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Jump on the foreign small-cap boom
But don't linger too long. Funds specializing in these soaring stocks often hit rough patches, so watch these investments closely.
By Timothy Middleton
Stocks in small foreign companies are racing ahead of other securities, with the average fund investing in the group skyrocketing 50% last year and a further 13% this year, as of Nov. 3, according to Morningstar. That's half again as much as the S&P 500 Index ($INX) returned in 2003 and more than double its gains this year, including dividends.
"Think small-cap stocks in the United States 20 years ago, when there were not very many people doing it and you could find some terrific little companies," says Michael Gerding, manager of Wasatch International Growth (WAIGX). Peter Lynch made his reputation investing in that market.
The market is so hot that Wasatch, a small-company specialist, is set to open a microcap foreign fund in January. The company doesn't create new funds simply to exploit markets and marketing. Six of its 10 funds are closed to existing as well as new investors, signaling a focus on husbanding shareholder assets rather than growing management fees. The new fund will close when assets reach $20 million.
"We think this is an area where there is a ton of opportunity because you've got great little businesses and great opportunities within those businesses," says Gerding, who is also a member of the team that will manage the new fund, Wasatch International Opportunities.
I love this corner of the market and have nearly 15% of my personal equity assets invested there. But this is money I watch like a hawk, and if you want to invest in this niche, I recommend you do likewise. It has been a very poor long-term performer and, worse, no mutual fund managers have yet mastered it.
Cutting back
So I recently trimmed my exposure, which had been more than 20% of equity assets, and expect within two or three years to cut it down to less than 10%. The signal I'll be looking for is when these funds start closing to investors. The last time that happened, in 2000, it presaged a three-year decline of more than 50%.
But for now, party on.
Foreign small- and mid-cap funds have been the top performers among diversified mutual funds last year, and this, for three basic reasons.
The first is currencies: The dollar has declined sharply against the euro and the yen. The London Stock Exchange, for example, is up 3.4% this year in pounds sterling, but 6.1% in dollar terms. In Tokyo, the advance is 0.1% in yen and 0.9% in dollars.
The second is fresh flows deserting a weak domestic market, especially for big-cap stocks. Measures like the Dow Jones Industrial Average ($INDU) are "not only down, but trending slowly down in a low-volatility range," notes Justin Thomson, London-based lead manager of T. Rowe Price International Discovery (PRIDX). Investors who ordinarily limit themselves to bigger companies "have been looking down the capitalization scale, looking harder to boost returns," he says.
The third is the small-cap effect, or the tendency of small stocks to outperform early in the economic cycle. On the whole, they're local companies dependent on their domestic economies and the first to rally when recession recedes. "That was especially true of Japan in the first half of the year," Thomson notes.
Losing force
The Price fund's top position is Aristocrat Leisure (ARLUF, news, msgs), an Australian manufacturer of slot machines and other gambling equipment. Its second-largest stake is K&S AG, which mines potash in Germany, mainly for fertilizer. While each exports some of its production, each is mainly dependent on local markets.
The first and third of these accelerants are losing force, however, as evidenced by the group's slowing performance this year compared with last. A U.S. rally would also take the market's eye off foreign equities, especially obscure ones.
Meanwhile, investors have begun flooding this marketplace with cash. Net inflows into foreign small- and mid-cap funds surged $4.1 billion in the first nine months of this year, compared with $2.85 billion in the same period last year, according to Financial Research Corp.
The Price fund has felt this keenly. Its assets have spurted to $872 million at the end of October from $704.8 million at the beginning of the year. "If that were to continue, we would have quite a lot of indigestion in the fund, and we're starting to see that already," Thomson says.
The Price fund, which has the best performance record in the group over the last 15 years, went through something even worse in 1999, when assets ballooned to $686.6 million from $193.2 million at the end of the prior year as the fund surged a stunning 155%.
In response, the fund closed to new investors in April 2000, the very moment its marketplace began to crater. It sank 15.6% that year, 24.6% the next and 16.3% in the third. As assets declined, it reopened in April 2003, the very moment its market began to explode. I'll report back if it closes again, and you can always check the T. Rowe Price Web site.
What to watch for
I'll be prepared to slash my holdings in this group if the Price fund closes, or some other signal such as faltering performance appears, because corrections in this marketplace can be calamitous. Compare the 10-year performance of this fund with the S&P 500.
The fund did miserably when domestic big-caps were rallying in the late 1990s, then fell further than they did in the bear market. Despite its fantastic performance in 1999 and 2003, when it shot up 65.3%, it trails the S&P by nearly two percentage points annually throughout this period, racking up a total gain over that decade of 80%, about half the domestic market's gain of 150%.
Further complicating an investor's challenges investing in foreign small- and mid-cap stocks is the paucity of reliable portfolios. Indexing options are few and, in theory, should be inferior to actively managed portfolios, which can separate good prospects from bad in what are usually volatile and thinly traded markets.
But no fund in this universe has been able to post a consistently successful record. None with a record of at least 10 years has managed to remain even in the top half of the group consistently. The 15-year leader, the Price fund, ranks in the 50th percentile for the last 10 years, and the 53rd for the 12 months ended Sept. 30. For five years it's in the 18th percentile, and for three years the 35th.
This is remarkable because in most categories, long-term success stories, while rare, do exist. American Funds Growth Fund of America (AGTHX), for example, has never ranked lower than the top 10% of similar large growth funds over any significant period for the last 15 years.
An opportunistic approach
So I'd be opportunistic entering this category, looking for funds doing best lately as opposed to lengthier periods. Here's a link to MSN Money's deluxe fund screener, set to search for small- and mid-value funds. You can also change the category to foreign/small growth.
And I'd be quick to slash my holdings in this group when it shows signs of fatigue. My buy-and-hold commitment here is low -- no more than 5% to 10% of equity assets, including emerging markets.
(Developing countries are a distinct and separate market, but their companies also tend to be small. The average market cap of Acadian Emerging Markets (AEMGX) is $4.73 billion, which puts it in the mid-cap range. And, as I reported last month, this fund closed to new investors in August. In line with the reasoning I've outlined here, I recently cut my investment in that fund by nearly half. I cut my stake in the Price fund by 30%.)
If you have an interest in the new Wasatch fund, click here to see the prospectus. In the subscription, the fund will accept a minimum of $5,000 ($1,000 in an IRA) and a maximum of $25,000.
Because today's leaders in this group are likely to be tomorrow's laggards, I intend to subscribe to the new Wasatch fund, cutting my other holdings in the group correspondingly. This is an area where owning more than one fund in the same category can pay off.
For example, Tweedy Browne Global Value (TBGVX) has among the worst three-year records in this group, but this year, as of Nov. 3, it was ahead 13.7%, edging out the 13.3% return of the Price fund, though both trail the 20.3% return of the Acadian fund.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: T. Rowe Price International Discovery, Acadian Emerging Markets and Tweedy Brown Global Value.
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