These funds find big opportunities in pint-size foreign firms. By Elizabeth Leary, Contributing Editor November 5, 2009 You’ve probably never heard of Aixtron, a small German firm that supplies semiconductor components to makers of light-emitting diodes and generates annual sales of less than $400 million. The management team at T. Rowe Price International Discovery (symbol PRIDX) had been following the company for some time; but after several Price analysts visited Taiwan, Justin Thomson, International Discovery’s manager, became far more interested. “The team’s biggest take-away was that very soon LEDs will be supplying backlighting for 100% of new computers,” says Thomson. Already familiar with Aixtron’s efficient manufacturing methods, he pounced after that new revelation. “We bought the stock earlier this year for 4 euros per share,” he says. Since then, the company has reported a huge pickup in orders, and the stock has more than quadrupled. Therein lies the appeal of investing in small foreign companies. The benefits of investing abroad have dwindled as the world’s economies have become increasingly interconnected. But unlike large multi-nationals, small companies tend to be closely tied to their local economies, and the value of their stock is often driven by fundamental business prospects and local developments, rather than by large global trends. Plus, because many of these companies receive little attention from analysts, there are plenty of gems to uncover. “The smaller the companies you look at, the more often you come across mispriced stocks,” Thomson says. The number of good choices among no-load mutual funds that invest in small foreign firms is surprisingly small. Only a handful of no-loads have long-term records, and Oakmark International Small Cap I (OAKEX) stands out on that list. Over the past ten years through October 8, the fund was the top-performing no-load fund in this category, with an annualized gain of 10.3%. Advertisement Manager David Herro, who has run the fund since its 1995 inception, looks for stocks in bargain bins. He typically won’t buy a stock unless it sells for at least a 40% discount to his estimate of a company’s true value, but he requires even larger markdowns when there are plenty of good deals. Herro, who usually holds on to stocks for a couple of years, doesn’t mind going against the crowd. That’s why he was comfortable owning financial stocks -- such as Swiss asset manager Julius Baer Holding (which recently split into two entities) and Japanese broker Ichiyoshi Securities -- as well as consumer-discretionary stocks, such as Italian luxury-goods maker Bulgari, during the financial crisis. And Herro cares not one iota whether his hunt for cheap stocks causes the fund’s country or sector weightings to diverge significantly from those of benchmarks. For example, he avoided energy stocks in 2007 and 2008 because he couldn’t find any bargains. Herro is optimistic, if not outright bullish, on the global economy. He thinks that swelling consumer classes in emerging nations will drive global growth in the coming years. But although Herro can invest up to 35% of his fund’s assets in developing countries, he has a below-average 6% of assets in those markets now. He’s finding better values in the developed markets of Japan and Western Europe. Thomson’s fund is another long-run standout. Over the past ten years, T. Rowe Price International Discovery has gained 9.0% annualized. Thomson begins his search for potential investments by screening for stocks that are relatively easy to trade. Advertisement Although he’ll consider companies with market capitalizations as large as $3 billion, he prefers to start with truly small companies. That way, he says, “the fund can hold a company as its earnings grow and as it gains recognition,” and as it commands a higher price-earnings ratio. Price’s 16% stake in emerging markets should be a boon in the long run, but it may add to volatility in the short run. Thomson doesn’t mind letting winners run. For example, the fund bought China-based Tencent, a Web-portal and social-network operator, when its market capitalization was below $3 billion and has held on to the stock as its value has climbed beyond $28 billion. As with most small-company overseas funds, the Price fund’s biggest weightings are in Japan and the U.K. (a natural byproduct of those nations’ relatively large number of publicly traded companies). Thomson isn’t a Pollyanna regarding those countries’ problems; Japanese stocks have been in a bear market for the past 20 years, and the U.K. has many of the same economic troubles as the U.S., including tapped-out consumers and a troubled housing market. But he’s still finding plenty of opportunity: “I’ve been covering this asset class for 15 years, and it’s never been as interesting as it is now.” If you’re looking for rock-bottom fees, you can’t beat Vanguard International Explorer (VINEX). With an annual expense ratio of just 0.36%, Explorer sports the lowest fees in this category, although the initial minimum-investment requirement is a steep $25,000. The fund, which is managed by Schroders, a London-based investment firm, holds a stock for an average of about three years. That helps ease the job of handling Explorer’s $1.9 billion in assets. Advertisement Manager Matthew Dobbs leads a team of five Schroders managers, who follow a strategy of growth at a reasonable price. “We don’t set any minimum earnings-growth rates, but we also won’t buy a stock simply because it’s cheap,” Dobbs says. “We’re looking for the right combination.” The team has a penchant for niche stories. For example, the fund holds shares of Union Tool Co., a Japanese manufacturer of specialized drill bits for making semiconductors. The drill bits have to keep pace with the technological advances of semiconductors, which continually get smaller. Another niche holding is Chugoku Marine Paints, also based in Japan, which makes high-quality paints used to coat newly built ships and old ships that need to be refurbished. “The costs to an owner of repainting a ship because its hull is rusting are quite high, so it’s important to use paints that hold up in harsh conditions,” Dobbs says. The managers picked up the stock at a beaten-down price during the financial crisis, as investors worried about the pace of shipbuilding activity. There are small companies, and then there are tiny companies. Wasatch International Opportunities (WAIOX) invests in the latter -- the average market capitalization of stocks in the fund’s portfolio is just $640 million. And at 20% of assets, the fund’s emerging-markets stake is at the high end for its category. Advertisement In other words, this fund isn’t for the faint of heart. But investors who can handle the volatility may find International Opportunities rewarding, as its recent performance demonstrates: From the bottom of global stock markets on March 9 through October 8, the fund gained 95.2%. Managers Roger Edgley and Blake Walker follow a meticulous stock-selection process that starts with companies’ balance sheets, which must show enough cash to cover any outstanding debt. The managers insist that potential investments exhibit stable growth in earnings and profit margins. And they prefer to invest in companies that are run by family members or whose founders still own significant portions of the business. Such managers, says Edgley, “tend to have a longer time horizon for the decisions they make.” He and Walker also prefer to own firms that boast some competitive advantage, such as a strong brand or proprietary technology. Why such sticklers for quality? “When you’re investing anywhere at a distance,” says Edgley, “you don’t always have the same ability to talk to everyone in an industry or trade in and out of a stock as you do when investing in U.S. companies. It’s better to buy a high-quality company that you can feel confident leaving alone in the fund.” Want to keep things simple? As its name suggests, Vanguard FTSE All-World Ex-US Small-Cap Index (VSS)seeks to match a benchmark of small-company foreign stocks. But even here, you have to make a choice between a traditional mutual fund version and an exchange-traded fund. In either case, the fund stashes 10% of assets in emerging markets and is widely diversified, with more than 2,000 holdings.