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Thursday, March 29, 2007

The Right Way to Invest Internationally

As we have pointed out in other posts, our investment strategyis based on the pioneering research of Fama and French and confirmed by the research work of other prominent academics. It takes advantage of the value and size premiums in stock performance. Long term data have shown that value (high book to market) and small cap stocks outperform the overall market with small cap value stocks showing particular outperformance. This outperformance occurs in international markets as well, in fact the value and small value outperformance are more pronounced in those markets. This can likely be attributed to the wide dissemination of this research in the US capital markets and consequent larger number of people employing this strategy, thus lowering the advantage.

A recent WSJ article got the story partially right when it reported the following:

It's a Small World, After All

Global Investors Look
Beyond Big-Cap Issues;
Will Streak Run Out?

By CRAIG KARMIN
March 26, 2007; Page C1

International investors are starting to think smaller. They should have started earlier.

Small and midsize stocks in Europe, Japan and other corners of the developed world have offered some of the best earnings growth anywhere in recent years. These stocks returned 25% a year, on average, for the five years through December, according to Morgan Stanley Capital International.

Like U.S. small-capitalization stocks, small-cap foreign stocks outperformed large-cap foreign stocks for each of the past six years. Up 7% year-to-date, foreign small stocks are ahead again this year.

And the small-cap stock gains came with fewer ups and downs than stocks in developing countries, and with about the same volatility as large foreign or U.S. stocks.

In other ways, the case for these small companies is less compelling. Earnings growth is slowing, smaller stocks have become relatively more expensive than large stocks and any sign that investors are getting nervous about owning riskier securities -- as when markets around the world nose-dived late last month -- usually hits small stocks harder.

Based on price relative to expected earnings, European small-cap stocks are now 19% more expensive than large European companies, according to Citigroup.

Small-cap international stocks offer some unique advantages to U.S. investors. They can provide better portfolio diversification than other foreign-stock categories.

Actually there is a simple solution to the dilemma of “overvalued” small cap international stocks: buy the small cap value stocks. And how should you buy them ? in an index fund. Unfortunately, for most investors there is no international small cap or small cap value fund or etf open to the general public. For those (like my clients) who work with an advisor that has access to Dimensional (DFA) funds, there are available a small cap international and an international small cap valuef und. As can be seen below the outperformance of the small cap value index (vs all intl stocks and small cap stocks) is quite persistent. And the small cap, which premium is quite persistent as well.

In fact looking at the data it may indeed be that the WSJ has, as is frequently the case, missed the real story. For all the periods listed small value stocks outperformed the small cap index (and the overall intl index). And for all but the 5 year period value stocks across all market capitalizations outperformed small cap stocks.


1 Year

3 Years

5 Years

10 Years

MSCI EAFE Index (all intl stocks)

26.86

20.41

15.43

8.06

Dimensional International Small Cap Value Index

27.76

28.13

29.57

14.50

Dimensional International Value Index(all cap)

32.96

25.95

23.77

15.39

Dimensional International Small Cap Index

25.62

25.96

25.36

10.54

So the lead in the article on investment strategies in international markets should really be “go value” rather than “go small”

The article also points out correctly that the diversification effect is greater with international small cap (and small value) stocks than the overall international markets, which as we noted in yesterday’s post, have an increasing, and high, correlation with US stocks:

Returns on small-cap foreign stocks were less likely to move in sync with Standard & Poor's 500-stock index in the past 12 years than either emerging-market stocks or large-cap international stocks, according to ING Investment Management. Analysts say this is because small-cap stocks are influenced more by domestic or regional factors than by global factors, such as the price of oil or interest-rate moves by the U.S. Federal Reserve.

ING also found that foreign small-cap stocks have been less volatile over those 12 years than the other hot area in overseas investment, emerging-market stocks. Price moves on foreign small-cap stocks were roughly the same as large-cap foreign and U.S. stocks.

"What all this says to me is that if you want to diversify with relatively low volatility, foreign small stocks are the way to go," says Brian Gendreau, an investment strategist at ING in New York.

Of course almost no WSJ article on investments is complete without buying into the eternal mantra of active management: that stock pickers can outperform the market. As readers of this blog know there is little evidence this is the case. But hope springs eternal :

Although the average market capitalization for foreign small stocks is nearly double that of U.S. small stocks, there is much less analyst coverage of international small-cap companies. Bargain "opportunities are greater when there's less analyst coverage," says Randy Farina, who helps to manage the $1.8 billion Putnam International Capital Opportunities Fund, which invests in foreign small-cap stocks.

Return numbers of the abovementioned fund:

1 yr 25.7 3 yr 26.4 5 yr 18.48 10 yr 16.48

In other words Mr. Farina, whose job it is to pick individual small cap international stocks, fails in all periods to beat the small cap value index.

But hope springs eternal !

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