What does successful investing have in common with particle physics? Not a great deal, you may be relieved to hear, but the two do perhaps share something in terms of how we should see the world.
The idea that all matter consists of particles was first proposed by Democritus, an Ancient Greek philosopher. He used the word ‘atomos’ – which literally means ‘indivisible’ – inferring nothing smaller could exist.
By the early 1900s, thanks to scientists such as Faraday and Rutherford, it was established that Democritus was mistaken. The discovery of neutrons, protons and electrons revealed new layers of subatomic structure.
Fast-forward another century or so and we can add to the mix fermions, quarks, leptons, neutrinos, photons, bosons and more besides. The quest to reveal new particles at the quantum level is ongoing.
So where is the parallel with investing? Here the story begins with Harry Markowitz’s Modern Portfolio Theory, which was published in 1952 and was the first work to outline in detail the advantages of diversification.
Markowitz showed how spreading investments across asset classes could reduce risk. In effect, his key message was that it is safer to own a variety of assets than it is to own just one.
Further studies duly built on this concept by highlighting the advantages of diversifying within asset classes. They showed, for instance, that it might be unrealistic to suppose all stocks will perform similarly at any given time.
Yet even today, more than 70 years after the emergence of Modern Portfolio Theory, many investors still have what we might call a Democritus-like approach to diversification. They believe they are viewing the investment universe at a granular level, but the truth is they are barely scratching the surface.
Levels of diversification
Emerging markets serve as a classic illustration. Indices can offer conspicuously broad exposure to emerging markets, potentially overlooking the advantages of examining the bigger picture more closely.
Take the MSCI Emerging Markets index, which represents companies across 24 countries. This might sound reasonably diversified, but the underpinning philosophy is ultimately more atomos than quantum.
For a start, four economies – China, Taiwan, India and South Korea – account for around three quarters of the index. Such top-heaviness might itself be said to fly in the face of diversification.
Relatedly, only large-cap and mid-cap companies feature. Small-caps are nowhere to be found, even though they can frequently outperform their more sizeable counterparts over the long term.
As it happens, all four of the nations that dominate the index are in the region where we invest. Yet our allocations across Asia are very different – not least because, as active investors, we do not have to follow the herd.
Maybe most notably, we have far less exposure to China – around 11%, as opposed to the index’s 27%. We feel this allows us to benefit from more diversification in the context of sectors and industries, as well as factors such as demographics, regulation, policies and politics.
Crucially, we also have substantial exposure to smaller companies. These can be thought of as the quarks, leptons and so on of the investment sphere – the entities that are key to countless vital processes but whose importance is fully appreciated only by a select group of experts.
The trailblazers in this case are not Faraday, Rutherford and subsequent sages. They are the specialist investment teams that conduct their own in-depth, on-the-ground assessments and face-to-face engagement.
Shedding light on the unknown
Just as few people devote themselves to unravelling the mysteries of the subatomic realm, few investment analysts are expressly dedicated to smaller companies in emerging markets. This is an area that is significantly under-researched.
Hundreds of analysts follow the fortunes of large-cap businesses in the US, while dozens monitor those in Europe and other developed markets. The result: a practically relentless flow of data and insights with which to shape investment decisions.
Even in these markets, though, coverage of small-caps is negligible. The appeal of many mid-caps also goes virtually unremarked. So it is not difficult to imagine how little attention the average emerging market smaller company tends to attract.
This can prove to investors’ detriment. Wherever they are in the world, smaller companies can be more agile and innovative than larger businesses – meaning they are better able to respond to or drive disruption and positive change.
In turn, this can translate into more capacity for outperformance over time. The phenomenon is especially evident at present in economies such as India, where we are unearthing more hidden gems than anywhere else in Asia, and Indonesia, where multiple dynamics appear to support continued growth.
The fundamental lesson, then, is to dig deeper. With a focus on sensible, high-conviction diversification – usually 50 to 60 stocks in our fund – and optimum investment outcomes, it is useful to get beneath the surface rather than merely scratch it.
This means it may not be sufficient to think of emerging markets in the most broad-brush terms. It may not be sufficient to apply a regional or even country-specific framing. And it may not be sufficient to concentrate only on companies that are in relatively plain sight.
Democritus once observed: “Nothing exists except atoms and empty space. Everything else is opinion.” In my opinion, the argument for diligent, informed, active stock-picking in emerging markets is well worth considering.
Gabriel Sacks is co-manager of abrdn Asia Focus. The views expressed above should not be taken as investment advice.