Seeking Alpha

The Time May Be Right For International Small Caps

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Includes: SCHC, VFSAX, VFSVX, VSS
by: Bottom Fisher Ideas
Summary

After alternating leadership for 50 years, international stocks have lagged US stocks for over a decade.

Small-cap stocks have trailed large-cap stocks for over 5 years, despite the traditional small-cap premium.

US-led trade tensions could be a boon to small-cap stocks with domestic focus and could make countries not involved in the trade conflict the relative winners.

Two ETFs stand out as excellent vehicles to increase international small-cap exposure.

With international markets having languished for a decade, small-cap stocks trailing their large-cap peers despite a history of outperformance, and with trade tensions dominating headlines, international small-cap stocks are poised to outperform the US.

International Diversification Has Disappointed Investors For Over A Decade

US stocks have long been the gold medal favorites in the world's stock markets. While they don't always win each year, they have outperformed their international peers in the long run.

Despite the historical strength of US stocks, history has also shown investors that international diversification is valuable, as it provides better risk-adjusted returns. Looking back to 1970, international stocks have outperformed US stocks for five periods of 2, 4, or 6 years at a time (1971-1974, 1977-1978, 1983-1988, 1993-1994, 2002-2007). It is difficult to predict when these periods will occur, however. Anyone who has bet on a resurgence in international stocks over the past decade has been sorely disappointed, but international diversification remains a core tenet of modern portfolio theory. While it will mute returns during periods of outperformance by US stocks, it will boost returns during those periods of international outperformance, smoothing out returns year after year.

From 2002 to 2007, international stocks outperformed US stocks by a significant margin. If one were were only invested in US stocks during that period of time, one would have missed out on some big gains elsewhere. I have chosen to examine the iShares Russell 1000 ETF (IWB) and the iShares MSCI EAFE ETF (EFA) because they have long histories, are offered by the same provider, and both focus on large- and mid cap stocks.

Chart Data by YCharts

We are currently experiencing the greatest period of US stock outperformance in recent memory, however. From 2008 to the present, US stocks have made international stocks look like terrible investments.

Chart Data by YCharts

Only part of the latest stretch of US stock performance can be attributed to business fundamentals. Part of it is multiple expansion: how much investors are willing to pay for US stocks. After this historic run by IWB, it is significantly more expensive than EFA by every metric.

Forward Valuation IWB EFA
Price/Earnings 17.87 14.10
Price/Book 2.99 1.48
Price/Sales 2.06 1.14
Price/Cash Flow 9.03 7.00
Dividend Yield % 1.97 3.49

Data from Morningstar as of 05/24/2019

Should we assume that the long history of alternating leadership between US and international stocks has come to an end and that US stocks will continue their dominance year after year? That seems incredibly unlikely. The mantra "this time is different" has been wrong more often than anyone can count.

Should we assume that international stocks are poised to retake the lead over the next 12 months? We can't predict that either, as short-term forecasts are nearly impossible to make accurately. But if an investor has a longer horizon, international stocks look like a good bet to revert to the mean and outperform over the medium-to-long term.

The Small Cap Premium Has Been Missing For Half Of A Decade

Small-cap stocks have historically outperformed large-cap stocks by a small but significant margin. Academics have studied this effect for decades, confirming it again and again. Investors have relied on this, and small-cap funds remain popular investments. The small cap premium makes intuitive sense, too. Individual small-cap companies are riskier than their large-cap peers; they are less financially secure, there is less information about them, and their position in the markets in which they compete is less dominant. Investors demand a higher return to compensate for this additional risk.

While small caps initially outperformed following the Great Recession, small caps have been struggling for the past 5 years. If we examine the Vanguard Large Cap ETF (VV) and the Vanguard Small Cap ETF (VB), we can see that US small caps have been trailing US large caps for the past 5 years, while they have outperformed slightly over the past 10 and 15 years.

Total Return % Category 3-Month 1-Year 3-Year 5-Year 10-Year 15-Year
VV US Large 0.99 5.01 12.45 10.07 14.31 8.76
VB US Small -2.97 -1.69 10.75 7.73 14.57 9.31

Data from Morningstar as of 05/28/2019

Recent small-cap weakness is not just a domestic phenomenon. If we compare the Vanguard FTSE All-World ex-US ETF (VEU) and the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS), we reach similar conclusions. Small caps have performed worse internationally over the past 5 years, while maintaining a small edge over the past 10.

Total Return % Category 3-Month 1-Year 3-Year 5-Year 10-Year
VEU Intl Large -1.45 -6.76 6.95 1.78 6.20
VSS Intl Small -2.52 -12.90 4.96 1.46 7.50

Data from Morningstar as of 05/28/2019

Has the small cap premium disappeared forever? Almost certainly not. This effect has persisted for decades, and with good reason. While there is no guarantee that small caps will resume their outperformance immediately, mean reversion is a powerful force, and a reasonable investor should assume that small caps will play catch-up over the medium-to-long term.

Why The Trade War Might Be A Catalyst For International Small Caps

International small caps have been the biggest losers in recent years. They combine the terrible performance of non-US stocks over the past 10 years with the weak performance of small caps over the past 5. In addition to the powerful forces of mean reversion that could lift both international and small cap stocks over the medium-to-long term, there are good reasons to hope for better performance in the short term.

