Institutional investors will have key role to play if the run in smaller-cap stocks is to continue

[SINGAPORE] During a meeting over lunch many years ago, a well-known fund manager told me that his emerging market funds had failed to outperform their benchmarks – not because he had backed the wrong stocks, but because his funds had been unable to maintain sufficiently high exposure to the best performers.

He said his funds were not allowed to be more than 10 per cent exposed to a single stock in order to mitigate concentration risk. Yet, their benchmarks were often dominated by a handful of big, well-run companies with shares that were relatively liquid and garnered premium market valuations.

Being unable to match the index weightings of these strong performers, the funds ended up trailing behind. While I was somewhat sceptical, the explanation seemed plausible enough at the time to stop me from pressing him any further about his underperformance.

Thinking back now, I should perhaps have asked him if engaging with professional fund managers such as himself had encouraged any of those emerging market companies to raise their game. This is, after all, how Singapore plans to revitalise the local market.

With the rollout of the S$5 billion Equity Market Development Programme (EQDP) by the Monetary Authority of Singapore, and the introduction of the iEdge Singapore Next 50 Indices by the Singapore Exchange (SGX), the expectation is that there will be wider institutional investor participation in the local market over time.

This, it is hoped, will lead to institutional investors taking on a key stewardship role, engaging with the boards and management of smaller-cap listed companies, and pushing them to unlock value and strengthen their core businesses.

Over the past few months, the optimism has been palpable. The iEdge Singapore Next 50 Index is up 21.7 per cent so far this year, while the iEdge Singapore Next 50 Liquidity Weighted Index has climbed 22.2 per cent. The Straits Times Index is up 14.3 per cent.

Will the smaller-cap segment of the Singapore market continue to shine? Or, will the institutional investors that are being drawn to the local market ultimately have to maintain big exposures to the largest cap stocks in order to generate decent returns?

Betting on the ecosystem

Earlier this month, The Business Times published a letter from a reader expressing disappointment that the iEdge Singapore Next 50 Indices emphasise market capitalisation and trading liquidity as their criteria for inclusion, with no consideration given to financial performance and corporate governance.

The reader noted that South Korea has introduced a new market index as part of its “value-up” programme, which includes among its criteria for inclusion whether a company generates a sufficiently high return-on-equity, and whether it has paid out dividends or repurchased its own shares.

This provides a clearer basis for investors to engage companies on their efforts to improve their fundamentals and governance, the reader argued.

SGX said in its own letter to The Business Times last week that liquidity considerations were important in ensuring the replicability and institutional relevance of the iEdge Singapore Next 50 Indices.

It added: “What we need is for the broader ecosystem to introduce new indices – including value-based and governance-driven ones – in our stock market so that market participants have greater choices to decide which segments of the market they would like to track.”

Big cap revival

In my view, the iEdge Singapore Next 50 Indices in their current form will be just as effective in promoting market discipline among smaller-cap companies as the STI has been in the large-cap space.

While the STI delivered dismal overall returns during the years leading up to the pandemic, it never ceased functioning as a barometer of corporate performance. Companies that meaningfully improved their fundamentals outperformed their peers and the wider market. Conversely, companies with weakening fundamentals trailed behind.

Notably, in late 2017, DBS edged ahead of Singtel in terms of market capitalisation. It never looked back. Today, DBS has a market value of S$147.6 billion, versus Singtel’s S$69.5 billion.

At the end of last month, DBS had a nearly 26 per cent weighting in the STI. OCBC and UOB were far behind, with weightings of 13.5 per cent and 10.8 per cent, respectively. Singtel is in fourth place, with a weighting of 7.5 per cent.

Without significant exposure to DBS, a Singapore-focused investor may have struggled to keep pace with the STI over the past decade.

Since the pandemic, however, a number of STI companies have made bold moves to reposition themselves, leading to big market re-ratings of their shares. Among the best performing STI components this year are ST Engineering (up 73.8 per cent), DFI Retail Group (up 46.8 per cent), Hongkong Land (up 38.9 per cent), Keppel (up 36.8 per cent), and Singtel (up 36.7 per cent).

Institutional investors crucial

In a similar fashion, efforts by components of the Next 50 Index to unlock value and strengthen their core businesses will probably be reflected by the market value of their shares over time, as well as their relative weightings in the index.

Last month, only two stocks – Yangzijiang Financial and CapitaLand Ascott Trust – had weightings of more than 5 per cent within the index. A further six – ComfortDelGro, NetLink NBN Trust, Keppel Reit, Suntec Reit, Keppel Infrastructure Trust and Parkway Life Reit – had weightings of between 4 per cent and 5 per cent.

Yet, many of the Next 50 stocks have charted very big moves. Since the beginning of this year, five of them have chalked up triple-digit percentage gains: Hong Leong Asia (up 176.9 per cent), Yangzijiang Financial (up 150.6 per cent), Propnex (up 140.2 per cent), Food Empire (up 118.2 per cent), and Pan-United Corp (up 101.8 per cent)

The worst performers since the beginning of the year were Riverstone (down 26.2 per cent), Singapore Post (down 23.6 per cent), and Olam Group (down 20.5 per cent).

The big question is whether the Next 50 stocks that trail the index for a protracted period of time will respond in the same positive manner as many of the STI’s erstwhile underperformers. Do they have businesses that can be scaled? Are their boards and management capable of driving the necessary change?

Whatever the case, a lot could depend on whether institutional investors play the stewardship role expected of them effectively. The way I see it, fund managers who receive EQDP funds should be encouraged to engage with companies more actively, and in a more public way.

This could go a long way in rallying other investors and motivating underperforming companies to at least try taking some remedial action, ensuring that the Singapore market delivers decent, broad-based returns.