The rally in international small-cap stocks is far from over, according to Edwin Lugo, manager of the Franklin International Small Cap Growth Fund (FKSCX).
Mr. Lugo, whose fund gained 52% this year through November, believes that the stock-picking challenges will intensify but that there are still ways to make money in select markets.
“We're at the middle point of what we would consider fully valued for international small-caps, and we're still seeing opportunities,” he said.
Mr. Lugo relies on a bottom-up stock-picking strategy that concentrates on growth, quality and valuation.
“We focus on the downside risk by trying to consider what can go wrong with a company over the next five years,” he said. “We prefer to try and buy a stock close to the worst-case-scenario price.”
Through November, the fund outperformed its benchmark MSCI EAFE Small Cap Index by 6 percentage points. Last year, the fund registered a 37% loss, compared with the index's 47% plunge.
Keeping volatility below that of the index is no small task for a fund with just 32 positions.
The fund has a five-star rating from Morningstar Inc. and has become increasingly popular with investors, who have pushed the assets up to $85 million, from just $14 million in March.
At 35%, the United Kingdom is the largest of 14 geographical weightings in the portfolio.
Mr. Lugo said he has lately been increasing the portfolio's exposure to Germany, Switzerland, Ireland and Japan.
On a sector basis, he has been trimming the fund's exposure to retail stocks after the recent run-up, while adding industrial- and financial-sector stocks.
The fund can allocate up to 10% of the portfolio to emerging-markets stocks, but Mr. Lugo prefers to stick with the developed markets for reasons related to transparency and security.
Besides, he said, when it comes to smaller-company stocks, you don't need to go to an emerging-markets country to find hidden gems.
“In the non-U.S. small-cap space, there are a large number of overlooked companies,” he said. “Analyst coverage on some of these companies can be quite low, which is why there are so many attractive valuations and pricing mismatches in the small-cap space.”
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