"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 said nearly 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 benefiting 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.
In the near term, I expect emerging market countries to outperform based on low relative valuations, falling inflation and stronger growth. Longer term, emerging market stocks are likely to benefit from falling emerging market volatility and rising developed market volatility. However, if you're specifically trying to capture, and profit from, the secular rise of emerging market middle class consumers, it's worth considering that small cap stocks provide a more targeted exposure. I prefer to access emerging market small caps through the iShares MSCI Emerging Markets Small Cap Index Fund (NYSEARCA: EEMS), which has a relatively high weight to consumer discretionary stocks and real estate management and development, as well as the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS) and the iShares MSCI Brazil Small Cap Index Fund (NYSEARCA: EWZS) for more targeted access to Chinese and Brazilian small caps.
Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Investments in smaller companies typically exhibit higher volatility. Index constituents are subject to change.