Scouting For Big Bargains Among Foreign Small Caps

Like a wallflower at a party, global small-cap stocks sat out the 1990s bull market. These smaller companies, with market capitalizations of $1 billion or less, have continued to be laggards lately. The three-year total annualized return for small-cap foreign funds through Dec. 31st was 5.57% compared with 15.10% for the average small-cap domestic fund, according to Morningstar, the Chicago-based mutual-fund research company. The returns also look meager compared with those of the Russell 2000, which gained 13.69%, and the Standard & Poor's 500-stock index, which rose 19.66% over the same period.

Economics is partly to blame for the malaise of international stocks in general and small-cap stocks specifically. "The economies of other countries haven't rebounded as well or as quickly from the 1990 recession as the U.S. economy," says Gary Bergstrom, president of Acadian Asset Management in Boston. But global small caps are affected more than blue chips because they are more closely tied to local economies and rely on domestic interest rates. Large caps, on the other hand, usually multinationals, aren't as subject to their home-market economies.

COMEBACK CAPS. But after years of being battered, global small caps may finally be ready for a rebound, many money managers predict. And for investors looking for value or a contrarian play, or who believe in market cycles, now could be the time to think small. "Global small-cap stocks have been dramatically underperforming the larger companies for so long that we have to expect they're going to do much better in the future," says David Booth, chief executive officer of Dimensional Fund Advisors. "This is about as good a time as you're ever going to get to get into this market."

Indeed, many of the stocks of these companies in Europe, the Far East, and emerging markets are selling at bargain prices. Overseas small caps have been unloved, in part, because no one has taken the time to look at them. "International small caps don't have the following overseas that the domestic small caps have in the U.S.," says George Murnaghan, executive vice-president at Rowe Price-Fleming International.

Of course, a dearth of research often yields bargains because securities are more likely to be mispriced, says Bruce Bee, president of Bee & Associates, an international money management firm in Denver. "In the U.S., small-cap stocks are appropriately valued, if not overvalued," says Bee. "It's the opposite around the world. There's a huge gap in value." Many stocks are selling at low price-earnings ratios relative to their high growth expectations. A domestic small cap growing 15% to 20% annually probably sells for 20 times earnings. A similar stock abroad is selling for just 15 times earnings, or less.

Take, for example, Instrumentation Laboratories, an Italian diagnostic medical equipment company with a U.S. market cap of $180 million, a p-e of 11, and an expected earnings growth rate of 30%. Compare that with Los Angeles-based Diagnostic Products, which has a market cap of $345 million, a p-e of 22, and 12% expected growth in earnings.

Another reason to consider investing: Equity markets tend to move in cycles. Sometimes large-cap or growth stocks are in favor, other times small-cap or value are popular. Several years ago, many retail investors began diversifying their portfolios with international stocks, but they stuck mainly with large, well-known companies that had market capitalizations of $5 billion or more, such as Glaxo Wellcome and British Telecommunications. Retail investors virtually ignored the small-cap stocks, however.

And, finally, who knows how much longer the U.S. market can continue racking up 20%-plus returns? Even if you're not optimistic that small caps will outpace larger caps in the foreseeable future, you still might want to invest simply as a way to diversify longer term.

There's no shortage of stocks to consider. Outside the U.S., the total market capitalization of all companies is $11 trillion, according to John Boich, senior portfolio manager of Montgomery International Small Cap Fund. Small caps' piece of the pie: $1.8 trillion. In the past year, the number of mutual funds that invest all of their assets in small-cap stocks outside the U.S. has nearly doubled, according to Lipper Analytical Services. There currently are 24 funds, with total assets of $3.8 billion. By comparison, there are now 374 international funds. "These smaller-cap markets are just coming into their own," says Tricia Rothschild, international editor at Morningstar Mutual Funds newsletter.

Should you want to do your own stockpicking, you can. A limited number of depositary receipts and foreign stocks allow direct investment in small-cap stocks. Britain's Border Television and Cityview, an Australian petroleum company, are currently available through most brokerage services.

NO STANDARD. But be careful. Investing overseas is fraught with risk. The data can be hard to unearth, especially for individual investors. Even when information is available, timeliness is an issue: It's tough to be on the cutting edge of news overseas when the newspaper arrives a week late from Kuala Lumpur.

Foreign companies--especially smaller ones--generally don't combine subsidiaries into one financial statement. Consequently, it's harder to determine a company's performance. Nor is there any standard financial accounting system across borders, making comparisons between companies difficult.

It's not unusual for companies to report earnings annually, instead of quarterly as in the U.S. And many small foreign companies lack investor relations personnel or aren't adept at dealing with foreign investors. What's more, international markets tend to be less liquid than in the U.S. And be aware of currency risk: If the dollar continues to be strong, you may be in for currency losses.

Still, if you're interested in investing solo, investigate a cross-section of industries, depending upon the country you're investing in. "In Germany, you'll want to look at construction companies, in Japan and Singapore, technology," suggests Murnaghan of Rowe Price-Fleming. Some countries, such as Britain and France, will mirror the hot small-cap sectors of the U.S.: health care, retailing, and technology. Others, such as Mexico, will focus on more mundane businesses such as paper goods.

To minimize your risk, you're better off in a mutual fund. Funds tend to concentrate on particular regions. The Invesco European Small Company Fund invests one-third of its assets in small British companies; the rest are small caps on the Continent such as Italian apparel maker Gucci, its biggest holding. Lexington Crosby Small Cap Asia Growth Fund targets small companies in Hong Kong, Singapore, and other Pacific Rim countries. Its biggest positions are Hong Kong real estate firm China Resources Enterprises and Hock Seng Lee Bhd, a Malaysian construction company. Most small-cap funds invest in developed countries, but a smattering are in emerging markets, too. Founders Passport Fund invests in small caps all over the map, including German financial services company MLP and British restaurateur J.D. Wetherspoon. Dimensional Fund Advisors, which has been in the field since 1986, launched a separate Small Cap Emerging Markets Fund in December.

TAKE A RISK? But before you buy, check the current holdings of your international mutual funds. It's likely you already have some exposure to these small caps without the aid of a separate fund. T. Rowe Price's International Fund, for example, invests 17% of its assets in smaller-cap stocks.

Most experts agree that if you want to keep earning big returns after the U.S. market inevitably cools, you'll have to be willing to invest in more speculative stocks and take on more risk. That could lead even savvy investors to some unfamiliar terrain--namely, offshore in smaller companies.