Morgan Stanley Capital International (MSCI) recently announced enhancements to their standard international indices.  These changes are designed to allow for greater comparability among emerging market investment managers and in the case of emerging markets small cap, will help establish its place on the global investment map.

In order to dissect emerging markets small caps, we first need to revisit emerging markets as a whole.  Emerging markets investing has long been classified as a boom-or-bust proposition, with countries often lumped into one broad category.  However, with increasingly sophisticated financial markets, access to capital and higher legal and regulatory standards, a new environment for emerging markets has been created.  The lines between emerging and developed economies have been blurring for some time now.

Growth in the U.S. and other developed international markets is slowing, while emerging markets growth is still in its infancy.  PricewaterhouseCoopers estimates composition of relative economic size among countries will change drastically over the coming decades.  Currently, the U.S. is the largest economy in the world, with seven of the next eight largest economies those of developed market countries.  By the year 2050, it is projected that the U.S. will still be the largest world economy, but five of the next six largest economies will be those of emerging market countries. See chart below.

Two major secular mega-themes are driving this scenario:  consumer-driven demand and infrastructure development.

Emerging Markets: Consumer Demand and Infrastructure Development
Emerging markets financial systems are becoming much more flexible, with banks and other lenders in a better position to finance consumption and investment than ever before.  Access to capital, coupled with all-time low inflation and interest rates, is driving a boom in spending.  Emerging markets consumer-driven areas are broadly diversified, including Mexican homebuilders, Brazilian automakers, Russian banks, Chinese branded apparel, and Southeast Asian real estate.  The expectation is for these trends to continue over the long-term.

Along with increased consumer spending, infrastructure demand in emerging markets economies is also exploding.  Demand for roads, bridges, rail, electrical supply and housing projects is at record levels across emerging markets countries.  General Electric predicts that developing market infrastructure spending could be $3 trillion over the next ten years.  This ends up being windfall demand for many countries such as South Africa, Brazil, and Russia who supply a majority of the world’s energy and materials.  This infrastructure development boom is also expected to continue for the foreseeable future.

Emerging Markets Indices
So, if growth in emerging markets should continue for some time, namely from consumer and infrastructure themes, then all investors need to do is to invest in a strategy that is similar to the MSCI Emerging Markets Index (EM) and hold it for a long time, right?  Not exactly.  While the current MSCI EM Index is the industry standard to gauge emerging markets performance, it does have its flaws, namely concentration in a handful of names and lack of broad sector coverage.

The current MSCI EM Index contains roughly 850 stocks, which account for approximately 85% of the market cap in emerging markets countries.  While on the surface this appears to be relatively representative of the basket of emerging markets securities, it is far from perfect.  Concentration in a few mega-cap names effectively skews performance results of small, less-capitalized companies.  Of the approximately 850 stocks in the current MSCI EM Index, the ten largest names account for nearly 20% of the entire index.  These names include the likes of Russian energy giant Gazprom and electronics maker Samsung, which account for 4.0% and 2.8% of the total index, respectively.  Many large-cap names such as these are driven by global aggregate demand, rather than anticipated growth in emerging markets.

Lack of broad sector coverage is also evident, with roughly 60% of the top forty positions in the current index comprised of energy, information technology, and materials sectors.  These particular sectors are also much more correlated to global demand than increased growth in emerging market countries.  Consumer-driven staples and discretionary sectors rest on the back burner representing only 11.7% of the current MSCI EM Index.  Owning the current index leaves investors less than diversified and doesn’t allow them to take advantage of the consumer-driven and infrastructure demand themes.

The new MSCI index should help create alternate routes to help drive emerging markets investing.  The new structure (dubbed Enhanced Standard by MSCI) will soon consist of roughly 700 large-cap stocks and will replace the old Emerging Markets universe.  This universe will still display concentration risk and sector coverage in larger-cap names as previously discussed.  However, a new small-cap emerging markets index is being developed and will include approximately 1,200 stocks, most of which are new additions from MSCI.  Together, the Enhanced Standard and new Small Cap indices will capture nearly 99% of the investable market cap within emerging markets.  There will be a gradual transition and timeline to move from the current MSCI EM benchmark to the new indexes.  MSCI will begin publishing the new small-cap index on June 5, 2007 and transition to the new indices will officially be completed in May 2008.  The exhibit at left shows sector weightings for the current MSCI EM Index alongside the new small cap index.  See chart below.

Notice the stark contrast of increased weightings of sectors such as industrials, along with consumer staples and discretionary, while energy, for example, has shrunk dramatically.  If projections for increased long-term growth for emerging markets economies are on track, these smaller-cap names should benefit over the longer-term.

There are still risks to investing in smaller-cap emerging markets stocks.  First, smaller-cap stocks are generally not as liquid and have less analyst coverage than their larger-cap counterparts.  Also, the possibilities for unstable governments, currency evaluation and general economic uncertainty are still higher than in developed countries.  This, however, creates opportunity for the bottom-up investor who can decipher information and identify best-of-breed companies who will capitalize on long-term themes.

The advent of the new MSCI Emerging Markets Small Cap Index will help create a more investable asset class with increased trading volumes, which will drive analyst coverage, and should ultimately lead to higher multiples and price appreciation.  These upcoming changes, coupled with consumer-driven and infrastructure demand themes, should offer long-term alpha opportunities in small-cap emerging markets stocks.