“If everyone in China lengthened their shirt tails by a foot, the textile mills of England would spin for a year.” That’s what one Englishman reportedly saidnearly two centuries ago about the prospect of selling to, and profiting from, consumers in emerging markets.
Today, not much has changed. In a world in which most developed markets are struggling with too much debt and too little growth, few themes get investors more excited than the prospect of benefitting from the billions of relatively debt-free consumers in emerging markets. Across the globe, emerging market growth continues to create hundreds of millions of new middle-class consumers. By 2025 China, India and Brazil are respectively expected to be the 2nd, 4th, and 9th largest consumer markets in the world.
However, accessing emerging market consumers may not be as simple as just owning broad emerging market funds. In fact, investors who are looking to specifically gain exposure to emerging market domestic consumption may want to consider the small cap segment of that market. Here’s why.
The companies that tend to dominate broad emerging market indices are large, multi-national firms that are often more levered to the global economic cycle than to local consumption. Such companies, for instance, make up roughly two-thirds of the MSCI World Emerging Market Index. Just consider the sectors that dominate that index: Financials (24% of the index), energy (15%), technology (14%) and materials (13%).
In contrast, small cap emerging market indices tend to provide a more concentrated exposure to domestic demand. These indices are less dominated by large, global cyclical plays and have a higher concentration of companies in industries with a local flavor, such as capital goods, real estate, consumer discretionary, and food and beverages.
To be sure, I’m not suggesting that investors abandon emerging market large cap stocks. As I’ve been advocating since the end of 2011, there are both short- and long-term rationales for overweighting certain emerging markets.