Small but Mighty
“…. My advice is either start very early or live very long. I guess I’d do it the same way: maybe I’d start with small companies and buy good businesses….”
- Warren Buffett, 1999, when asked what he would do differently in building up his investment empire.
This advice is decidedly apt when it comes to small-cap investing. Across Asia, continuous innovation, a growing middle class and urbanisation are cultivating fertile soil for small-cap companies that are yet to take flight.
According to Elizabeth Soon, Hong Kong-based portfolio manager of PineBridge Asia ex Japan Small Cap Equity Strategy, Asia’s small-cap stock market offers a wide variety of opportunities for investors seeking long-term growth and capital appreciation.
An under-researched segment with depth of diversity
Compared to their larger counterparts, Asian small caps are often unexplored – and that offers investors an attractive opportunity, says Soon.
Large-cap companies are very closely followed by global investors, and because information about them is widely available, to a certain degree, demand is tightly priced in. Also worth taking into account, the growth of many larger companies is limited by their sheer size. However, with less coverage from analysts, institutional investors and the financial media, many small-caps fly under the radar.
Over 90 per cent of listed companies in Asia, excluding Japan, are defined as small capitalisation companies. The Asian pool of small-cap stocks includes more than 15,000 companies, offering a plethora of investment choices across different sectors, markets and trends. Characterised by this diversity, Asian small-caps offer abundant investment opportunities.
For the savvy and the skilled investor this untapped segment can present mispricing opportunities. Especially for those investors who are able to unlock the hidden value from underpriced stocks, which over time can generate exponential returns.
With a large pool of off-the-radar and potentially underpriced small-cap stocks available in the Asia ex-Japan markets, Soon's team focuses on using a fundamental bottom-up selection process to pick the best companies and construct portfolios, while allowing for an adequate margin of safety.
“We don't believe in portfolio churning," Soon says. "The strategy we employ works better for those who are willing to hold on to quality stocks through short-term volatility, at least for a medium term," advises Soon who adds that patience is a big virtue, especially when investing in small-cap companies. "It is important for the investor to have a longer-term investment horizon to realize the true potential of these companies,” she says.
Take advantage of market volatility, mitigate the strategy’s volatility
Contrary to what is taught in mainstream finance, stock price volatility is not necessarily an indication of risk. In fact, volatility in stock price provides opportunities for long-term investors to invest in growth opportunities at lower prices.
“In times of market stress, small-caps may bear the brunt of selling pressure first. However, this only affects the nominal prices at which they are traded. Their intrinsic value does not necessarily change," explains Soon.
Soon says the real risk of investing is in the failure to determine the intrinsic value of the company. Understanding their products and services, grasping their competitive advantages, examining their financial statements, gaining in-depth insight into their management practices – these are factors that provide a true picture into what the company is worth. For an active manager, matching true value with the right price in the market is where the opportunity lies. And so, the risk of investing in a company should be determined by its fundamentals, not its market cap or the fluctuation of their share price.
"The risks associated with the strategy can however, be effectively mitigated by following a rigorous due diligence process that combines a meticulous selection process, experience and knowledge," says Soon.
Using proprietary methods, Soon follows a rigorous due diligence process that combines a comprehensive checklist approach, investing experience and a deep knowledge of the asset class. Soon elaborates on the detailed approach with an interesting analogy. “The investor's role is similar to a pilot or surgeon who is also dealing with many unknowns and uncertainties. A careless oversight, no matter how minor it may seem to be, can cost dearly," Soon continues. “The most experienced airline pilot or surgeon with the most advanced equipment relies on a methodical process to perform the most routine tasks in an aircraft or an operating room.”
This selection process helps Soon identify small caps that offer true investment value – and equally important – at the right price.
Since its inception, under PineBridge Investments’ proprietary portfolio management process, the PineBridge Asia ex-Japan Small Cap Equity Strategy has yielded first-quartile performance*.
Importantly, Soon’s small-cap strategy has a beta of about 0.8. As a standard measure, a beta of less than 1 means that the portfolio is theoretically less volatile than the market; greater than 1 indicates the strategy is more volatile than the asset class. A small-cap strategy that has a beta of less than 1 is laudable and speaks not only about its lower volatility, but also its strong focus on high-quality companies – a major tenet of Soon’s approach.
Liquidity built from the bottom up
An important aspect to managing a strategy is ensuring adequate liquidity. And for Soon, she looks at this on multiple levels – both on an individual stock level as well as through the structure of the overall portfolio.
“Addressing the liquidity issue is an integral part of our due diligence," stresses Soon. "In fact, liquidity is where we start off and it is vital to understand how long it will take to move a stock into and out of the portfolio," she explains. As such, Soon only includes stocks once they have passed the firm's meticulous selection process.
“We invest in companies that have competitive advantages against their peers. These advantages can be in the form of their dominance in market share, the strength of their brand and gaining advantages in areas such as technology," Soon says. Companies that successfully operate in industries with solid entry barriers showcase competitive advantages that fortify their position. "Beyond this, we ensure that these companies have good management responsible for running the business for sustainable growth."
Soon argues that companies meeting such stringent criteria of her approach are few and far between and investor demand for such stocks is high. This provides Soon with a unique opportunity wherein selling these quality names in order to generate liquidity is not a problem due to demand for quality. On the contrary, investing in them could take longer because people owning such names are not ready to part with them under normal market conditions.
On the second level, Soon ensures the strategy also maintains cash holdings, which can be used for redemptions in times of exigencies. Also on the portfolio level, the strategy is regulated against strict investment guidelines which ensure adequate diversification that avoids concentration. This diversification also helps to generate liquidity.
Soon says while it is true that small-caps are relatively less liquid than their larger counterparts and as a consequence, the strategy works better for those who are willing to hold onto quality stocks through short-term volatility, at least for a medium term.
Opportunities abound, if you know where to look
Uncovering opportunities while managing risks in this asset class is far from easy. The role of an active strategy manager is to determine which small-cap companies will likely succeed and become future leaders over time while simultaneously managing the risks of the overall asset class. If done well, the strategy will provide investors with enhanced risk-adjusted returns, strong liquidity and access to strong growth trends in the world’s fastest growing region. It is worth bearing in mind that many of today’s large caps were yesterday’s small caps. Some of today's most successful global companies, such as Apple. Google, Nike, and Amazon emerged from humble beginnings, reportedly, even starting out in a garage.
Fund Profile Box
*Source: Morningstar, as of September 30 2017.
Note 1: The website has not been reviewed by the Securities and Futures Commission.
Investment involves risks. Past performance is not indicative of future performance. Investors should refer to the offering documents for details, including risk factors. This material is issued by PineBridge Investments Asia Limited and has not been reviewed by the Securities and Futures Commission. PineBridge Asia ex Japan Small Cap Equity Fund (the “Fund”) is a sub-fund of PineBridge Global Funds, an Irish domiciled UCITS umbrella fund, authorized and regulated by the Central Bank of Ireland.