Aug 01, 2016

Are Emerging Market Small Caps Oversold?

By the Emerging Markets Team

Are Emerging Market Small Caps Oversold?

While emerging market earnings growth and revisions stabilized earlier in the year, the current rally in EM equities has been largely a macro phenomenon—the byproduct of a global search for yield that has pulled investors into emerging market debt (with obvious knock-on effects for equities). To illustrate, while the MSCI Emerging Markets Index has risen 26% in US dollar terms since bottoming on January 21, 85% of the performance has been due to price-to-earnings multiple expansion while 15% has been due to growth in earnings per share.

In this environment, inflows into emerging markets have been concentrated in passive vehicles such as ETFs and futures, a dynamic that naturally favors larger companies that are more heavily represented in the index. As a result, we have witnessed significant underperformance by small cap stocks relative to their large cap counterparts. In fact, the magnitude of underperformance has reached a multi-year extreme. The chart below shows the rolling six-month performance of the MSCI Emerging Markets Small Cap Index versus the MSCI Emerging Markets Large Cap Index. As you can see, small caps have now underperformed by more than 7%, which is the largest rolling period of underperformance since early 2012.

Rolling six-month performance of EM small caps versus large caps

Source: Bloomberg

We believe that if this emerging markets rally is to be sustained, flows will broaden beyond shorter-term tactical positioning shifts to more strategic allocations with greater emphasis on active management and stock-level differentiation. Such an environment would incrementally favor small caps, particularly those companies with truly differentiated business models, competitive positions, and growth potential—companies that our investment philosophy favors. We are actively looking for opportunities presented by the year-to-date underperformance of small caps.

This information is not intended to provide investment advice. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, market sectors, other investments or to adopt any investment strategy or strategies. You should assess your own investment needs based on your individual financial circumstances and investment objectives. This material is not intended to be relied upon as a forecast or research. The opinions expressed are those of Driehaus Capital Management LLC (“Driehaus”) as of August 2016 and are subject to change at any time due to changes in market or economic conditions. The information has not been updated since August 2016 and may not reflect recent market activity. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable and are not necessarily all inclusive. Driehaus does not guarantee the accuracy or completeness of this informa­tion. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

About Emerging Markets

The Driehaus Emerging Markets team focuses on investing in emerging markets securities of all capitalizations, through the Driehaus Emerging Markets Growth, Driehaus Emerging Markets Opportunities and Driehaus Emerging Markets Small Cap Equity strategies.