'm Rick Bisignano. I head up the Eastern region for the Institutional Client Group at Allspring Global Investments. Welcome to SpringTalk. Today, I'm with my colleague Prashant Paroda, who is a portfolio manager for the Allspring Intrinsic Emerging Markets Equity team. Prashant, thank you for joining us today.

Prashant Paroda: Thank you for having me, Rick.

Rick: So, emerging markets have been in a prolonged period of underperformance, especially versus U.S. equities. However, over the last 18 months, emerging markets have actually outperformed. What we're hearing from a lot of global investors, particularly on the institutional side, is that they're looking to diversify away from the U.S. assets and equity markets. So, as an emerging markets portfolio manager, what are some of your thoughts with respect to U.S. versus non-U.S.?

Prashant: Sure. And I think the tailwinds are all moving toward emerging markets, and we expect further growth from here on. I think if you look just from a valuation perspective, EM (emerging markets) trades at a much cheaper valuation and gives you faster earnings growth. Not only that, there are structural tailwinds, which are from AI and the China Plus One supply chain capex (capital expenditure) story. And there’s a potentially weaker dollar going to happen in the future. So, we think all of these are catalysts that set the stage for the EM asset class, and particularly small cap, to outperform in the future.

Rick: Yeah, those are some really good points there. So, the case for EM small cap has been compelling for many years. What makes this current environment particularly compelling?

Prashant: I think now specifically, if you look at the way supply chains are moving, especially if you look at the hyper-scalers in the U.S., they've all gone from cash-flowing companies to high capex companies. And you have to understand where the money is flowing. So, the money is flowing from these hyper-scalers to TSMC (Taiwan Semiconductor Manufacturing Company) to Micron and further downstream in the supply chain. We think AI is a very powerful technology. It's here, and it will be with us for a long period of time. And we think these tailwinds especially favor our asset class.

Rick: So, we talked about the theme of diversifying away from the U.S.—clearly, a big thing going on in the marketplace. And then, you just hit on the other one: AI (artificial intelligence). You can't see a headline. You can't go to a conference. You can't go anywhere with someone mentioning something about AI. But investors are thinking about AI spending versus AI beneficiaries. They’re thinking about the concentration risk that AI is creating within market indexes. There's going to be winners and there's going to be losers. How do you think about that as it relates to, again, emerging markets and then, particularly, emerging markets small cap?

Prashant: Sure. And if you look at the ecosystem of the supply chain, most of the beneficiaries lie in Taiwan and South Korea. They're supplying to your TSMCs of the world and data centers that are being rebuilt in this new industrial revolution. But outside of that, there are some countries that might go through some headwinds as well. For example, IT services is a big component of India's GDP (gross domestic product). But, however, for small cap as a class, it's not a big issue because most of these companies are large cap in nature while most of the companies we see in small cap in India are actually seeing accelerated earnings growth. So, from that point of view, we think there'll be winners and losers, but the small-cap asset class stands to gain out in terms of concentration risk that you mentioned. If you look at the top 10 names in the EM index, roughly 40% of the larger index is just top 10 names. Whereas, if you look at the small cap, the top 10 names are roughly 6%. So, if you're looking at that from a diversity perspective, you need to broaden your exposure, which small cap provides.

Rick: So, we talked about a couple trends. But beyond AI and beyond diversifying away from the U.S., what are some of the bigger secular growth trends that you're seeing within the emerging markets and, again, specifically within the small-cap universe?

