Guest Column:

By Andrew Reitenbach

This article is sponsored by Pinnacle International Management

Ten years ago, the U.S. had just come out of a recession, the Gulf War had left us feeling more than a little nervous, Eastern Europe and the former Soviet Union were still waking up from the Cold War, and guerrilla wars were either still raging or only recently ended throughout Latin America. The last place most people would have chosen to invest was in emerging markets. And yet, emerging market stocks handily beat all asset classes in the three years from 1992 to 1994.

A similar convergence of circumstances has now come together to favor another much-maligned and ignored asset class – international small-cap stocks. After the booming 1990s when stocks with no earnings and sky-high valuations were rewarded for their long-term ideas that had little or no basis in reality, investors have come back down to Earth and have run from risk over the past two years.

At first glance, international small-cap stocks would seem like the first area to suffer. Instead, these "hidden jewels," as my colleagues at SG Cowen like to call them, are starting to make a comeback, having outperformed international large-cap stocks over the past two years. And they are ripe for an extended renaissance due to a number of factors which I’ve outlined below.

Throughout virtually all of the 1990s, international large-cap stocks outperformed international small-cap stocks. It wasn’t until 2000 that that trend began to turn around. While stock markets on the whole suffered during the dot-com bust and the ensuing global recession, investors still searching for the elusive "growth at a reasonable price" began to find it in international small caps.

International small caps, as measured by the Salomon Smith Barney EMI World ex-U.S. Index, posted losses of 10.33 percent in 2000 and 15.70 percent in 2001, which, while nothing to brag about, nonetheless beat their large-cap brethren as measured by the MSCI EAFE Index, which posted losses of 15.21 percent in 2000 and 22.61 percent in 2001. The SSB EMI World ex-U.S. Index represents companies in the bottom 20 percent of investable market capitalization in developed country stock markets outside of the United States.

The valuations of international small caps, in almost all countries and across almost all industries, are at or near their lowest levels historically, and offer significantly lower price-to-sales, price-to-book and price-to-earnings ratios than that of international large caps. (See chart below).

Source: Salomon Smith Barney

And valuations are only part of the story. While the U.S. continues to suffer from what could be a protracted slow economy, economic growth and domestic consumption is already on the upswing in parts of Europe and Asia, creating a rebound environment that favors small local companies as opposed to large, export-oriented multinationals.

What’s more, across most European and Asian countries, forward-looking earnings estimates for small caps are as much as double those of large caps, according to analyst-tracking firms First Call and I.B.E.S.

In a survey conducted last year by consulting firm KPMG of money managers and investment experts worldwide, international small cap stocks were picked to have the highest long-term growth potential over both the next five and ten-year periods, with estimated average annual growth rates of 12.7 percent and 13.1 percent, respectively. By comparison, large-cap U.S. stocks were forecast to grow 9.1 percent annually over the next five years and 9.3 percent annually over the next 10.

This year’s survey, while not complete, already appears to be showing similar results, said Bruno Grimaldi, who directs the study at KPMG. "Money managers seem to be increasing their exposure to international small caps."

And institutional investors are taking notice. A study by InterSec Research Corp. showed the amount of U.S. tax-exempt assets dedicated to international small caps more than doubled between 1995 and 2000 to $9 billion, and InterSec forecasts that amount to more than quadruple to $40 billion by 2004.

Another reason why now is a good time to look at international small caps is precisely because they have been ignored, especially by large investment houses that don’t have the time, and don’t want to spend the resources, to comb through hundreds if not thousands of earnings statements, news, and research reports. Smaller fund managers willing to put in the time and effort necessary have an advantage in this respect, especially given the breadth of information that is now available over the Internet.

Liquidity constraints, ironically, is another reason why smaller funds can excel in investing in international small caps. One of the primary reasons that large investment banks avoid international small caps is due to liquidity constraints. If their investment goes sour, it can take days, if not weeks, to sell off a $100 million stake in a chain of Korean pharmacies, while it might take just one trading session to exit a $1,000,000 position.

The case for including international small caps as part of any investor’s portfolio has always been a compelling one, and is more so now than ever given the reasons I’ve just stated.

While it might seem counter-intuitive, including international small caps as part of an overall investment portfolio can significantly reduce risk. Investment experts have long shown the importance of diversification – across asset classes and investment styles, as well as geographically. However, diversification does little to improve a portfolio’s long-term performance if the stocks in that portfolio are highly correlated – that is, if they move in lock-step with each other. The world’s stock markets have gradually been getting more and more correlated, to the point that the average European large-cap index is now but a shadow of the S&P 500 Index. Not so for international small caps, with the SSB EMI World ex-U.S. Index correlated just 0.52 versus the S&P 500 over the past decade. (See the chart below.)

Diversification is just one of the long-term reasons to invest in international small caps. Others include:

When investing in international small caps, stock picking is key. As far as I know, there are no index funds out there to broadly invest in the international small cap asset class, and even if there were they are unlikely to outperform a good active manager given the incredible number of international small caps from which to choose. At the risk of sounding self-serving, small, nimble fund managers with strong track records offer the most compelling cases for investing in international small caps.

International small cap investing is also not for the light of heart, or the inexperienced. International small caps tend to be more volatile.

"The correlation between U.S. large-caps and foreign small-caps tends to be low, but correlations are only part of the overall calculation of volatility or risk of combining asset classes," says Leila Heckman, director of global asset allocation for Salomon Smith Barney. She also points out that while international small caps tend to be more volatile, "portfolios made up of combinations of U.S. large-cap and foreign small-cap stocks tend to have even lower volatility."

So where are the bargains? Just because companies are "small," doesn’t mean you can’t eliminate much of the risks involved in buying their stocks. It’s important to look for industry leaders with strong growth potential due to their unique products or services. There are strong companies across industries worldwide, and as the world economy begins to recover and the tragedy of Sept. 11 is left behind us, it’s time to start moving away from some of the more defensive, value stocks and into more growth-oriented companies that are poised to benefit from an economic recovery. While it’s too early to plunge full force into these stocks, many of them should have a long run ahead of them once it is believed that the world economy is in the clear.

Andrew Reitenbach is a portfolio manager specializing in international small cap stocks at Pinnacle International Management in New York.