Under the Radar
Home Country Bias is defined as investors’ natural tendency to be most attracted to companies in domestic markets because they are familiar. Small foreign companies comprise 79% of the global investment opportunity set, but only 2% of all investment industry products are focused in this area.
Thriving businesses can grow at much faster rates than the general economy. Nimble small-sized companies have delivered returns 3% greater than their large company counterparts over long periods of time. While most investors understand the benefits of owning small companies, they often invest in small U.S. companies and completely overlook small foreign companies. This is unfortunate because small foreign companies provide similar long-term performance benefits, and they often accomplish this with less downside along the way than small U.S. companies exhibit. Given the attractive features of small foreign company investments, Paracle places a portfolio weight on small foreign stocks that is 4 times as great as their weight in global stock market indexes.
Small Foreign Company Landscape
Sizeable Investment Universe. There are over 25,000 small foreign companies. This embodies 79% of the publicly traded companies in the world. Further, only about 4,300 of these companies are tracked by a market index, which means that much of the opportunity set is not even measured in mainstream financial channels.
Moreover, this opportunity set is growing larger. Tax structures and cultural norms of many countries encourage companies to stay small, so business segments are spun off rather than creating larger conglomerates. As a result, IPO activity has been greater in foreign countries than domestically, which results in an expanding universe of highly specialized companies. Active stock-pickers can study these companies long before they reach the radar of large institutions or are added to market benchmarks.
Lack of Outside Interest. Many small foreign companies are majority-owned by local citizens and have little interaction with large U.S.-based financial institutions. In fact, most Americans are simply not aware of small foreign companies and do not invest in them. (Anecdotally, we seldom see small foreign company investments in the existing portfolios of new clients who engage Paracle.) As a result, there is less global investment capital placed in small foreign companies than in other stock categories.
This low level of capital investment can result in undervaluation of foreign companies. For illustration, how many times have you heard of someone getting a great deal in an auction because there was no one else bidding? A similar dynamic holds true in investment markets, and there are often good deals to be had in markets where less people are involved. In these cases, an individual company’s market value is much more likely to get out of step with its intrinsic business value. As a result, small foreign company specialists tell stories that one would seldom encounter in U.S. financial markets. For instance, it is not uncommon to find companies whose market valuation at times falls below the value of cash held on their balance sheets.
Muted demand for investment products in this space corresponds with little financial analyst coverage. Stocks within the small foreign company index are covered by an average of 4 analysts. However, companies outside the index are covered by 0 to 1 analysts, leaving many opportunities for a careful stock-picker to analyze and explore.
Corporate Freedom. This lack of analyst coverage results in meaningful nuances for corporate management decisions. Corporate management teams are much freer to focus their time developing and implementing plans to achieve longrange goals than thinking about how to present short-term results to the financial industry each quarter.
On the flip side of this flexibility, sometimes the high level of freedom and lack of outside scrutiny leads to inconsistencies and missteps. There are differences in accounting standards across countries and regions, cultural differences, and even outright fraud in some cases (mostly in a few specific countries with loose accountability standards). Nearly every investment manager that we interviewed spoke of the importance of verifying data and information that comes from small foreign companies.
In one extreme example, a manager we interviewed told the story of a Chinese company with sizeable market capitalization, and which was a constituent of the market index, that turned out to be fraudulent. His due diligence uncovered that the only assets were a rusted out tractor and a broken down building. No one had bothered to check if there was actually an operating business before placing it in the market’s index.
In sum, it pays to knock on the doors of small foreign companies. A thoughtful stock-picker is able to investigate and separate the incredibly good opportunities from bad ones.
Variation Amongst Companies. The products of small foreign companies are often sold primarily within local markets. With companies spread over 45 different countries, each with a unique local economic environment, there is considerable variation amongst the individual companies. Contrast this with large U.S. and large foreign companies that sell their products globally in countries all over the world and whose stock prices often move very tightly with one another in response to global macroeconomic events.
This variability amongst the companies within a category is referred to as “cross sectional volatility.” While the concept itself is a bit complicated, there is a simple takeaway. In categories where the performance of individual companies is widely dispersed, an active stock-picker has a greater opportunity to select stocks that are temporarily out of step with the market index and hold on to them until they appreciate nicely. (Conversely, if all companies move tightly around the index, then there is little opportunity to add value through stock selection.)
Taken altogether, there are many attractive dynamic elements for active stock-pickers. But how many small foreign stock-pickers are actually successful? The odds of selecting an outperforming manager are quite good, better here than in any other investment category. When managers with higher-than-median fees are removed, the success rate for active stock-pickers has averaged 78% over 10 year periods of time.
We also consider whether the level of performance for successful stock-pickers is high enough to justify the increased costs associated with active management, which include explicit strategy expenses as well as tax-related costs from portfolio turnover. Paracle only pursues active stock selection strategies in categories where we anticipate at least 2.0% return in excess of the market index. Small foreign company manager outperformance has exceeded this level in all 10-year periods, with outperformance ranging from 2% – 3%.
Taken together, we believe that we have a very good chance of selecting stock-pickers who are able to add value for our clients. Critically important too, we anticipate that active stock-pickers will continue to be successful going forward, especially since meaningful aspects of the small foreign company investment landscape appear to be structural. Most significantly, the impracticalities of creating large-scale investment products will likely result in a continued low level of participation by sales-oriented investment organizations. This in turn will mean that analyst coverage will continue to be thin, resulting in ongoing “inefficiencies” that active stock pickers are able to take advantage of.