How to pick small cap stocks? Top fund manager shares her strategy

In this edition of ‘Kopi-Gao: Outperforming Markets with Top Fund Managers’, we speak to Grace Yan, Senior Portfolio Manager of Asian Equity at Nikko Asset Management. 

Grace manages the award-winning Nikko AM Shenton Emerging Enterprise Discovery Fund (SEED Fund), and shares with us on how investing in stocks of Asia ex-Japan smaller companies can potentially be advantageous to an investor’s portfolio. 

The SEED Fund offers investors easy access to a managed portfolio of small and medium-sized companies in the Asia-Pacific region that are hidden gems and have the potential to grow into stable and matured companies. 

The Fund has won the Fund Selector Asia Fund Awards for Asia Pacific Equity (Gold) 2023 and 2024. 

1. What is the Shenton Emerging Enterprise Discovery Fund? 

The Nikko AM Shenton Emerging Enterprise Discovery Fund contains all our best ideas of small companies in Asia excluding Japan. “Small companies” refers generically to both small and medium-sized companies.

Our fund has three unique characteristics. 

• We look for undervalued small cap stocks across the entire investable universe which amounts to about 4500 stocks. The MSCI Asia ex Japan small cap index has more than 1000 stocks, despite that, 42% of our portfolio is in non index stocks. This means we really scour the investible universe with a fine-toothed comb. 
• We are genuinely invested in small companies; 34% of our fund is invested in stocks less than 1 billion USD in terms of market cap. 
• Many small cap companies in the region are not well researched and analysed, which means there is a higher chance for mispricing. 32% of our fund has fewer than 6 sell side analysts covering it, so there’s a higher probability of the stocks being mispriced in the market. 

Note: Numbers as of end March 2024.

"Many small cap companies in the region are not well researched and analysed, which means there is a higher chance for mispricing."

2. What interests you about small companies in Asia? 

There are both long term and short term drivers that support small cap companies in Asia.

60% of the world’s population live in Asia, therefore there is a robust workforce for companies in Asia to tap on.  

Importantly, Asia has a growing consumer class which supports consumption and growth, providing a conducive environment for small companies to thrive. 

Millennials and Generation Zers, also known as the MZ generation, will account for 50% of Asia Pacific consumers by 2025. It is therefore important to understand them and tailor products for them. 

We think small cap companies in Asia are well positioned to benefit from this given their agility and adaptability. Smaller companies in general have flatter corporate structures and less bureaucracy and as a result are nimble and can respond to changes more easily and quickly. 

In the short term, we expect small companies to benefit from the falling interest rate cycle as they tend to outperform. In addition, with the current geopolitical environment of uncertainty, we think small companies will benefit as being more nimble will enable them to respond well to risks. 

"Asia has a growing consumer class which supports consumption and growth, providing a conducive environment for small companies to thrive. "

Past Performance is not indicative of future performance. 

3. What are some of the challenges investing in small cap companies in Asia? 

With the massive number of companies in Asia, it is simply impossible to analyse them all. 65% of small companies are covered by fewer than 5 sell side analysts. In contrast, 60% of larger companies in the universe are covered by more than 11 analysts. 

This means small companies are under researched, and herein lies our opportunity to invest in them. There is higher chance for these stocks to mispriced and trade away from their fair value. As a result, there is more room for alpha upside when we uncover these stocks. 

65% of small companies are covered by fewer than 5 sell side analysts.

4. How do you go about selecting stocks to own in the Shenton Emerging Enterprise Discovery Fund?

Change is a constant in Asia and small companies are nimble and well-positioned to capitalise on positive change. We look for positive change in sectors and/or countries which can benefit companies that are efficient and well managed. 

We over lay this with an ESG lens. Particularly in Asia where markets are diverse, we believe that focusing on these areas are key to delivering alpha. This is especially important for small companies which do not have ESG ratings on public sources. Hence, our own analysts do the analysis and engagement to rate them. Valuation is also incorporated as part of our analysis.

Through meeting companies, experts and channel checks, we generate our investment ideas.

"Change is a constant in Asia and small companies are nimble and well-positioned to capitalise on positive change. "

5. Can you share more about some of the top holdings in the Shenton Emerging Enterprise Discovery Fund?

Gold Circuit Electronics (GCE) is a PCB (printed circuit board) company in Taiwan with high exposure in server and networking. The company benefits from the growth in AI server as well as specification migration in general servers. GCE benefits from the growth in AI servers boosted with increase content growth per server. We view these fundamental changes positively. 