Prashant: Sure. One big trend that we see is the financial services inclusion. If you look at mortgage penetration rates in countries like India, it's only 12%, while in the U.S., it's almost five times as much. So, there's definitely room for it to go. One thing we realize is as these countries move up from low-income to medium-income countries, there's an S-curve that you can participate in. For example, air conditioners. Once you move up to a certain price point in income levels, you get the first air conditioner in the house, and a few years later, you have four air conditioners in all your rooms. So, the small caps play into that theme. So, there's an S-curve, whether it's with smartphones, air conditioners, that you can participate in. There are also better corporate governance opportunities that you see with regard to small cap as well. A lot of the countries, such as in Korea, there's a value-up program that they'll happily want their companies to do more shareholder dividend buybacks. And before they used to hold cash, which will result in low ROEs (returns on equity). But now, they are actively participating in better capital allocation. So, we think there are a lot of separate themes apart from AI. And the interesting thing is these separate themes are a bigger weight in the small-cap index than they are in the larger-cap index.

Rick: So, moving off of AI and some of the bigger secular growth themes, when you're investing in the emerging markets, you have to think about China, right? And investors are really taking the China decision very differently. Some are going ex-China. Some are actually doubling down on China. As you think about emerging markets small cap, how do you think about China?

Prashant: Yes. China is actually half the weight in the EM small-cap index versus the large cap. So, in the large-cap index, it’s roughly 19%. In the small cap, it's 8% and change. And the India weight flips as well. The India weight in the large-cap index is roughly 11%, but in the small cap, it’s roughly 20%. So, a lot of investors and allocators that we speak to, they feel very positively about this. They say this is exactly the allocation we want. And small cap offers less of China headwinds, so they would allocate more to the asset class in the future.

Rick: Interesting. So, you get more diversification at the name level and then more diversification at the country level as well.

Prashant: Yes.

Rick: Switching gears a little bit, emerging markets is a high-return, high-risk asset class. It's an inefficient asset class. Active managers have done quite well there. What are your thoughts there?

Prashant: Yes. If you have to allocate to EM small cap, you have to go active. And one of the key reasons for that is if you look at the average analyst coverage across our universe—and with the small cap, there are 1,800+ names—the analyst coverage is 40% less versus the large-cap index—the MSCI EM Index—and it's 25% less than the S&P 500. There are several names in our universe that have little or no coverage. And as the research budgets of sell-side firms evolve, the first thing they actually do is they cut small-cap coverage. So, we think the opportunity set to outperform actually is widening in the future.

Rick: Interesting. So, less coverage could also mean more risk potentially. And, so, as you think about risk, and obviously it's emerging markets, so it's a very volatile asset class. And some of these companies, to your point, are not being covered. How do you sift through the universe of companies, of thousands of securities in the index and differentiate the high-quality companies—the durable businesses that will be around in 5, 7, 10 years’ time—versus the more speculative companies that could go out of business?

Prashant: Yes. The central thesis of our philosophy is that not all small caps are equal. In any country or industry, there is a small minority of companies that create and generate most of the value. We aspire to find these companies. So, the way we go about it is we distill the universe into a quality pool of 300-odd names. And what do we mean by quality? The first thing we look for is capable management teams with high inside ownership. When we speak to a company’s management, we are trying to figure out whether they aspire to do more. We're interested in small caps that will become mid and large caps. So, the aspiration level should be high. You should understand that it's way hard being a small-cap company in emerging markets. These entrepreneurs are really fighting against the grain. And a lot of them put their heart and soul in building these businesses. The second thing we look for is if there are any cross holdings. So, typically we find that families control 60%, 70% of the flow of the business. Sometimes they have one good business and three bad businesses, and they lever up the bad businesses and use the good business as collateral. We tend to avoid such situations. Charlie Munger once said that he invests in companies that are high quality that any idiot would run. We look the opposite way. We want to avoid the idiots because bad management can destroy a company in ways that's hard for minority investors to fathom. Beyond looking at the management team, we also look at how big this business can become in 5, 10, 15 years. This has helped us identify opportunities, whether it's e-commerce companies in Brazil, beauty companies in Korea, or financial services companies in India for the benefit of our investors. With EM small caps, the game that we are playing—quality plus valuation—is not necessarily played by other investors in the world. When we are investing, we are investing against local investors and local shareholders as well. And what we do find when we listen to the earnings call transcripts by the questions they ask, they're often looking to hit the next home run. So, they are very careful about whether the company will beat or miss earnings in the next quarter. When the company misses, they indiscriminately sell. That allows us to pick up opportunities that are cyclically depressed but structurally sound. And the reason this exists is because we are playing a different game. We're trying to hit singles and doubles while they're trying to hit home runs on every pitch. That means they have a higher strikeout rate, and that gives us opportunity to patiently allocate our capital.

