What It Takes to Invest in Small Foreign Firms

This year could not have unfolded any better for emerging-growth investors than it has so far. Small U.S. stocks have rallied sharply since mid-January in one of their biggest surges since the early 1980s. Mutual funds that specialize in this area of the market are showing gains of about 18% on average.

Does all this suggest some upcoming fireworks for small foreign companies and the funds that hold them? Don’t bet on it.

“The run of small stocks in our country doesn’t mean there will be one elsewhere,” says Jon Woronoff, editor of the International Fund Monitor, a newsletter based in Washington, D.C. Although these investments have good long-term promise, he says, do not expect any short-term bounces.

The reason is simple: Emerging-growth issues in most overseas markets had not become as undervalued as they had here. This year “was the first time in several years that small foreign stocks under-performed large companies,” explains George Murnaghan, vice president of the T. Rowe Price International Discovery Fund in Baltimore. By contrast, smaller U.S. equities had generally lagged from 1984 through 1990.

Of course, the situation varies so much from country to country that it is hard to describe the global small-stock market as a cohesive unit.

Emerging Japanese companies, for example, scored impressive gains in the mid- to late ‘80s, dropped sharply last year and are rallying strongly this year. Smaller British stocks surged in ’87 but haven’t done much since. So too with other European markets. The DFA Continental Small Company Portfolio, a Santa Monica-based index fund that tracks smaller stocks in nine European nations excluding Britain, vaulted 45% in ‘89, slipped 4% last year and has risen a modest 4% so far in ’91.

In many foreign markets, it is hard to single out small companies as a distinct category, says Christian Wignall, chief investment officer of GT Global Financial Services, a San Francisco fund company. For example, he says, Siam Cement, a blue chip company in the Thai market, really rates as a smaller stock by world standards. Murnaghan agrees. “We might hold the biggest stock in a particular market, but it still might not be an especially large company,” he says.

The shares of small companies--and even some of the larger stocks in emerging markets--are often thinly traded. This means that mutual funds and other big institutional investors could have trouble buying or selling the shares without moving the price significantly. Transaction costs can also run relatively high.

This illiquidity problem explains why it is often easier to invest in emerging foreign companies or markets through closed-end funds, which do not have to redeem shares on demand (unlike regular mutual funds) and thus can afford to sit on a promising investment for several years if necessary. Examples include the Templeton Emerging Markets Fund, the Clemente Global Growth Fund and the Scudder New Asia Fund, all of which trade on the New York Stock Exchange.

Small companies, both in this country and abroad, might also carry certain business risks that blue chips do not have to worry about. These include:

* Limited financial resources.

* A narrow product line.

* Dependence on a few key managers.

Because of the illiquidity problems and other risks, most international funds stick with the bigger overseas corporations, the ones that are easy to find, research and follow. Besides, a good chunk of any company’s growth potential depends on the economy it is in, Wignall notes--so identifying the right market is half the battle.

On the other hand, smaller companies, whether in this country or elsewhere, often have above-average sales and profit growth rates--a factor that should eventually be reflected in higher share prices. Woronoff believes that many smaller firms in Western Europe have special appeal at the moment because of takeover activity leading up to economic unification in 1992. “With the opening of the Common Market, a lot of big companies are swallowing up small ones,” he says. “It’s not just a question of their being more dynamic, with better profit potential.”

Murnaghan likes the potential of Southeast Asia. “The whole Pacific Rim is growing at a very rapid clip,” he notes. And after last year’s rough investment climate, he considers prices much more reasonable in places such as Malaysia and Thailand. T. Rowe Price anticipates that economic growth in those countries will run 9.5% and 6%, respectively, in 1991.

In addition to T. Rowe Price International Discovery (no-load; 800-638-5660), several regular mutual funds invest in small stocks from around the globe. They include Alliance Global Small Cap (5.5% load; 800-227-4618), Merrill Lynch Developing Capital Markets (4% load; 800-637-3863), Prudential Global Genesis (5% load; 800-225-1852) and Templeton Small Company Growth (8.5% load; 800-237-0738). Smallcap World (5.75% load; 800-421-0180), part of the American Funds Group of Los Angeles, is now closed to new investors.

In addition, Dimensional Fund Advisors of Santa Monica has three no-load index funds: DFA Continental Small Company, Japanese Small Company and United Kingdom Small Company Portfolios. Each requires a $50,000 minimum investment, unless purchased through a fee-only financial adviser.

Most foreign small-company funds have not been around for more than a few years. But if their brief track records are any indication, you can expect some roller-coaster rides in the future. T. Rowe Price International Discovery, for example, appreciated nearly 42% in 1989, its first year, then fell 13% in 1990. Swings in the value of the dollar can magnify the funds’ gains or losses. Clearly, these investments are not for the timid.

However, the funds do invest in stocks and markets with good potential--in many cases, better prospects than what are available here. And because they do not move in sync with small U.S. stock portfolios, they offer an added layer of diversification.

If you like the idea of investing in emerging companies and can tolerate some volatility, consider placing some money in a foreign small-stock fund--especially if you are willing to hold on for a couple of years or more. “The argument for small-cap stocks is a long-term one anyway,” Woronoff says. “Over time, they should do well.”

FINDING GROWTH OVERSEAS Everybody wants to invest in the next IBM . . . or Sony or British Petroleum. That explains why several mutual fund companies have unveiled global small-stock funds in recent years. These portfolios invest in what they consider to be promising, yet less visible, foreign companies. As this chart shows, small stocks in overseas markets such as Britain and Japan don’t rise and fall in step with their U.S. counterparts. So in addition to the growth angle, they can help add an extra layer of diversification to your portfolio.

Sources: Small U.S. Stocks: Lipper Small Company Fund Average; Small British Stocks: DFA United Kingdom Small Company Portfolio; Small Japanese Stocks: DFA Japanese Small Company Portfolio. FINDING GROWTH OVERSEAS, Los Angeles Times