Now Might Be the Time to Think Small and Foreign

If you’re looking for potential bargains and can stand some pain, mutual funds that invest in small foreign stocks could be an answer.

These investments offer a different spin from what people normally envision when they think of foreign funds. Unlike the dominant and most popular international funds, they don’t load up on large foreign stocks--the Nestles, Toyotas and British Airways of the world.

And, unlike emerging-markets funds, they aren’t likely to go overboard in the nascent stock markets of Asia, Latin America or Eastern Europe.

Instead, they mainly invest in small corporations operating in the developed economies of Western Europe, Japan, Hong Kong and a few other places. Although small-company definitions vary, you probably haven’t heard of most of the firms these funds buy--outfits with colorful if not easily pronounceable names like Fyffes of Ireland, Woong Jin Publishing of South Korea or Yip’s Hang Cheung of Hong Kong.

The fact that these funds invest in obscure companies attests to their high potential--and to their riskiness.

For the five-year period ended in December, researcher Lipper Analytical Services reports, foreign small-stock funds returned 74%, a step behind the 78% average gain for broad international portfolios, which stick mainly to large companies. Over the last year, the performance gap has widened.

“Small stocks have lagged big stocks in the U.S., they’ve done worse in Europe and even more so in Japan,” said Jean-Marie Eveillard, who runs the SoGen International and SoGen Overseas funds in New York.

One in eight companies on the Tokyo Stock Exchange sells at a price below what its net assets are worth on a per-share basis. “You’re paying less than nothing for the fixed assets of these companies,” Eveillard said.

Small stocks in 1997 lagged their large counterparts in 24 of the world’s 28 biggest stock markets, including in the U.S.

Yet such are the statistics contrarians dream of. David Herro, co-manager of the Oakmark International and Oakmark Small Cap funds in Chicago, said many small foreign companies are quality outfits that have little or no debt, pay sizable dividends and continue to post profit increases.

“In Asia, most of the good companies are small or mid-sized firms because they don’t have the large bureaucracies typical of the big companies,” he said. “In Britain, you can find small companies that are debt-free, growing moderately and paying dividend yields of 6% to 7%.”

Sarah Ketterer, co-manager of the Hotckis & Wiley International fund in Los Angeles, also has been buying small and mid-sized British stocks for the last year or so, attracted by what she calls “unbelievably low” valuations. Ketterer believes many Japanese small stocks are cheap as well, but she is moving more cautiously in this market.

Many of the fund managers who voice a preference for small foreign stocks--including Herro, Eveillard and Ketterer--are “value” investors. They hope to pick up bargains by purchasing stocks when they’re down and out. It’s an approach that demands patience and discipline.

Small companies struggle more than their big brothers during a time of disinflation, such as now, because they lack the same economies of scale. Large firms have more control over pricing and can do more to cut costs through layoffs, investing in technology and the like.

Another significant trend has been the movement toward indexing as an investment approach. Indexing is the strategy of buying the same stocks that make up a market average such as the Standard & Poor’s 500 in the U.S. or the FTSE-100 in Britain.

“There’s a strong proclivity by U.K. fund managers to index,” said Ketterer, explaining why large British stocks have beaten their smaller rivals.

What might spur small foreign stocks to rebound? One catalyst could be a realization among outsiders that small stocks offer better values. In Europe, for example, merger and acquisition activity has started to pick up, which could mean more large companies buying small ones, Eveillard said.

Another possibility is that executives themselves will come to appreciate their companies’ values. Even some Japanese firms have started to repurchase shares, said Herro.

On the other hand, foreign managers, especially in Japan, have been less enthusiastic in embracing the types of reforms that have boosted shareholder values in the United States--ranging from layoffs to sales of unprofitable divisions.

The upshot is that small foreign stocks, and the mutual funds that hold them, offer a contrarian play at a time when big stocks in the U.S. and Europe seem justifiably pricey. Certainly, there are good reasons for small stocks to have lagged, and there are few signs now that this period of underperformance is over.

But over time, investors can assume that small firms--and the mutual funds that own them--should fare reasonably well. After all, small companies typically are more nimble and innovative, and they frequently post larger percentage gains in sales and profits.

Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com