Dr Wu Skincare Co Limited is a skincare company that ranks number 1 in the cosmeceutical market in Taiwan. The company has introduced ingredients developed by dermatologic cosmetics labs and has been granted international patents. Its products are based on Dr. Ying-Chin Wu’s exclusive formulas, discovered and developed over the course of 50 years of clinical studies. 

The company has been growing steadily in Taiwan as well as overseas markets such as ASEAN, Japan and China. New growth drivers include cosmetics as well as health supplements. The company has high sustainable returns with return of equity ratios above 20% and net margins of above 30%. The company is in a net cash position and pays a 4% dividend yield. 

Note: Reference to the companies above is purely for illustrative purposes only and does not constitute a recommendation to buy, sell or hold any securities nor to be relied upon as financial advice in any way.

6. What kind of investors would be suitable for the Shenton Emerging Enterprise Discovery Fund?

We are looking for investors with a longer term horizon and a healthy appetite for risk. And with an interest in seeing their seeds sprout into trees that bear fruit. We call the Shenton Emerging Enterprise Discovery Fund SEED for short.

"Change is a constant in Asia and small companies are nimble and well-positioned to capitalise on positive change. "

7. What is one investing philosophy you hold? 

Collectively as a team, we believe that Change is important. We seek to understand the impact of change and how companies can benefit from positive fundamental change.

The introduction of ChatGPT is a good example of the change we look for. It took only two months for ChatGPT to reach 100 million users, as compared to Instagram which took 2.5 years to reach the same number of users.  The growth potential is huge. Companies are now racing to invest in Artificial Intelligence (AI). 

Closer to home in Asia, we see this change positively impacting both software and hardware companies. In Taiwan, there are many component suppliers that benefit from the growth in AI servers, from cooling fans, to multi-layer printed circuit boards. In Korea, companies that are benefitting from this change range from equipment manufacturers to software providers. In ASEAN, we also find multiple companies that benefit such as assembly and equipment manufacturers.

Another example of positive fundamental change we have seen recently is in Korea. The corporate value up programme announced by the KRX, with detailed plans on corporate changes to be disclosed in February after working closely with listed firms, has led to low Price-to-Book ratio stocks in Korea to rally.

8. What’s one tip you can share with those looking to invest in small and mid cap companies in Asia? 

There are many small companies in Asia which itself is an exciting region. It is important to have a firm understanding of the business model. If you cannot explain to others what the company does in your own words, it’s probably best to avoid it.

 "It is important to have a firm understanding of the business model."

About Shenton Emerging Enterprise Discovery (SEED) Fund

The Nikko AM Shenton Emerging Enterprise Discovery Fund (SEED Fund) invests primarily in the listed equities of small to medium-sized companies in Asia ex-Japan which in the Managers’ opinion are undervalued. 

The SEED Fund allows investors to access small and medium-sized companies that are hidden gems in the Asia ex-Japan equity sector. This presents plenty of opportunities for investors to invest in such companies that have the potential to grow into stable and matured companies.

Learn more about the SEED Fund here. 

About Nikko Asset Management 

With USD228.6 billion* under management, Nikko Asset Management is one of Asia’s largest asset managers, providing high-conviction, active fund management across a range of equity, fixed income, multi-asset and alternative strategies. In addition, its complementary range of passive strategies covers more than 20 indices and includes some of Asia’s leading exchange-traded funds (ETFs).

Headquartered in Asia since 1959, Nikko Asset Management has a presence through subsidiaries or affiliates in a total of 11 countries and regions. More than 400 banks, brokers, financial advisors and life insurance companies around the world distribute the firm’s products.

For more information about Nikko Asset Management and to access its investment insights, please visit the firm’s homepage.

* Consolidated assets under management and sub-advisory of Nikko Asset Management and its subsidiaries as of 31 Dec 2023.

About Kopi-Gao: Generating Alpha with Top Fund Managers

Kopi-Gao is regular column by Beansprout that features conversations with professional fund managers, offering a rare glimpse into the strategic thinking and personal philosophies that drive the world of investment. These interviews are aimed at providing insights and actionable knowledge for individuals looking to understand the art and science of successful fund management in today's ever-evolving financial landscape.