Rick: Interesting. Switching gears just a little bit. So, let's pretend that you're sitting across from an investment committee member and they're considering making a first-time dedicated EM small-cap allocation. What's the single strongest argument you can make to help them feel comfortable about doing so?

Prashant: Sure. If you look at the eVestment universe, only 2.5% of the capital in equities is allocated to EM small caps. We think this is a big mistake. First, if you look at the median manager, he's outperforming by roughly 300 basis points on a 1-, 3-, 5-, and 10-year basis in the small-cap universe. This is much higher than what the median manager does in the larger-cap indices. Second, the large-cap index is becoming very concentrated. We mentioned the top 10 names are now 40% of the index. This makes it much harder for the active managers in that index to outperform. We think concentration is a double-edged sword. You might need it to generate wealth, but you need to diversify to preserve wealth. A wise man once said—this is Sir John Templeton—he said that the only people who do not need to diversify are the people who are right 100% of the time. So, we believe allocators would benefit not just by the diversification. But third, the question comes: Why are they using these two points? Why is there only 2.5% of your assets allocated to this asset class? Surely, the asset class must have done poorly compared to the larger EM index. And the answer to that is also no. So, if you look at the rolling 5-year rolled monthly over the last 25 years, EM small-cap indexes outperformed the EM larger index 73% of the time. So, we believe by under-allocating to EM small cap, investors are not only losing the alpha opportunity but also losing the total return opportunity.

Rick: So, last question or serious question, and I think you touched on a lot of these things throughout your comments and maybe just kind of bringing it all home. Looking out five years, what needs to happen for emerging markets small-cap companies to outperform their global equity counterparts?

Prashant: Well, some of the things we already touched on. It's faster earnings growth. We already know the valuations are much lower. The structural tailwinds, such as AI and China Plus One, we think these are decade-long stories. And these will continue as well. There's a potential for a weaker dollar, which will be a tailwind for the asset class as well. And better corporate governance, which we think is also here to stay because governments are getting involved as well.

Rick: Great. OK, so I said last serious question. Let’s have a little fun. We'll do a little rapid fire.

Prashant: Sure.

Rick: You travel a lot to the emerging markets. So, a few questions in relation to your travel—most beautiful city you've ever been to?

Prashant: Rio de Janeiro, by far. I think it has everything you want: lush rainforests, mountains, and beautiful beaches.

Rick: Favorite restaurant?

Prashant: Hands down, it has to be Bukhara in New Delhi. This is my favorite Indian restaurant. The key is if you ever eat there, there's cutlery, but it's better to eat by hand. And that's what heads of states do as well.

Rick: Interesting.

Prashant: And my favorite dishes there are lamb, chicken, and dal. The dal they use, they actually simmer for like 18 hours.

Rick: Wow. Sounds delicious. Something interesting from a recent trip?

Prashant: Sure. This was while I was shopping for my daughter and my wife at a beauty store, Olive Young in South Korea, and interacting with Gen Z because I didn't know about all the new brands. They were helping educate me of what's trending and what's not, and that made me realize that South Korea is really the epicenter of the beauty revolution in the world. And coming back and looking at Sephora and Ulta, they have a lot of catching up to do.

Rick: Be sure to mention it to my wife and my daughter. Prashant, thank you very much for your insights today.

Prashant: Thank you for having me, Rick.

Rick: And to our audience, thank you for joining SpringTalk.