Although U.S. investors have poured billions into international stock investments in recent years, most have overlooked international small- and mid-cap stocks.
Consider this comparison based on research from Putnam Investments of Boston: The universe of international small- and mid-cap stocks is about two-thirds as large, in terms of market capitalization, as the universe of their U.S. counterparts.
Yet U.S. investors have about eight times as much money invested in U.S. small-and mid-caps. Given the impressive track record and future potential of international small- and mid-caps, this represents a significant underweighting.
It is possible that this underweighting results from investors' not knowing enough about the asset class. Investors may perceive these stocks as being too risky because of the combination of international and small-company risks, or too illiquid because of the trading restrictions of various overseas exchanges.
In reality, the asset class offers solid business fundamentals, attractive valuations, ample liquidity and an impressive performance history, with a reasonable level of volatility, compared with other broad equity classes. Small- and mid-cap international stocks, however, battle some common misperceptions over what they are and aren't.
First, they are not emerging-markets stocks. International small- and mid-caps largely provide exposure to developed markets. In a common benchmark for this asset class, the S&P/
Citigroup Extended Market Index World ex-U.S., about 96% of the stocks are located in developed markets. Only about 4% are in emerging markets.
Many international small-caps are well-established companies. Since there is generally less information about smaller international companies available to U.S. investors, many might regard these businesses as high-risk startup firms. In fact, this asset class is large and diverse, and includes a wide variety of well-run businesses that have been operating for decades.
Although small, many of these companies have established brand names or provide well-known products and services. You probably are familiar with Adidas sportswear, Michelin tires, Logitech electronics, Kia automobiles and Schindler elevators.
What's more, international small-caps exhibit fundamental business strength. Beyond the famous names are many small companies that benefit from profitable niches in other regions of the world.
Our research indicates that companies in the benchmark index generated an average annualized return on equity of 18% in the first quarter — much higher than the 10% for U.S. small companies in the Russell 2000 Index.
We also believe that international small-caps are reasonably valued. In many cases, the investment potential of these small companies may not yet be fully reflected in their prices, which can make them attractive opportunities for U.S. investors.
A comparison as of March 31 shows international small- and mid-cap stocks priced attractively with a forward-looking price/earnings ratio of $12.44, versus $17.77 for U.S. small companies.
Finally, among major equity classes, international small- and mid-cap stocks have a solid reward-to-risk profile. Over the past 10 years, they rank among the equity asset classes with the lowest volatility, yet their returns rank second only to emerging-markets stocks.
When reviewing a client's financial program, we believe that it makes sense to consider the track record of international small- and mid-cap stocks. These shares deserve consideration on equal footing with other equity asset classes in the portfolio.
Since the size of the international small- and mid-cap universe is roughly equivalent to U.S. small- and mid-caps, and their track record is quite competitive, we believe that financial representatives ought to consider a weighting in international small- and mid-cap stocks appropriate for their clients' investment objectives and risk profiles.
Joe Joseph is a managing director and chief investment officer on the small- and mid-cap-core equity team, and portfolio leader for the Putnam International Capital Opportunities fund, offered by Putnam Investments of Boston. Randy Farina is a senior vice president and a portfolio manager in Putnam's small-cap-equities group, and a portfolio member for the fund.
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