Outperforming in today’s investment climate requires taking advantage of the wealth of opportunities available globally. Foreign stocks offer strong growth potential and attractive fundamentals, particularly small cap and micro cap companies. In this paper we explore what makes international investing particularly compelling, and the unique advantages of foreign small and micro cap companies, including:

 - Higher Growth potential, and ability to tap into faster growing economies

 - Better Valuations due to the market inefficiencies of smaller companies

 - Lower Correlation with U.S. stocks, and underrepresentation in portfolio allocations

WHY INVESTORS SHOULD LOOK INTERNATIONALLY

1. That’s Where the Growth Is . . .

GDP Growth: As investors question the U.S. outlook for employment, government spending, real estate, and the overall economy on the heels of the Great Recession, many foreign countries continue to show much stronger growth prospects. Despite ominous European headlines in 2010, globalization continues to spur expansion in many corners of the globe. According to the International Monetary Fund, economic growth internationally will significantly outpace the U.S. over the next five years.¹

 

Middle Class Growth: The number of fast-growing economies around the globe is expanding quickly. Large numbers of people are moving from rural areas to cities, and the number of foreign middle-class consumers is expected to continue to grow significantly in the decades ahead.²

Initial Public Offering (IPO) Growth: Helping to drive international GDP growth is a plethora of successful new companies. International companies are coming public at a rate of 12-to-1 versus U.S. companies. In fact, the United States has accounted for less than 8% of global IPOs over the past five years.³ Consequently, investors looking for great new investment opportunities may be more likely to find them outside of the U.S.

Company Earnings Growth: Analyst projections for 2011 show foreign companies continuing to outpace the U.S. in company earnings growth.

2. Valuations are Better . . .

Despite a strong 2010 for international stock markets relative to U.S. markets, international companies still have compelling valuations, particular in light of the growth opportunities ahead.

3. Most Investors are Under-Allocated in International Stocks . . .

Global investing has been gaining traction, but it’s still a small component of most portfolio allocations for U.S. investors due to an inherent U.S. bias. The U.S. economy represents less than 5% of the world’s GDP, and stocks trading on U.S. markets represent only 32% of the global universe of public companies.⁴ Yet, standard equity allocation recommendations for U.S. investor remain in the range of 70% to 90% of equities being allocated to U.S. stocks due to our home country bias.

WHY SMALL & MICRO CAPS ARE PARTICULARLY COMPELLING

1. They Offer the Largest Selection . . .

Just as investors typically favor companies based in their home country, there is also a tendency to gravitate to large cap, better known stocks. Meanwhile, foreign small cap and micro cap companies represent 90% of public foreign companies, thus offering a much broader universe of opportunities for investors.

2. Better Growth Potential . . .

In U.S. markets, it’s no secret that small cap stocks have historically outperformed large caps over the long-term.⁵ The factors that have brought about small cap outperformance in the U.S. apply equally to international small cap companies. We believe these advantages frequently include higher earnings growth potential, leaner operations, and the ability to respond more quickly to changing market dynamics. According to Standard & Poor’s, earnings of foreign micro cap and small cap companies are again expected to lead the charge in 2011 to 2012.

Another element of the foreign small cap growth advantage is that small and micro cap companies generally have purer exposure to the rapidly growing economies where they are located.

3. Undiscovered Gems . . .

It takes a lot of work to analyze the expansive universe of foreign small and micro cap companies, and there is limited market capitalization in these stocks. Consequently, small cap stocks are typically overlooked by international fund managers, as well as by Wall Street analysts. According to FactSet, publicly traded foreign micro cap companies have, on average, only one analyst following them, as compared to 19 analysts covering the average foreign large cap firm. This lack of analyst coverage can present a significant opportunity for investment managers who have the commitment and skill to capitalize on the resulting market inefficiency.

4. Better Valuations . . .

As of 12/7/10, small caps traded at more than a 10% discount to large cap stocks, while they are also expected to grow earnings faster than large caps over the next several years (see chart on page 5 for growth projections)

5. Potential to Reduce Portfolio Volatility While Improving Returns . . .

Despite their volatility, foreign small cap and foreign micro cap stocks historically have acted as effective portfolio diversifiers—as measured by correlation with the U.S. equity market. Correlation gauges how closely returns of one investment track another. A value of 1.00 indicates perfect correlation (i.e. that returns of the two have moved in lockstep). A value closer to zero indicates returns have moved in opposite directions.

Combining investments with relatively low correlation has the potential to reduce overall portfolio volatility. For example, it may be possible to lower portfolio volatility and increase total portfolio returns by adding foreign small or micro cap stocks to a portfolio of domestic stocks if the correlation of the foreign and domestic stocks remains less than 1.00 and the foreign stocks outperform the domestic stocks over the observation period.

6. Small Cap Effect . . .

For the 10-year period ending December 31, 2009, returns of international small and micro cap stocks generated average annual returns of more than 9%. These gains were a far cry from the “lost decade” experienced by domestic stocks, and significantly above the returns of larger cap foreign stocks.

 

 

 

 

 

(c) Wasatch Funds

www.wasatchfunds.com