The nice thing about investing in small-cap stocks is that you can always find a bull market somewhere. While it’s true that small-cap stocks in the United States have been underperforming in recent months, it’s equally true that there are lots of good opportunities if you cast a more global net.

The Wall Street Journal recently reported on how well small-cap stocks are doing in emerging markets.

“The riskiest stocks in the riskiest markets are among the biggest winners in Asia this year, despite worries about the impact of rising U.S. interest rates on developing countries,” the Journal noted.

That’s why, when I assemble my stock portfolios, I always look at international stocks as well as domestic ones.  Two of the selections I’m proudest of are Vipshop Holdings (NYSE: VIPS) and Bitauto (NYSE: BITA).

Vipshop is China’s leading online discount retailer for brands. The company offers high quality and popular branded products to consumers throughout China at a significant discount from retail prices. As compared to conventional on-line marketplaces or large-scale multi-category online retailers, Vipshop has successfully created and proven there is a third e-commerce model that can provide tremendous scale and profitability. By providing special offers and deep discounts on branded products, the company has pioneered the online discount retail model in China.

Bitauto Holdings Limited is a leading provider of internet content and marketing services for China’s fast-growing automotive industry. Bitauto manages its businesses in four segments: the bitauto.com advertising business, the EP platform business, the taoche.com business, and the digital marketing solutions business. The company’s bitauto.com advertising business offers automakers and dealers a variety of advertising services, which provides consumers with up-to-date new automobile pricing.

The View from Abroad

In the classic investment book Stocks for the Long Run (4^th ed.), Wharton finance professor Jeremy Siegel explained the importance for U.S. residents to invest not only in the stocks of U.S.-based companies but in foreign stocks as well:

The reason to invest internationally is to diversify your portfolio and reduce risk. Foreign investing provides diversification in the same way that investing in different sectors of the domestic economy provides diversification. It would not be good investment policy to pin your hopes on just one stock or one sector of the economy. Similarly, it is not a good policy to buy the stocks only in your own country, especially when developed economies are becoming an ever smaller part of the world’s market.

International diversification reduces risk because the stock prices of one country often rise at the same time those of another country fall, and this asynchronous movement of returns dampens the volatility of the portfolio.

According to the MSCI All-Country World Index (ACWI), stocks in the U.S. account for only 46.74% of the world’s stock market capitalization. That means that a U.S. investor who only invests in U.S.-based companies is missing out on more than half of the world’s economic growth! When one considers that annual U.S.GDP growth is currently only 1.7% — compared to 8% in China, 6% in Indonesia, and 5% in India – the detrimental effect of not investing in the rest of the world becomes even more glaring.  In his 2005 book The Future for Investors , Professor Siegel recommends that U.S. investors allocate 40 percent of their equity portfolio to foreign stocks.

Despite the diversification benefits of allocating 40 percent to foreign stocks, the average U.S. investor only has a 14 percent allocation to foreign stocks – 2/3rds less than recommended! Why so low? The answer is an irrational behavior known as “home equity bias” which has been an “important yet unresolved empirical puzzle in financial economics since the 1970s.” Simply put, people favor the familiar over the unfamiliar and are willing to sacrifice additional risk-adjusted profit for this familiar feeling. The bias is a universal human attribute which one 2005 study was able to document existed in each of the 48 developed and emerging markets across the globe that it vetted. Of course, some investor fear of the unfamiliar may be justified due to foreign exchange fluctuations, higher transaction costs, accounting fraud (China), and political corruption (Russia), but the bias is much larger than all of these issues collectively warrant. Furthermore, the greater the home equity bias in a country, the cheaper the country’s equity valuations.

Bottom line: those investors who successfully avoid home equity bias not only improve the diversification of their portfolios, but also take advantage of the bias of others by purchasing undervalued foreign shares.

According to a 2007 Brandes Institute report, the reason why foreign small caps and U.S. small caps have such low correlations is because they are fundamentally different U.S. small caps are typically young start-ups whereas foreign small caps are typically much older and more established:

Perhaps the origins of small-cap companies are different across regions.  For example, within the small-cap segment in Europe, there may be a greater number of companies spun off from mature firms vs. business conceived and launched as start-ups. Results presented here confirm that European small caps are indeed the oldest of the world’s small caps, as measured by average age since incorporation.  Extending that theme, if one thinks in terms of a company’s “life cycle,” there likely is a greater number of North American small-cap firms in the earlier, rapid-growth stages of their existence.

Whereas U.S. large caps and foreign large caps have experienced relatively high correlations since the 2008 financial crisis, the correlations between U.S. small caps and foreign small caps have remained low.  The reason  has to do with the exclusively domestic focus of small caps in their respective countries vs. the uniform international business focus of large caps.

The superior diversification benefits from small-caps are primarily due to those stocks being more highly correlated with their domestic economies than larger multinational stocks which tend to have higher correlations with other countries including the U.S. Therefore, international small-cap stocks offer more country diversification compared to larger multinational stocks in either the developed or emerging market universes.

With the explosive development of the middle class in emerging markets, domestic-focused foreign small caps will offer U.S. investors some of the highest growth potential in the world.