NEW YORK (TheStreet) -- When foreign stocks sank last year, the damage was particularly severe for small-caps.
According to Morningstar, foreign small- and mid-cap value mutual funds lost 16.0% in 2011, while foreign large-cap value funds dropped 12.8%, and the S&P 500 returned 2.1%. Now many foreign stocks look cheap compared to U.S. counterparts. The average price-earnings ratio of foreign small- and mid-cap growth funds is 16, compared to a figure of 21 for the U.S. small growth category. Foreign small-caps are particularly appealing because they sometimes provide diversification, rising when U.S. stocks fall. During the past 10 years, foreign small- and mid-cap value funds returned 8.6% annually, outdoing the S&P 500 by about 6 percentage points. Despite the compelling record of foreign small-caps, many investors ignore them, says Ralf Scherschmidt, portfolio manager of Oberweis International Opportunities Fund. Scherschmidt says that foreign small-caps account for 7% of the total world market capitalization, but most U.S. investors have less than 2% of their assets in the category. Those who ignore the small-caps are missing an important growth opportunity, he says. Even in the sluggish economies of Europe and Japan, many little companies are recording strong sales gains by expanding their market shares or exporting to the emerging markets. "Investors should overweight international small-caps because they have growth potential," Scherschmidt argues. To own foreign small-caps, you can buy a fund that is dedicated to the sector, or you can try a fund that holds stocks of all sizes. A top-performing small-cap fund is Royce Global Value, which returned 5.6% annually during the past five years, outdoing 97% of its competitors in the world stock category. Royce favors companies with rock-solid balance sheets and high returns on invested capital. Holdings must be efficient competitors in healthy industries. Die-hard value investors, the Royce managers aim to buy stocks that have been overlooked by the market. To find bargains, the managers often take unexciting companies that may be reporting only modest growth. A holding is Mayr-Melnhof Karton (MNHFY.PK), an Austrian maker of packaging material that is used for cereal boxes and cigarette cartons. "The company is a leader in a small industry," says Royce portfolio manager David Nadel. "Every cycle they take a little bit more of market share." Nadel also likes FamilyMart (FYRTF.PK), a Japanese operator of convenience stores. He says that the stock sells for only four times forward earnings. The shares have been marked down because investors have soured on the outlook for the Japanese economy. But FamilyMart, which has most of its stores outside Japan, is growing rapidly in Korea and other Asian markets. Another solid fund is Oberweis International Opportunities, which returned 27.6% annually during the past three years, outdoing 88% of competitors in the foreign small/mid growth category. Portfolio manager Ralf Scherschmidt seeks companies that are undergoing big positive changes, such as entering new markets or restructuring businesses. His aim is to buy before the new developments help push up shares. Scherschmidt likes Harry Winston Diamond, a Canadian company that mines diamonds and sells them in luxury stores. Sales are booming in Asia, he says. In the past, few Chinese bought diamond rings, but that is changing quickly. "In China there is growing demand for diamond engagement rings," he says. A low-risk fund is First Eagle Overseas, which has returned 12.9% annually during the past 10 years, outdoing 92% of foreign small/mid value funds. First Eagle holds stocks of all sizes, including a big stake in small-caps. The fund excels in downturns. During 2011, First Eagle lost 5.6% and outdid its average competitor by 10 percentage points. In 2008, the fund topped its peers by 26 percentage points. First Eagle achieved the results by following a cautious value strategy. The portfolio managers look for companies with good balance sheets that sell for big discounts. When they can't spot bargains, the managers hold cash. The fund often has more than 10% of assets in cash, which helps to dampen volatility. Willing to take contrarian positions, First Eagle currently has 40% of assets in Japan, an usual position at a time when many fund managers are underweighting the country. "By some measures, Japan is the cheapest market in the world," says portfolio manager Kimball Brooker. Brooker likes Shimano (SHMDF.PK), a Japanese producer of bicycle parts. Most of the company's sales come from abroad, including strong businesses in the U.S. and Europe. Another fund that owns stocks of all sizes is Causeway International Value. During the past 10 years, Causeway has returned 7.1% annually, outdoing 77% of competitors in the foreign large value category. Lately the fund has been increasing its holdings in small- and mid-cap stocks. "We go where we see the most value," says portfolio manager James Doyle. Doyle looks for unloved stocks of leading companies with strong balance sheets. He is not afraid to take contrarian positions. The fund currently has most of its assets in Europe. Doyle says that European stocks have become excessively cheap as investors worry about the outlook for the European Union. A holding is Michael Page International (MPGF.PK), a U.K. company that provides temporary employees for financial and legal positions. Doyle says that Michael Page can grow as struggling European companies look to cut costs by relying on temporary employees.