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Why investors prefer petit stocks over small ones

Published on NewsOK Modified: July 31, 2014 at 2:45 pm •  Published: July 31, 2014
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NEW YORK (AP) — Small-cap stocks are getting the cold shoulder, unless they come with a nice accent.

Stocks of smaller U.S. companies have dropped this year following a spate of warnings that they've become too expensive. But investors continue to buy stocks of smaller companies based in Italy, South Korea and elsewhere outside the United States. Like their U.S. counterparts, foreign small-cap stocks offer the potential to profit from big growth. Unlike them, foreign small-cap stocks generally come with lower price tags, though they come with their own risks.

It's an about-face for U.S. small-cap stocks, which had been at the leading edge of the surging market since the financial crisis ended. Last year was the fourth time in five years that the Russell 2000 index beat the large-cap stocks in the Standard & Poor's 500 index. U.S. small-cap stocks also beat their foreign counterparts.

Much of the excitement focused on how U.S. small-cap stocks generate more of their revenue domestically, compared with big multinational companies. That benefited smaller companies because the U.S. economy has been stronger than other regions: The U.S. unemployment rate is at its lowest level since 2008. Europe, in comparison, is still recovering from its debt crisis, and Japan is trying to jolt its economy from a decades-long slumber.

Smaller companies also can offer stronger earnings growth than bigger companies. A new product or two could have a significant impact on their overall revenue. It's more difficult for an Exxon Mobil or Wal-Mart Stores to produce a big percentage change in its annual revenue when it is measured in the hundreds of billions of dollars rather than millions.

But the surge in small-cap stocks made them more expensive. Valuations got high enough that the Federal Reserve called them out in its mid-July monetary policy report, a move that spooked many investors.

"Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched," the central bank wrote in its report. The Fed cited how high the prices of these stocks were relative to their expected earnings.

The mention helped send small-cap stocks down, and the Russell 2000 index is down 0.8 percent for the year through Wednesday. Over the same time, an index of foreign small-cap stocks has returned 6.4 percent.

Through the first half of the year, investors plugged $5 billion into foreign small- and mid-cap stock mutual funds, according to Morningstar. That's nearly five times as much as they put into their U.S. counterparts.

One of the main draws is the lower price tag: Foreign small-cap stocks were trading at 15 times their expected earnings per share at the end of the last quarter, versus 21 times for their U.S. counterparts, according to MSCI indexes.

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