Think International, Think Small
(January 04, 2011)
Why International Small/Micro Cap Stocks May Be Poised to Continue Outperforming
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.
THE WASATCH FUNDS ADVANTAGE IN INTERNATIONAL
SMALL & MICRO CAP INVESTING
1. Small Cap Specialists
Wasatch was founded in 1975 as a Small Cap investment firm. We have spent over 35 years developing a unique expertise in the small and micro cap segments. We began investing in foreign companies in the early 1990s and launched our first global fund in 2000. We have continued to build our international team and international fund offerings over the past decade.
2. Deep Due Diligence
To take full advantage of the opportunities and inefficiencies around the globe, our analysts are willing to roll up their sleeves and travel through the countryside to gain hands-on understanding of the companies and their markets. A Wasatch cornerstone has always been deep due diligence around each investment we make. Our team regularly travels the world, gets off the beaten path, and frequently meets with management teams that mention to us just how rare it is for them to get a visit from an analyst.
It is through our deep due diligence that we believe we can better determine a company’s longer-term growth potential, financial stability, and management quality. After studying smaller companies for over 35 years, we have a strong framework from which to evaluate the potential of these smaller firms.
3. Cross-Team Collaboration
Another key element of Wasatch’s approach is cross-team collaboration. We don’t send one person to Asia and ask them to determine the best small companies there. We send a team to Asia with different backgrounds in order to get a more robust understanding of each company. Then we bring those analysts together with analysts who have been trekking through other parts of the world (as well as our U.S. team), to compare companies from around the globe as we select investments that we believe have the most potential.
4. High-Quality Investments
By utilizing Wasatch’s small cap expertise, thorough hands-on research, and cross-team collaboration we believe we can identify higher quality companies with better long-term potential. We believe the quality of our investments can be partially seen through the financial metrics of our companies. Our portfolios of companies tend to have better growth, higher margins, and higher returns on assets (ROA) and equity (ROE) than the companies in their benchmark indices, while achieving these results using less leverage. We constantly work to build portfolios of such high-quality companies without paying significantly higher prices for expected future earnings than the index average.
For example, here is how the Wasatch International Growth Fund (WAIGX) compared to its benchmark index as of September 30, 2010.
5. Strong Performance
The Wasatch International Team has demonstrated that the Wasatch process can be successfully transferred to international investing. As of September 30, 2011, the Wasatch international and global funds had impressive results relative to peer funds.
None of the Wasatch international or global funds have had negative performance over the last one-year or five-year periods.
In addition to the risks of investing in foreign securities in general, the risks of investing in the securities of companies domiciled in emerging market countries include increased political or social instability, economies based on only a few industries, unstable currencies, runaway inflation, highly volatile securities markets, unpredictable shifts in policies relating to foreign investments, lack of protection for investors against parties who fail to complete transactions, and the potential for government seizure of assets or nationalization of companies. Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap funds.
An investor should consider investment objectives, risks, charges, and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit www.wasatchfunds.com or call 800.551.1700. Please read it carefully before investing.
Information in this report regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this report. These statements should not be relied upon for any other purpose.
Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
The Morningstar percentile rank is the rank of a fund among its category peers, which rank is based on a comparison of a fund’s total return performance against its peers over a given time period. © 2011 Morningstar, Inc. All rights reserved. The information contained herein (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
The IMF (International Monetary Fund) is an international organization that was created for the purpose of promoting global monetary and exchange stability, facilitating the expansion and balanced growth of international trade, and assisting in the establishment of a multilateral system of payments for current transactions.
GDP (Gross Domestic Product) is the monetary value of all the finished goods and services produced within a country’s borders annually.
An initial public offering (IPO) is a company’s first sale of stock to the public.
Earnings Growth is a measure of growth in a company’s earnings per share from one year to the next.
The Price-to-Earnings (P/E) ratio is a valuation ratio of a company’s current share price compared to its per-share earnings.
Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
The Debt/Equity ratio shows the proportion of debt (leverage) a company is using to finance its assets.
The “Lost Decade” was the 10-year period from 2000-2009 during which U.S. equities (as represented by the S&P 500) essentially delivered no return to investors.
The MSCI Emerging Markets and Small-Mid Cap Indices are free float-adjusted market capitalization indices that are designed to measure equity market performance in the global emerging markets. The S&P 500 Index represents 500 of the United States’ largest stocks from a broad variety of industries. The S&P/Citigroup Global Broad Market Index is comprised of stocks of all sizes from around the world, including developed and emerging markets. The MSCI EAFE (Europe, Australasia, Far East) Index is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI AC (All Country) World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. You cannot invest directly in these or other indices.
1Source: “International Monetary Fund World Economic Outlook” Database, April 2010.
2Source: “The Emerging Middle Class in Developing Countries,” OECD, January 2010.
3Source: Bloomberg, 1/2/05 - 10/31/10.
4Sources: International Monetary Fund; Standard & Poor’s.
5Source: Center for Research in Security Prices (CRSP), The University of Chicago Booth School of Business. Data from 12/31/25 – 9/30/09.
© 2011 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS002545 1/20/2012