Investing in Asian mid-small caps: Identifying long term performers and avoiding disappointments

Ernest Yeung, CFA Portfolio Manager International Small Cap Equity Strategy T. Rowe Price Hong Kong

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Ernest Yeung is a portfolio manager for the International Small-Cap Equity

Strategy at T. Rowe Price. Mr. Yeung is a vice president of T. Rowe Price

Group, Inc., and T. Rowe Price Hong Kong Limited. Mr. Yeung has 12

years of investment experience, 10 of which have been with T. Rowe

Price. Prior to joining T. Rowe Price, he was an analyst with HSBC Asset

Management in London. Mr. Yeung earned an M.A. with honours in

economics from Cambridge University. He achieved his I.M.C. in 2001

and has also earned the Chartered Financial Analyst designation.

Discussion outline

Why do we invest in mid-small caps?

What makes a sustainable growth small cap company?

How to avoid pitfalls in small cap investing?

Defining the Mid-Small cap universe

We define mid-small cap as companies with market cap of below 5

billion USD.

This opportunity set is dynamic- IPOs, mergers and privatizations are

active

Quality of companies varies; we tend to focus on only 20-30% of this

opportunity set.

What are the differences between small cap and large cap investing?

A rough comparison between large cap and small cap investing in AxJ

Large cap >5b Mid-Small cap >200mil, <5bn

Number of names ~350 ~2500

Heavy weight sectors Energy, Banks, telco, tech,

properties

Healthcare, consumers,

industrials, media

Ownership structure SoE or professionals,

large free float

Large family/founder

ownership, low free float

Sell side coverage >10 analysts per stock 3-5 analysts per stock

The sector composition is different. The mid-small cap space has fewer quality

companies in financials, energy, tech. There are more domestic orientated

sectors like media, retail, healthcare, industrials.

The major shareholder is often the founding family as well as the key

operation executive, and this results in a different incentive dynamic

Lack of sell side coverage is a risk as well as an opportunity

In the short term, small caps can be more volatile than large caps; Trading

liquidity can be an issue. Hence you need to take a long time horizon when

investing.

Why invest in mid-small cap stocks?

We believe in the small cap effect: picking the right small cap company

means its business will grow in a sustainable manner through business

cycles.

Its small market cap can compound into a large cap company, resulting in a

handsome return for the minority shareholders.

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Not all high growth stocks will experience the “small cap effect”

The key is the word ‘sustainable’ and not just ‘growth’.

Majority of Asian SMIDs have good growth. The economies are growing, they are

taking share, base effect is low. But this does not make them good stocks.

In many cases the revenue growth does not turn into profit or cash flow, i.e. minorities

will not benefit.

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WHAT MAKES A SUSTAINABLE GROWTH SMALL CAP COMPANY?

Evaluating competitive dynamics

To ensure a small company will grow through business cycles- it has to

withstand competition.

We find the simple Porter’s Five Forces framework yields very good results.

Source: Porter, M.E. (1980)

Evaluating the management

It’s a human business: Knowing the management’s past track-record as well as

monitoring their execution is very important.

We have had better success with professional managers than founders/ entrepreneurs.

Good managers tend to allocate capital efficiently: cash return to shareholders, value-

accretive MnAs.

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HOW TO AVOID PITFALLS IN SMALL CAP INVESTING?

Risk control is another key component when investing in EM mid-small caps

We need to be humble. No matter how much due diligence we do, information

is asymmetric and there are always things that we don’t know.

Companies can go from good to bad.

Management can make bad decisions.

Monitor red flags and spot the inflection points in the thesis- we need to be

early to exit.

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Red flag examples- financial metrics

Complicated corporate structure/confusing business model – You can’t explain the business model by drawing a simple picture

Change of auditors – Frequent (and unexplained) change in auditors. Going to a non-big 4

– E.g. “KPMG is too expensive. We are going to Haribhakti & Co.”

Weak cash generation, large working capital swing – Sustained outflow of operating cash and free cash even during the period of strong earning growth.

– Unusual AR/inventory day trends

Aggressive accounting – Use of creative accounting policies to inflate revenue or to deflate expenses

– Significantly faster revenue growth vs peers. Abnormally high margins that cannot be explained by

competitors.

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Red flag examples- management behavior

Unintelligent management

– A simple-minded CEO/CFO is worse than a poorly executing manager.

– He/she had no idea of company financials or industry metrics- "I will get back to you"

– Failed to realize mistakes made in the past

Insider selling/share pledge

– Consistent pattern of share sales by main shareholders + investing in other (allied) businesses.

– Pledge of shares as collateral, especially if a very large % of management's shareholding.

Management putting their self interest over minorities

– Earn out payments to key managers

– Questionable option pricing

– Managers own direct stake in subsidiaries

Arrogant/Stubborn management

– Mgmt seem to be smug about prospects. Downplay reasonable risks

– Bad body language, avoid inconvenient questions

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Price Chart for company E