Nick: Hello, everybody. This is Nick Robinson from abrdn and you're listening to the Emerging markets Equity Podcast, a show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. So, it's not been the easiest time to be an EM investor. If we look at how the broad MSCI EM Index has performed since the beginning of the pandemic, it's basically flat over those four years. So, it's hardly the most exciting performance despite some pretty big swings along the way. However, there's one part of the emerging investment world that's done quite well, and I think it's still largely overlooked by investors. That is, emerging markets smaller companies. So, looking at the EM small-cap benchmark, we've seen a return of some 40% in those same four years, well ahead of their large EM peers, and pretty much in line with the MSCI World Index, which benefits from all the exposure to the US and tech which certainly don't feel like overlooked parts of the market. So today we're going to go down the size, scale and talk about investing in smaller companies in emerging markets. To provide the expertise I'm delighted to be joined by my colleague, Osamu Yamagata. Osamu has been on our EM team based in London for 16 years and he's been running our small-cap funds for the last five years. So, he has a huge wealth of experience in this asset class. Osamu thanks for joining today I think the last time you were on was a couple of years ago when you were talking Latin American tech. So, it's great to have you all talking about something different today.

Osamu: No pleasure to be here. Thank you.

Nick: That's great. Well, why don't we kick off with perhaps, you know, I talked about the asset class being a bit overlooked. So, what do you think the biggest misconception is that investors have about the small-cap asset class?

Osamu: Yeah, I think people think that EM small caps is the riskiest segment of the riskiest region of the riskiest asset class. And, you know, to invest, you have to be a kind of a real emerging market bull to do that. But, you know, the truth is actually the opposite. I mean, historically, the standard deviation or volatility or I guess the risk for the asset class has been lower than the majority of regional small caps and even the EM large cap space. And then from an absolute return perspective, this delivers some of the strongest returns over the last few years. And that's, you know, even within the global peers, so from a risk adjusted basis it's actually been a very very strong performance. So, I think that's the biggest misconception that people think you're taking excessive risk when actually you're really not in the small cap space.

Nick: Yeah, I mean, that's certainly how we see our clients behave in that typically they'll go to a large cap product first and then as bullishness increases, they'll may go into the small cap universe or even the frontier universe although that was some time ago now. I mean, you mentioned the strong returns and this big divergence that I highlighted in the intro between larger companies and smaller companies. What's really been behind that in in your view?

Osamu: Yeah, I think there are two things, two main factors, I’ll sort of go through in the order of importance. The first is that smaller companies have in general outperformed their large cap peers in their respective local markets. Why is that, local flows drive small caps and we've seen a huge democratization of access to equity markets, which has benefited the small end of the market, whether the inefficiencies are higher. On top of that, we've seen a pickup in global CapEx spending, whether it's infrastructure, green energy and just, you know, outright technology. And small companies tend to actually have a large exposure to the themes compared to the large cap peers. Where indexes tend to be more dominated by consumption and financials. Second is actually the makeup of the companies themselves. So, the biggest listed companies in emerging markets are largely in China. And when you include their A shares, you end up commanding a large portion of that index. In the small cap world, free flow liquidity is a lot more diverse and China actually ends up being quite a small component of the market. It's about 8% today, I guess. I think it's about 27% in the large cap space. You know, actually the biggest market for us in the small cap space is India, which has been very strong. And now constitute around a quarter of the index and obviously India has done better. So yeah, those to the that the biggest reasons for that for the outperformance.

Nick: I'm pleased that you mentioned China and India. I mean I feel like that is yeah one of the key kind of issues at the moment for portfolio constructors in emerging markets. And I think just on the last podcast we had, we had James Thom from our Singapore office to talk in depth about India and, you know, I guess the struggle that we have in terms of, you know, China being a large part of the benchmark with a quite challenging outlook, and then conversely, India also a large part of the benchmark, but with, you know, great outlook, but valuations to match. I mean, how have you fallen on that issue in terms of how you're running the small-cap funds? The India versus China issue?

Osamu: It's a really good question and one that we will certainly grapple with as a as a long-term investor. I'm still very much more confident in the growth of Indian companies and the stocks that we own are sort of exceeding expectations in a vibrant market. In China, we continue to see stocks under delivering on what have been very lofty expectations in the past. So, I do see that if there's any rotation from, say, expensive India to cheap China, I think it will be more opportunistic. And, you know, it's not something that we discount doing. But I suspect, you know, it's been more incremental than wholesale change in years, you know we do prefer investing for the longer term and I think India is the place to be.

