Small caps to drive next stage in Asian domestic growth, says Matthews Asia’s Lydia So
As domestic demand and consumption grows across Asia so too is the universe of suitable smaller company investments, says Matthews Asia portfolio manager Lydia So.
As small companies have grown and access to capital has increased, their importance as a driver of innovation and employment has risen. Small companies are nimble enough to react quickly to the region’s changing patterns of domestic consumption, designing and developing products and services that appeal to local markets. As their products and services become brands in their own right, this leads to more sustainable returns on equity and returns to shareholders.
Small companies in Asia are typically under-researched and often under-valued compared to large companies. This creates an opportunity for specialist fund managers with the resources to identify mispriced companies.
The management teams of small companies are closely aligned to shareholder interests as they usually hold significant ownership stakes themselves. In many cases, small companies are managed by entrepreneurs whose ambitions for their company lie beyond any short-term price movement in their stock. Their primary desire is to see the company grow and to create wealth.
The universe of small companies in Asia has deepened, not only in pure numbers, but also in terms of breadth and diversity. More companies from a wide range of industries are coming to the capital markets as a result of improved access to credit and capital, as well as deregulation in certain industries. Small companies now operate across all key sectors within the region’s economy.
At the end of 2012 there were 3,572 small companies (with a market cap of $100m to $3bn) listed on the stock markets of Asia, excluding Japan, according to Bloomberg. That compares to a small cap universe of 2,204 companies in Asia ex Japan at the end of 2008. To put this into broader context there are currently less than 3,400 small companies in the US.
Small companies in Asia often operate in niche markets and in industries that are at the early stages of development. As such, small companies can occupy strong market positions and therefore enjoy healthy earnings growth.
Small companies are also starting to emerge in industries that, while new to Asia, are well established in other parts of the world. These small companies are leveraging proven business models in order to succeed. Household incomes are growing and that is leading to a more domestic consumption driven economies and the emergence of businesses like branded consumer goods, modern retail, distribution, healthcare and financial services.
Furthermore, small companies have the potential to benefit from mergers and acquisitions activity, as sectors and industries consolidate-an increasingly important trend as Asia’s economy continues to grow and competition increases. Small companies are of also particular interest to large multi-national companies looking to penetrate the Asian market.
Of course, while smaller companies may offer substantial opportunities for capital growth, they also involve significant risks. They often have limited product lines, markets or financial resources. Smaller companies may also be more dependent on one or few key persons and may lack depth of management. Other issues can include poor liquidity of stock due to larger portions being held by a small number of investors (including founders and management) than is typical of larger companies. Additional potential problems facing investors include difficulty in obtaining information about how changing market, economic, regulatory and other factors may impact these businesses. All these factors point to the importance of conducting thorough due diligence on companies prior to investing.
A common misperception, however, is that small companies are much more volatile. In fact, over the past five years (which includes the last major market correction) the volatility for small companies has been largely similar to that of large companies.
In conclusion, smaller companies have been an integral part of the Asia’s development over the past few decades and their ability to adapt to local consumers stands them in good stead for further success. As the region’s capital markets have deepened, the investment universe for small companies has also grown considerably, providing new opportunities. Smaller companies are more reliant on domestic consumption and less influenced by the broader macro environment and by western markets than their larger competitors, hence providing diversification for investors’ global portfolios.