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
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.
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