Nick: So, thanks for that. Why don't you tell us about the small cap investing landscape? And you know, what have some of the most exciting opportunities and perhaps how does that differ from large cap?

Osamu: So the key drivers are domestic growth and obviously no where is currently more attractive than India, then it's technological innovation and green transition and supply chain diversification, and I’ll probably have that in that order. And most of our stocks have exposure to these future megatrends, you know, take an example our best stock performer last year was an IC chip designer house called Alchip they designed what's called ASIC or the full term is applications specific integrated circuits and you know the company's main driver is helping companies achieve AI or highly complex computing goals and it counts for most or around 75% of their revenue. You know, artificial intelligence requires horizontal processing, which is what GPU processes like Nvidia do very well. The alternative approach, which is more efficient, is to have lots of little chips with specific tasks working together to achieve the same goal. Now, without going into too much detail Alchip is a key designer for Amazon's artificial intelligence inference chips as well as other blue chip clients. In the large cap space and I guess this is why some of the differences, the common approach to that theme is to own TSMC, which is a fantastic, great company, and they might have it at sort of between 5 to 10%. And you can kind of tick off a large part of the chip innovation by having that single exposure. But for TSMC, artificial intelligence or high performance computing exposures that big piece of revenue. So, you know, when the market is appreciating the future growth drivers, you know, Alchip share price sort of tripled last year and that compared to TSMC around 30%. And that's where the risks of obviously if you do well the returns are in the small cap space. It's a more adventurous approach I'll say but yeah the rewards are there if you explore down the market cap spectrum.

Nick: Okay that's interesting. So, you could really focus in on a particular theme by investing in these companies which are much more levered to that theme. So, if you find a, you know, a great company and this bit of a basic question. But if you find a great company that's hugely successful and the share price goes up and it becomes a larger company, yeah, can you still own it if it leaves the small cap universe?

Osamu: Yeah, we like to let winners run. We won't buy anymore. But it does buy us some time to hopefully find the next idea that can do the same and graduate from small cap to large cap.

Nick: Great. And when we think about some of the most exciting things in EM like what you mentioned, so nearshoring, AI, green commodities, I mean can you find enough companies that benefit from those themes in the small-cap universe?

Osamu: Yeah, absolutely. There is a potential Alchip in every thematic that you mentioned in the small cap space. You know, there's a wealth of opportunities out there. And as I mentioned, the growth of those themes will be a really important tailwind for the asset class. We just have to make sure that we have a well-built ship of great companies. And as I put ourselves up and let them grow.

Nick: So trying to continue on your sailing analogy. As a skipper, how do you select your crew? So, I suppose what in your view makes a great company and what kind of factors are you looking for in terms of selecting companies for the fund?

Osamu: I mean, first and foremost, you want people you can trust. So, fraud, nepotism, poor ethics, these are the biggest risks for smaller companies. And it really boils down to ESG. And, you know, but I would put EG as the biggest, biggest risk and, you know, identify the risk takes experience and market knowledge. And fortunately, we have a really experienced investment team located near the companies that we invest in. So, you know, there's a very stringent quality test that all our companies have to go through. And then ultimately, it's about finding compounders, companies where you can see them deliver these better over the longer term than what market typically project where their focus tends to be more short term. And that's what really what quality companies do. They consistently beat expectations over cycles and expand returns in their own domain.

Nick: And do you stray much into frontier markets when you're investing or even some of the more racy emerging markets like Argentina and Turkey and the like?

Osamu: Yeah, no, you know, I think we learnt our lessons from the past. I think when you spend more time talking about the macro than the stock specifics, you're taking the wrong kind of risks. And that's not really our forte.

Nick: Yeah, it's funny, isn't it. Countries like Turkey and the stock market performance their sometimes completely mystifies me. And it's you have these years where the macro looks terrible, but the stocks and the stock market does really well because investors are trying to hedge inflation by putting their money into the stock market because things have got so bad in the banks, for instance. So it's it's often things you really couldn't even couldn't predict.