It's tough to draw conclusions about tariffs and trade wars, as full-blown trade wars have occurred so infrequently in recent history. The fact remains that we don't know if the situation between the US and China will escalate, get resolved quickly, or drag on, and while the disputes between the US and Japan and the US and the EU have been kicked down the road, we don't know what will happen there either.

The conventional wisdom on trade conflict is that small caps provide a safe haven. The theory goes that large-cap stocks have the most international exposure, so anything that reduces trade between nations will impact large caps inordinately. Small caps, meanwhile, are more domestically focused. Often, they produce goods and services and sell them within the country they reside, so while a general economic downturn will hurt them, trade between countries will not impact them directly. As far as theories go, it makes sense. But with few trade conflicts in recent history, there is little data to back it up.

Recent commentary by BofA-Merrill Lynch small cap expert Jill Carey Hall disputes this idea, however. She has been warning investors away from US small caps, remarking on CNBC:

A lot of these companies are suppliers to the big multinationals. Many of them have been highlighting the impact of trade on calls this earnings season. A lot of these companies might not be able to be as nimble about shifting their supply chains or pricing that through.

So, one should take that piece of conventional wisdom with a certain amount of skepticism.

Meanwhile, history tells us that the winners in trade wars are frequently countries that are not involved. In the late 1800s, Italy and France scrapped free trade and raised tariffs against each other as high as 60%. This hurt both the countries, as well as numerous peripheral countries. There were winners, however. Both Germany and Austria-Hungary came out ahead as they forged closer economic and diplomatic ties with Italy. Similarly, in the early 1900s, the US enacted protectionist measures which prompted Canada and much of Europe to retaliate. The tit-for-tat trade fight hurt everyone involved, but there was a winner: Russia. They increased trade with Western Europe and improved diplomatic relations, as well.

If the threat of a protracted trade war causes US businesses to move their supply chains out of China, then the beneficiaries are likely to be uninvolved countries. Similarly, if China recognizes that they are too economically dependent on the US, then they are likely to develop trade elsewhere to reduce that dependence. The beneficiaries will once again be other countries that aren't involved in the trade war.

The markets are in uncharted territory. We have seen a record long period of US stock market strength and a recent spate of small-cap weakness that is unusual. After decades of reduced trade barriers and increased global trade, tariffs are being raised and there are signs of an impasse between two of the world's largest economies. The forces of mean reversion are prepared to boost long-term returns for both international and small-cap stocks, and the potential trade war could serve as a short-term catalyst for both. While nothing is certain, only one or two of these four tailwinds has to pick up in order to make international small-cap stocks a good place to put new money to work.

There Has Never Been A Better Time To Invest in International Small Caps

As recently as a few years ago, it was much more expensive to get international small-cap exposure. But thanks to competition between Vanguard and Schwab, there are now two ETFs that stand out with expense ratios of only 0.12%:

Schwab International Small-Cap Equity ETF (SCHC)

  • Expense Ratio: 0.12%
  • Avg. Daily Volume: 200k
  • The fund attempts to track the performance of the FTSE Developed Small Cap ex US Liquid Index and invests in small-cap companies in developed countries outside of the United States.

Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)

  • Expense Ratio: 0.12%
  • Avg. Daily Volume: 100k
  • This fund attempts to track the performance of the FTSE Global Small Cap ex US Index and invests in small-cap companies in developed and emerging countries outside of the United States.

The big difference between these two ETFs is that the Vanguard ETF includes emerging markets, while the Schwab ETF does not. SCHC avoids the 3.6% exposure to China, which could be a drag on the ETF if there is a protracted trade war between China and the US. VSS, on the other hand, comes in with a slightly lower valuation and a slightly larger dividend yield.

Regardless of which ETF an investor chooses, international small caps provide a strong value proposition when compared to US markets. If you compare VSS and SCHC to the iShares Core S&P Total U.S. Stock Market ETF (ITOT), the disparity is clear. Perhaps most shocking is that you can get a 3% dividend yield from international small caps, while the US stock market is providing less than 2%.

Forward Valuation VSS SCHC ITOT
Price/Earnings 13.43 14.02 17.85
Price/Book 1.32 1.33 2.87
Price/Sales 0.82 0.84 1.93
Price/Cash Flow 5.93 6.16 8.92
Dividend Yield % 3.11 2.91 1.93

Data from Morningstar as of 05/24/2019

If you'd prefer a mutual fund, Vanguard offers a mutual fund version of VSS. The investor shares (VFSVX) have an expense ratio of 0.22%, while the admiral shares (VFSAX) have an expense ratio of 0.16%.

Many investors favor active management when it comes to international small caps, believing that the market is less efficient and their odds of beating the benchmarks are higher. But with the poor performance of the asset class over the past decade and the incredibly attractive valuation, purchasing the entire index at a very low expense ratio seems like the correct approach.

Conclusion

International stocks are perceived as riskier than US stocks, and small caps can be more volatile than large caps, so it might seem counterintuitive to think about investing in international small caps with the stock market near its highs and with trade tensions ratcheting up. But after years of weak performance, international small caps have gotten so cheap that they actually represent a smaller risk than US large caps. They have higher dividend yields, lower multiples, are more insulated from US-created trade tensions, and are poised for relative outperformance over the next several years. I have been buying the Vanguard FTSE All-World ex-US Small-Cap ETF and I will sleep soundly at night with that as a long-term investment.

Disclosure: I am/we are long VSS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.