Ferreting Out the Best Foreign Small-Caps

Often cheap, they can help you to diversify

To fund manager Jean-Marie Eveillard, OPG Groep is the mouse that roared. Thanks to sharp rallies in tiny, unknown stocks, such as this Dutch pharmaceutical distributor, Eveillard's First Eagle SoGen Overseas Fund has delivered an 8.3% return in the past 12 months, while most foreign equity funds have stumbled. "In continental Europe and Japan, small-caps are much more neglected than in the U.S.," he says. "We see that as strictly an advantage."

Neglected stocks are usually cheap, foreign small-caps exceptionally so. Right now, such stocks have an average price-to-book ratio of only 2.4, less than half that of the Standard & Poor's 500-stock index. These bargains often become the subject of takeovers or leveraged buyouts; that can give a big boost in returns. Yet most foreign equity funds won't benefit from this trend because they don't buy small-caps: Their median stock has a hefty $18 billion market capitalization.

Because of their obscurity, foreign small-caps also make better diversifiers than large companies. A measurement known as R2 determines how well the returns of a stock match, or "correlate," with those of a benchmark index every month. According to fund company Dimensional Fund Advisors, the R2 of the average foreign small-cap stock was just 0.49, or 49%, correlated to the S&P 500 over the past five years. By contrast, large-cap foreign stocks were 77% correlated. By giving you greater diversification, small-caps should reduce your risk over time.

Since tiny companies trade mainly in local markets and require extensive research, it's best to purchase them through one of the 28 foreign small-cap funds. Oakmark International Small Cap Fund is good for value investors, having delivered a 22.6% annualized return over the past three years. Growth investors may like Schroder International Smaller Companies and CS Warburg Pincus International Small Company funds, though they've suffered in the tech rout.

A fund needn't have "small-cap" in its name to invest in them. Such top performers as Tweedy, Browne Global Value, MFS International New Discovery, and Eveillard's SoGen buy small caps, though they have the leeway to own larger companies. To see if a fund does the same, check its median market capitalization at www.morningstar.com. This stat measures the capitalization of the holdings. If the market cap is below $1.4 billion, the fund is small-cap.

For value loyalist Eveillard, Japan is bargain heaven. But growth managers, such as Schroder's Matthew Dobbs, aren't always interested in waiting for takeovers. "I want to own great companies in the early stages of their development," he says, "so identifying superior earnings growth is key." Dobbs is betting on British construction stocks Taylor Woodrow and Carillion because the government is raising public works spending.

Both strategies have worked in the past, but right now value stocks seem to be more in favor. Oakmark manager Michael Welsh profited recently when Hong Kong retailer Jusco Stores nearly doubled in two days, thanks to a positive earnings report. "You may sit on dead money until these companies are discovered, but a 90% move in two days makes it all worthwhile," he says. With small-cap investing, waiting for others to discover your stock is half the battle. That patience is usually rewarded.

By Lewis Braham

    Before it's here, it's on the Bloomberg Terminal.