Small-cap stocks are getting the cold shoulder, unless they come with a nice accent.
Stocks of smaller U.S. companies have dropped this year following a spate of warnings that they've become too expensive. But investors continue to buy stocks of smaller companies based in Italy, South Korea and elsewhere outside the United States. Like their U.S. counterparts, foreign small-cap stocks offer the potential to profit from big growth. Unlike them, foreign small-cap stocks generally come with lower price tags, though they come with their own risks.
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It's an about-face for U.S. small-cap stocks, which had been at the leading edge of the surging market since the financial crisis ended. Last year was the fourth time in five years that the Russell 2000 index beat the large-cap stocks in the Standard & Poor's 500 index. U.S. small-cap stocks also beat their foreign counterparts.
Much of the excitement focused on how U.S. small-cap stocks generate more of their revenue domestically, compared with big multinational companies. That benefited smaller companies because the U.S. economy has been stronger than other regions: The U.S. unemployment rate is at its lowest level since 2008. Europe, in comparison, is still recovering from its debt crisis, and Japan is trying to jolt its economy from a decades-long slumber.
Smaller companies also can offer stronger earnings growth than bigger companies. A new product or two could have a significant impact on their overall revenue. It's more difficult for an Exxon Mobil or Wal-Mart Stores to produce a big percentage change in its annual revenue when it is measured in the hundreds of billions of dollars rather than millions.
But the surge in small-cap stocks made them more expensive. Valuations got high enough that the Federal Reserve called them out in its mid-July monetary policy report, a move that spooked many investors.
"Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched," the central bank wrote in its report. The Fed cited how high the prices of these stocks were relative to their expected earnings.
The mention helped send small-cap stocks down, and the Russell 2000 index is down 0.8 percent for the year through Wednesday. Over the same time, an index of foreign small-cap stocks has returned 6.4 percent.
Through the first half of the year, investors plugged $5 billion into foreign small- and mid-cap stock mutual funds, according to Morningstar. That's nearly five times as much as they put into their U.S. counterparts.
One of the main draws is the lower price tag: Foreign small-cap stocks were trading at 15 times their expected earnings per share at the end of the last quarter, versus 21 times for their U.S. counterparts, according to MSCI indexes.
Foreign markets also offer more opportunities for fund managers to find undiscovered companies, says Kabir Goyal, a senior analyst at Wasatch Advisors. Wasatch runs several mutual funds that specialize in small-cap and international stocks, and many of the foreign small-cap stocks that it buys have few -- if any -- financial analysts covering them.
Buying foreign stocks adds diversification to a portfolio that's full of only U.S. stocks. They also generally offer bigger dividend yields than U.S. stocks, but investors should still keep in mind that foreign stocks carry their own risks.
THEY'RE CHEAPER FOR A REASON.
Stocks are cheaper outside the U.S. because doubts are higher about the strength of their home economies.
"On a longer term basis, European small-caps appear more attractive than domestic small-caps," says Jim Tringas, a senior portfolio manager who helps run the Wells Fargo Advantage Global Opportunities fund. "But you're dealing with a lot of things that can go bump in the night."
Confidence in European economies has improved, but investors are still worried that inflation may be too low. In July, the annual inflation rate was just 0.4 percent. If prices start falling, Europe could fall into a trap where shoppers cut back on their spending in anticipation of cheaper prices, which only further weakens the economy.
Tringas' Global Opportunities keeps its portfolio of small- and mid-cap stocks nearly evenly split between those from the U.S. and from other developed economies.
CHANGES IN CURRENCY VALUES ARE A RISK.
Adding foreign stocks can help diversify a portfolio, but it also adds the risk that changing currency values can affect returns.
Foreign small-cap stocks outside the U.S. lost 1 percent in dollar terms in July through Wednesday, for example. If all currency values had remained flat, those same stocks would have had a positive 0.4 percent return.
THEY CAN BE MORE VOLATILE THAN LARGE-CAPS.
Smaller companies can fall more sharply when fear grips the market.
In 2011, for example, foreign small-cap stocks lost 18.2 percent as worries crested about the European debt crisis. Foreign large-cap stocks lost a more modest 12.9 percent.