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Consider Going Abroad for Small-Value Exposure

Foreign small-value stocks are generally cheaper with less debt.

U.S. small-value stocks have made a nice run of late. Over the past six months, the Russell 2000 Value Index gained 44.2% through Jan. 21 versus 19.3% for the S&P 500. But small-value stocks still have a lot of ground to make up after being the worst-performing segment of the U.S. equity market over the trailing 10 and 15 years. This still makes the group a potential target for contrarian investors.

But there are good reasons why small-value stocks lagged over those periods. It is arguably the most economically sensitive part of the market, with nearly 55% of the Russell 2000 Value Index in cyclical stocks versus 31% for the S&P 500. So, these companies have borne the brunt of recent economic volatility.

While many large-growth companies like (AMZN) and Apple (AAPL) have grown stronger through this crisis, many small-value companies are struggling to survive. The return on assets for the average company in the tech-laden Russell 1000 Growth Index was 11.1% over the trailing 12 months, but it was negative 0.9% for the Russell 2000 Value Index. The average net margin for that index was just 4.5% versus 17.4% for the Russell 1000 Growth Index. So, there are fundamental reasons that the Russell 2000 Value Index is trading just above book value while the Russell 1000 Growth Index is trading at more than 11 times book value.

Even so, small-value stocks are perhaps the one corner of the U.S. market that could be considered cheap, at least based on their average price multiples. But, as mentioned above, risks abound. One more risk is on their balance sheets. The typical Russell 2000 Value Index constituent has a debt/capital ratio of 40.9%, which spiked from 35.5% just over the past 12 months. With considerable economic uncertainty, bankruptcy remains a real risk for many small-value companies.

One potential way to mitigate this risk is to look abroad. Although foreign companies have increased their borrowing over the past five years, their debt levels are generally below those of their U.S. counterparts. This shows within the small-value subgroup as well. The foreign small/mid-value Morningstar Category had an average debt/capital ratio of 33.6%. 

Meanwhile, the group's average price multiples were lower than those of the Russell 2000 Value Index across the board. This owes in part to the fact that foreign small/mid-value stocks haven't rallied to the same extent as their U.S. counterparts. The group has gained 27.6% over the past six months ended Jan. 21, trailing U.S. small-value by nearly 17 percentage points. Plus, foreign small/mid-value has also lagged over the past five, 10, and 15 years.

However, foreign small/mid-value funds have risks of their own. For example, DFA International Small Value (DISVX) is heavily weighted in cyclical companies as well, with a whopping 16.3% of assets in materials companies and another 24.4% in industrials. One other drawback is that the fund limits itself to developed-market companies. Thus, investors miss out on what many consider to be one of the most-attractive parts of the global equity universe, emerging markets.

Bronze-rated Pear Tree Polaris Foreign Value Small Cap (QUSIX), which had 16.6% of its portfolio in emerging markets as of December, offers an alternative. Its portfolio is also better diversified across sectors, including a more-reasonable 6.7% in materials, although it still held 42.0% in cyclical stocks overall. Plus, its holdings are much more profitable on average. Those considering this fund should stick to the Institutional shares, if possible, as they have a far lower expense ratio than the ordinary shares (1.06% versus 1.43%).

For more foreign small/mid-value ideas, consult our Morningstar Medalist funds.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.