Osamu: I mean, one thing you can go with is volatility.

Nick: Yes, absolutely and those markets like Argentina always seem to stay volatile despite the changes in government that may be good.

Osamu: Yeah.

Nick: You've been, as I mentioned in the intro, you've been doing this for a long time. And what what are some of the key lessons you take away from investing in the in the small companies?

Osamu: Yeah, I mean, invest in companies not markets and actually that sometimes means that we have to be careful because features by companies we like, we might be unintentionally buying into a market or a macro trend. And when tides turn, you know, inevitably they always know you might find the stocks you bought individually ends up being a lot more correlated than you think. And that's the most important thing I've learned. Buy fewer and better companies, but make sure they are, you know, diversified,

Nick: So, diversified within the portfolio context rather than the companies themselves having different diverse revenue streams.

Osamu: Yeah. So, you know, don't buy a whole bunch of consumer staple companies because you like them. You know, quality companies in every country and every sector except the super racy ones, you know. And I think our job is to identify the best in each one.

Nick: And you've also invested in and analysed lots of large-cap companies is there much difference between the analysis that's required on large cap versus small cap? And thinking a little bit about the economic cycle, are there particular points where owning small caps tend to be more attractive as an investment opportunity.

Osamu: No, not really. I mean, what I would probably say is that large cap companies tend to have an army of analysts so there's probably less inefficiencies in terms of information. And again, they're probably more mature. So, it tends to be less about maybe taking market share or driving new avenues of growth, but may be more about calling a bigger economic cycle that is probably more about the macro or the secular trend. Small-cap companies are affected by that too, of course. But I would say the micro in terms of things like market share and product penetration is more important and that's probably a risky proposition. But correctly identified, the large caps of tomorrow I think has the biggest alpha potential. You just have to be quite diligent and do the work yourself. And this is all relative. And of course, you know, emerging markets by their nature still hold lots of potential and there are really some amazing large caps out there.

Nick: Yeah, Yeah, there certainly are. I mean, I suppose that comes back to your earlier examples of TSMC versus Alchip and how TSMC is much more geared into the global CapEx. TSMC is much more geared into the global semiconductor cycle, whereas Alchip is focused in on AI. Maybe if thinking about some of the other investments you've made within the strategy. Yeah. What's been your best investment and cruelly what's been your worst investment?

Osamu: I mean our best investment probably has been some ASM International and I feel like we've owned that since as long as I've been involved as a newbie at the company. So, it must be decades now. You know, initially we bought it as a holding company and to take advantage of the discount to the subsidiary ASM Pacific, and that's a well-known company that helps the back end process for making semiconductor chips. What we weren’t particular aware at the time was that they had also bought a company that was a pioneer of a nascent technology called ALD or Atomic Layer Deposition. And they basically had a thin film of material in exact places as part of the chip fabrication process and as chips get smaller and they are really really tiny now, the layers had to continue to get thinner. And they got to the point that this new technology was vital to progress Moore's Law, you know, looking at it now it's a 23 billion market cap. But it was our first sort of ten bagger. We still actually hold it in the fund. So, it kind of goes with the whole we like to let winners run. But yeah, we've been taking a fair amount of profit and recycling that into, you know, hopefully names like Alchip and other innovative companies. The other on, the worst investment. I don't actually want to single out a particular company and they're still listed, but I would say that investing in illiquid stocks and frontier markets as a group has been the worst investment, And to this day I mean, I don't think any of the stocks were badly or fraudulently managed or anything like that. But the unfortunate the countries that they operating in were and that's been the painful lesson to learn.

Nick: I feel like you might be talking about Russia there.

Osamu: Russia, Nigeria, Pakistan, Turkey. Russia wasn't so bad because actually we made back the costs of the investments that we have because we were we sold into a rally prior to that. But yeah, it’s definitely up there.

Nick: Yeah. I mean, I certainly don't recall many great conversations we've had on the team about companies in Nigeria and Pakistan recently. So, probably good to avoid those. Yeah. Okay. Well, well that's just like a good place to draw the podcast to a close. So, thank you very much Osamu for joining, it's been great to have you on.

Osamu: It’s been a pleasure, absolute pleasure.

Nick: And thanks to everyone today who took the time to listen in. If you enjoyed it, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode and tune in.