This year's cumulative increase is nearly 15%! Buying small-cap stocks is becoming a winning strategy for emerging market investors.

With the approach of the last quarter of 2023, a winning strategy in emerging markets is becoming increasingly clear: buying stocks of small companies.

According to the Dolphin Research APP, the return on this trade so far this year has been 12 percentage points higher than the MSCI broad stock index, making it potentially the second-highest relative return trade in the past 14 years. This is partly because large companies are more susceptible to the influence of some major Asian economies.

On the other hand, small-cap stocks are benefiting from local growth stories in countries like India, as well as the hype surrounding investments in young companies in the artificial intelligence and electric vehicle sectors.

Jitania Kandhari, Deputy Chief Investment Officer at Dolphin Research, which manages over $1 trillion in assets, said, "Since the end of the COVID-19 pandemic, small-cap stocks in emerging markets have outperformed large-cap stocks, consistent with historical trends where small-cap stocks have performed better than large-cap stocks after emerging from a recession. The strong domestic recovery cycle has driven the initial strong performance, while the underperformance of large-cap stocks has further fueled this trend."

Year-to-date, the MSCI Emerging Markets Small Cap Index has risen by 14.7%. The index includes 1,905 stocks with an average market capitalization of $583 million. In comparison, large-cap stocks have an average market capitalization of $7.9 billion and a growth rate of 2.5%.

Growth Stories

Certain small-cap stocks are generating impressive returns: Wistron Corp. and Global Unichip Corp. in Taiwan have surged 255% and 131% respectively this year, benefiting from their association with the development of artificial intelligence. Stocks like Jindal Stainless Ltd. and Rail Vikas Nigam Ltd. in India have risen by at least 100%, primarily due to India's status as the fastest-growing economy among major countries.

Ecopro BM Co. in South Korea has seen the largest increase in an electric vehicle index, rising by 204%. Yduqs Participacoes SA, an education company in Brazil, has seen its stock price soar by 103%, benefiting investors who bet on the company's recovery from the slump caused by the COVID-19 pandemic and its emphasis on digital revenue.

Ashish Chugh, Portfolio Manager at Loomis Sayles & Co. Portfolios, said, "Small-cap stocks in emerging markets outperforming large-cap stocks is more due to country-specific factors." He added that his current investment strategy prioritizes portfolios in India, Taiwan, and South Korea. However, the high rate of return also means an increased risk for investors. The volatility of small-cap stocks in emerging markets is notoriously high, and these stocks are usually the first to be sold off when risk sentiment worsens. During the bursting of the dot-com bubble in 2000, the financial crisis in 2008, and the geopolitical tensions in 2018, these stocks caused significant losses for investors, with the performance of the MSCI Small Cap Index lagging behind the Large Cap Index by about 30%.

Low regulatory standards, political intervention, and governance issues all affect the performance of small-cap stocks. Even in large economies like India, these stocks are targeted by market manipulators, rendering retail investors' investments worthless.

For well-managed and sound business plans of small-cap stocks, the next boost may come from central banks preparing for interest rate cuts. Nenad Dinic, a stock strategist at UBS in Zurich, Switzerland, said that a new growth cycle could prolong their outstanding performance.

"With the backdrop of declining borrowing costs, small-cap stocks clearly benefit as they often rely more on debt financing than large-cap stocks," Dinic said.