Four reasons to consider small- and mid-cap international stocks

The year 2017 may mark a turning point for international equities. Stocks of non-U.S. companies are outperforming U.S. benchmarks for the first time this cycle, and asset flows are following suit.

There are a number of reasons for this shift. After several years of subpar performance, international stocks have more attractive valuations than U.S. equities on average, with many European companies, for example, still reporting earnings below peak levels achieved in 2011. Those earnings, and economic growth broadly, are rebounding across developed and emerging markets. Monetary policy remains accommodative in many regions of the world, whereas the U.S. Federal Reserve is tightening. Several currencies are strengthening against the U.S. dollar, providing a performance tailwind for U.S. investors, and political uncertainty in Europe has eased while the U.S. political climate is unsettled.

Investors have taken notice, and asset flows to international markets are up sharply, along with institutional search activity. In July, the 10 most searched investment categories per product in the eVestment database were all within international equities; all but one were in the international small- or all-cap categories.

The question for U.S. investors today is how to best achieve exposure to international equities. We see four reasons why investors should consider small and midsize international stocks for a portion of their active allocation: stronger earnings growth, lower correlation with U.S. equities, a greater net benefit from strengthening currencies, and more opportunities for active managers to add value.

One current tailwind for small- and mid-cap stocks is that most of these smaller companies generate more substantial portions of their revenue from their domestic markets than larger companies, especially multinationals. With the economic outlook in many of these international markets improving markedly in recent months, smaller companies with a domestic market focus could see earnings momentum pick up more rapidly than many larger firms. This potential is reflected in analysts’ earnings expectations: As of August, 2017, international small caps were forecast to generate substantially stronger earnings growth throughout 2017 and in 2018 than international large caps and U.S. large caps.

From the standpoint of portfolio construction, smaller international stocks also offer a diversification benefit, in that the domestic market forces driving their revenues and shaping the competitive landscapes in their industries are distinct from those affecting U.S.-based companies. In the large-cap space, many companies have global footprints, and the revenue sources of a U.S.-based multinational may differ relatively little from those of a non-U.S. competitor in the same industry. This diversification benefit is reflected in the relatively low correlation coefficients of the MSCI EAFE Small Cap Index with common U.S. and global equity benchmarks over the long term. For an equity portfolio allocated primarily to U.S. large-cap stocks, international small caps have provided a greater diversification benefit than U.S. small caps.

Currency markets reflected the shift in economic momentum entering 2017, and the euro and other currencies rallied relative to the U.S. dollar through the first half of the year. This reversal turned what had been a headwind for dollar-denominated investment returns into a tailwind, as strength in foreign currencies is favorable for U.S. investors’ international equity returns after local currencies are translated into dollars. However, not all companies are affected by currency movements in the same ways. The competitiveness of large, export-focused companies will eventually be hurt by a more expensive currency, whereas smaller companies that sell primarily to their home markets are unaffected. As a result, U.S. investors in smaller international stocks may derive a greater net benefit from strengthening currencies than investors in the stocks of foreign multinationals.

In our view, the current international equity environment presents abundant opportunities for active managers, particularly within the mid- and small-cap segments. In the U.S. market, legions of Wall Street analysts parse seemingly every piece of company news, especially when it comes to the largest stocks. In some international markets, detailed financial metrics may not be readily available for all publicly traded companies, and data and news on non-U.S. companies tend to draw less attention than information in our heavily researched market. These imbalances create a unique opportunity for skilled international managers to stand out from the crowd in a positive way.

These opportunities are most pronounced at the international equity market’s smaller capitalization levels, where analysts’ research capabilities are typically thinner than at larger capitalization levels. Indeed, 104 of the nearly 2,300 stocks in the MSCI EAFE Small Cap Index had no analyst coverage at all as of July 2017, according to Bloomberg data; in contrast, an average of 22 analysts covered each stock within the S&P 500 Index.

Given the generally limited coverage of international equities overall, small-cap international stocks make up a uniquely overlooked universe of opportunities where skilled investment managers can truly add value.