More Big Gains Ahead for Foreign Small Stocks?
Smaller stocks and the mutual funds that own them have been on fire this year, leaving the competition in the ash heap.
Just not in this country.
Driven by a powerful market rebound in Japan, deregulation in Europe, stronger foreign currencies and brisker economic growth in many regions, foreign small-company shares have racked up huge gains in 1999 while their U.S. counterparts have mostly struggled.
The average foreign small-company stock mutual fund was up 33% year-to-date through last Thursday, according to fund tracker Lipper Inc. The average U.S. small-company fund, by contrast, was up a modest 6.4%.
Foreign small-stock funds also have far outperformed their big-stock brethren. Diversified foreign mutual funds, most of which are dominated by bigger stocks, are up 13.5% this year.
The heady gains of the foreign small-stock sector over the last 12 months stand in stark contrast to its lackluster performance over the preceding several years.
Indeed, for the 10 years ended last Dec. 31, the sector’s average total return was a mere 89.3%, compared with 316% for the average U.S. small-stock fund.
Of course, it’s an understatement to say that smaller foreign stocks are risky. After all, they combine two sectors that present their own special risks. Together, they add an extra element of volatility to a portfolio.
You wouldn’t recognize most of the companies these funds own even if you spent the summer touring the world.
How about Eidos, a British software company? Or Goldcrest, a Japanese condominium brokerage, and Zee Telefilms, a broadcasting company in India? All three are top holdings of the T. Rowe Price International Discovery fund.
Many investment advisors say they don’t even consider foreign small-company stock funds for their clients’ portfolios.
“The majority of work that we do for clients doesn’t involve international small caps at all,” says Mike Coultrip, a senior consultant at Ibbotson Associates in Chicago. “Nor have we had much demand for these investments from clients.”
Among his criticisms are that there is relatively little performance data available for the sector’s stocks, and that the three dozen or so mutual funds that target the sector constitute too small a universe--though the funds’ ranks continue to grow.
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However, some analysts say foreign small-stock funds could be an intriguing bet for the new decade.
These investments shouldn’t be confused with emerging-markets mutual funds, which target companies of various sizes in the developing nations of Asia, Eastern Europe, Latin America and Africa.
Foreign small-stock funds stick primarily with issues in the industrialized nations of Western Europe, in Japan and in a few other rich countries.
Much of the turnaround for the sector this year stems from an improving situation in Japan, where prices of smaller stocks have rocketed since Jan. 1.
The moribund Japanese economy is slowly being revitalized by long-delayed cost-cutting efforts and restructuring moves by many large companies. Small companies have been prime beneficiaries as they find growth niches in an economy less dominated by the giants.
Justin Thomson, a London-based portfolio manager for T. Rowe Price, says Japan’s smaller companies are among the few places investors can find true high-growth opportunities in that still-weak economy.
He predicts their popularity will be further enhanced by “new economy” developments sparked by the burgeoning Internet and other technological breakthroughs.
Thomson cautions, however, that many smaller Japanese stocks have rallied from their severely depressed levels of a year ago to positions of fair value or even overvaluation now.
Furthermore, the recovery in the yen has helped juice the performance of all Japanese stocks held by U.S. investors: The Jasdaq index of smaller Japanese stocks is up 178% in yen terms this year, but 203% in dollar terms.
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Europe, too, is contributing to foreign small-stock funds’ momentum, helped by merger activity, spinoffs, outsourcing and other trends resulting from deregulation.
“One manifestation of outsourcing is that large companies are using smaller companies for help,” says Loretta Morris, a partner at Nicholas Applegate in San Diego and co-lead manager of the Pilgrim International Small Cap fund. “This gives an opportunity for new entrants to do things better.”
Despite the run-up in many foreign small stocks, Morris says, the potential remains strong. “These structural changes in foreign economies are long-term trends,” she argues.
Henrik Strabo, chief investment officer in Greenwich, Conn., for American Century’s foreign funds, also is optimistic.
“Before, if someone in Europe had a great idea, they’d have to come to the U.S. to get financing or the idea would die,” he said. “There’s much more of an entrepreneurial spirit in Europe now.”
There also is more of a U.S.-style focus on improving returns for shareholders, he said. The upshot is that more foreign companies, including smaller ones, are tying management’s compensation to stock and profit performance.
Be that as it may, there also are several worries that bear watching at least temporarily, some say.
For one, concern about the year-2000 computer bug could compel some investors to pull out of higher-risk investment sectors between now and Jan. 1.
What’s more, rising interest rates in Europe could be problematic for smaller stocks--much more so than for larger issues, because more speculative investments tend to suffer more as rates rise and investors grow more cautious.
But if prospects for the European and Japanese economies continue to improve, many analysts say, smaller foreign companies should fare well even in an environment of moderately rising interest rates.
Some experts also argue that smaller foreign stocks still look more like greater bargains than many blue-chip foreign issues.
“Because their valuations are so depressed, small caps have less market risk today than the large, blue-chip names,” said Elizabeth Pearce, who manages the Highmark Small-Cap Value fund in Los Angeles. “Yet investors still view the big, blue-chip companies as safer.”
Thomson even sees something of a backlash developing over the globalization trend and the rise of huge multinational firms in the 1990s.
“We’re seeing more deregulation . . . and more start-up companies” in the foreign-stock arena, he says, which suggests that investors worldwide are much more inclined to pay attention to new ideas among smaller firms.
* Russ Wiles is a regular contributor to The Times. He can be reached at russ.wiles@pni.com.
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Fishing for Golden Minnows Overseas
Here’s a sampling of foreign small-stock mutual funds. Note that despite strong gains so far this year, the funds’ performance was miserable for the five years ended in 1998 compared with the average general U.S. stock fund.
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Five-year total return 1999 800 phone Fund through 1998: return* number T. Rowe Price Intl. Disc. +0.7% +69.5% 638-5660 Federated Intl. Small Co. A NA +56.9 341-7400 Pilgrim Intl. Small Cap A NA +52.3 334-3444 American Century Intl. Disc. NA +29.9 345-2021 Acorn Intl. +46.2 +29.9 922-6769 Founders Passport +53.1 +21.1 525-2440 Templeton Foreign Small Co. A +32.0 +15.7 342-5236 Avg. foreign small-stock fund +34.5 +32.9 Avg. emerging-market fund --41.0 +27.8 Avg. general foreign fund +46.1 +13.5 Avg. general U.S. fund +122.9 +8.1
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* Through last Thursday
NA: Not available (fund may not have existed for entire period)
Source: Lipper Inc.
