26 June 2019

How to Think Big in Asia ex Japan Small Cap Equities

Across Asia, continual innovation, a growing middle class, and urbanization are cultivating fertile soil for small-cap companies that have yet to fully bloom. In fact, within the Asia ex Japan region, 90% of all listed corporations – about 15,000 – are small-cap. These businesses offer a plethora of investment choices across different sectors, markets, and trends. Yet this segment of the market is often under-researched, under-owned, and, in many cases, undervalued. Here, Portfolio Manager Elizabeth Soon answers some frequently asked questions about this potentially rewarding, yet often overlooked, asset class.

Q: Why do Asia ex Japan small-cap stocks, which often are perceived as risky, present an opportunity?

A: Compared with their larger counterparts, Asian small caps often are unexplored. That offers investors an attractive opportunity in the form of mispricing – especially for investors able to unlock the hidden value from underpriced stocks, which can potentially generate exponential returns over time. To allow for an adequate margin of safety, we use a fundamental bottom-up selection process to pick the best companies and construct portfolios. Since we don’t believe in portfolio churning, our strategy likely works better for those who have a longer-term investment horizon and are willing to hold on to quality stocks through short-term volatility.

Q: How do you identify underpriced stocks?

A: We emphasize the assessment of value. We believe that process starts by going back to basics. Instead of relying on news, our first step with a newly listed issue is reading and analyzing the prospectus. We look deeply into past performance to determine whether the company can continue to deliver in the future, and then we find out more about the company, its industry, and the competitive landscape. Once we do all that, we have a truer picture of what the company is worth and can determine its intrinsic value. Matching that value with the right price in the market is where the opportunity lies.

Q: How do you determine when to sell a stock?

A: While we are long-term investors, there are times when we have to sell shares, such as when a company’s management team changes its strategy, if it overpromises and under-delivers, or if the quality of management deteriorates significantly. We also may sell when shares reach our target price or when other stocks present significantly better opportunities. However, because liquidity is an integral part of our due diligence and selection process, we only include stocks in our portfolio that meet rigorous liquidity standards. The companies meeting such stringent criteria are few and far between, which makes investor demand for such stocks high, regardless of market conditions. The diversification of our portfolio also supports liquidity, and we maintain an adequate cash cushion, which can be used for redemptions in times of exigencies.

Q: How do you manage volatility and risk?

A: Contrary to what is taught in mainstream finance, stock price volatility is not necessarily a synonym for risk. It really depends on an investor’s time horizon. For long-term investors, volatility provides opportunities to invest in growth potential at lower prices. In the short term, though, especially at times of market stress, small caps may bear the brunt of selling pressure first because markets for these stocks tend to be less liquid than markets for large-cap stocks. Yet despite the essentially technical pricing pressure of a sell-off, the intrinsic values of the stocks under siege typically haven’t changed, only current nominal prices have shifted – which matters to those who think short-term, of course, but shouldn’t concern long-term investors very much. True long-term risk, therefore, should be determined by a company’s fundamentals, not its current market cap or the fluctuation of its share price.

To mitigate true long-term risk, we follow a rigorous due diligence process that combines experience, deep knowledge of the asset class, and a checklist approach. Think of our checklist approach as the way experienced pilots approach their jobs. Even though they rely on highly sophisticated technology, pilots still follow a methodical process to perform the most routine tasks, ensuring that nothing is overlooked or missed. Likewise, we follow a similarly rigorous methodology to identify small-cap stocks that offer true investment value at the right price.

Q: Is this a good time to invest in Asia ex Japan small cap equities?

A: Equity markets will always have issues to address; that is the nature of the investment business. Today, global attention is focused on trade rhetoric. Before this, it was Brexit and geopolitical issues.

The trade conflict can hit Asian companies through two channels. One is through products and services that might get disrupted and potentially damage a company’s business model. The other is confidence, where stock prices might fall without affecting the underlying value of the company. Product and service disruption can be avoided, whereas confidence cannot. As an active manager, we seek to avoid companies whose business models may be disrupted due to ongoing trade issues. Thankfully, Asia is a big region with diverse growth drivers, which allows us to scout for companies whose businesses are regionally or domestically focused and are relatively insulated from external factors.

In the middle of difficulty lies opportunity. In the ongoing trade friction, we are seeing a structural shift where companies are moving to other developing countries in the region, which could help Asia’s overall development. Indeed, on the ground, we are seeing increasing foreign investment enquiries and activities in Southeast Asia, and we will continue to monitor this trend.

As we construct portfolios, we must deal with uncertainties. The key is to ensure that the portfolio weathers such crises. The MSCI Asia Pacific ex Japan Small Cap Index has gone up over two times from October 2008 through to 20 June 2019. During this time period, we have gone through many adverse market events including the global financial crisis, geopolitical crises, and China-related issues in 2011, 2015, and 2018.

Overall, investors should remember the most important things: what businesses are doing on the ground and the prices at which their stocks are available. In our view, despite the souring investor sentiment toward Asian companies, it is business as usual for most of the companies that we follow. And to top it all off, their valuations have come down significantly. In other words, though the prices of these companies have either not moved or have come down, the value of the underlying businesses measured by company earnings has appreciated. This price-value gap will eventually correct, and investors, especially those who are going to be net savers for a long time, could use this near-term negative sentiment to increase their allocations to equity.


Disclosure

Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any re-publication or sharing of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.

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