Asian Small Caps: A Historical Lens on 2025's Undervalued Opportunity

The current small-cap rally in Asia is not a new anomaly. It is a recurrence of a historical pattern where stress creates opportunity. The recent market correction, with indexes like the Hang Seng plunging over 8% in a single session, mirrors the panic selling seen during the 1997 Asian financial crisis. In that crisis, regional contagion was the primary risk. Today, the structural insulation provided by a smaller China weighting in the small-cap index is proving advantageous. The MSCI AC Asia ex-Japan Small Caps index has only a 6.7% weighting to China, compared to 28.6% in the broader large-cap index. This feature, which proved beneficial during past regional crises, is now creating a divergence in performance.

The result is a clear outperformance. While the broader MSCI AC Asia ex-Japan index is roughly flat at 0.38%, the small-cap index has returned 14% year-to-date. This isn't just a temporary bounce; it's a sustained pattern. Data shows that small-cap focused strategies stand out as the most common type of strategy that delivered strong returns both in the short run and long run. The recent correction has created valuation opportunities similar to historical patterns of stress followed by recovery, challenging the perception of small caps as inherently more volatile.

The investment logic is straightforward. When a market sells off, the most heavily leveraged and speculative names often lead the decline. This creates a natural sorting process.

The small-cap index's lower China exposure provides a buffer against regional contagion, while its focus on domestic-focused companies can insulate it from external shocks. The recent rally, therefore, is a test of this pattern. It validates the thesis that in times of stress, the structural advantages of a diversified, less China-dependent portfolio can translate into outperformance. For investors, the setup is clear: the historical playbook of stress followed by recovery is being written again, with small caps as the likely beneficiary.

Sector Mechanics: From Automotive to AI, the Growth Engine

The outperformance of emerging markets in 2025 is not a broad macro bet; it is being driven by specific, powerful sector tailwinds. These are the durable, company-level catalysts that cut through the noise of geopolitical headlines and Fed policy debates. The mechanics are clear: when industrial demand aligns with technological shifts, small-cap earnings can accelerate at a pace that signals a structural or cyclical inflection.

The automotive components sector is a prime example of this acceleration. Zhejiang Asia-Pacific Mechanical & Electronic, a supplier to the global auto industry, reported earnings growth of 145% last year. That level of performance is extreme, far outpacing the industry's 8% growth. It points to a powerful shift, likely driven by a combination of a cyclical recovery in global vehicle production and a structural push toward electric and connected vehicles, which require more complex, electronics-heavy components. This isn't just a seasonal bounce; it's a fundamental earnings ramp that can sustain outperformance if the underlying demand holds.

A parallel story is unfolding in the semiconductor supply chain, where AI demand is acting as a powerful export-led engine for regional small caps. As noted, South Korea was the top-performer among our markets in 2025, as leading memory chip companies benefited from strong demand in the AI-related High Bandwidth Memory (HBM) market. This mirrors the historical pattern where export-driven industrial sectors were central to regional recoveries, like in the late 1990s. The tailwind is direct and measurable: hyperscaler capital expenditure for AI is creating a multi-year demand cycle for specialized chips, directly boosting the earnings of companies in Taiwan and South Korea that are embedded in that chain.

The quality of earnings in these sectors is critical for sustainability. Look at GMO Internet in Japan, a company that has turned around from a loss to a net income rebound of ¥4.01 billion for the nine months ending September 2025. Its financial health is robust, with interest payments covered by EBIT at a 56x coverage and it maintains positive free cash flow. This demonstrates that strong earnings momentum, backed by solid balance sheets, provides a more durable foundation for rerating than price momentum alone. It's the kind of quality that can weather the volatility of a sector cycle.