Do You Have a Bias Against International Small-Cap Stocks?

Do You Have a Bias Against International Small-Cap Stocks?

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With the S&P 500 fully recovered from the correction earlier this year, and hovering near its all-time high, the current bull market in U.S. large-cap stocks remains one of the longest in history. The reasons for this bull market are still in debate. Skeptics suggest the rise is a product of artificially low, government-suppressed interest rates. Supporters, on the other hand, point to an ever-strengthening U.S. economy and impressive stock-earnings growth. Whatever the cause, there’s no debating that there’s been a long rise in U.S. large-cap stocks.

When one type of investment performs especially well, it becomes easy to believe that other types of investments aren’t worth considering. The 2017 Bitcoin euphoria that lured some investors into making untimely and aggressive bets serves as a case in point. When something goes up and up and up, people tend to overlook the virtues of other investments. Take small-cap U.S. stocks, for example.

Last year, U.S. small-cap stocks (as measured by the Russell 2000 Index) under-performed their U.S. large-cap counterparts (as measured by the S&P 500) by 7%. This kind of divergence often happens. But it doesn’t mean that small-cap U.S. stocks are broken. If we examine their performance over a longer period of time, we can get a better understanding of what happened in the last year. When we compare the five-year rolling returns of the Russell 2000 with the S&P 500 since 1996, the U.S. small-cap stocks perform well:

Index Average 5-Year Rolling Returns, 1996-2017
S&P 500 6.19%
Russell 2000 8.16%

As the chart suggests, the good years for U.S. small-cap stocks outweigh the bad ones. The same can be said for international small-cap stocks as well. Take the same time period starting in 1996. That’s the year that the Russell Global ex-US Index — the index that tracks international small-cap stocks — came into being. The chart below shows the five-year rolling return of international small-cap stocks, as measured by the Russell Global ex-US index:

Index Average 5-Year Rolling Returns, 1996-2017
S&P 500 6.19%
Russell Global ex-US 8.43%

Tougher Markets, but Higher Quality

The performance of international small-cap stocks may come as a surprise. After all, many international small-cap companies operate in countries that are not as business-friendly as the United States. And their home countries may not have a sufficient customer base for the company to really grow. Whereas plenty of U.S. small-cap companies can thrive without having to sell their goods and services outside even their home state, much less outside the U.S., many international small-cap companies don’t have that luxury. But this initial disadvantage creates some great companies. To succeed, international small-cap companies often have to be world leaders in what they do. Their goods and services must be attractive to people living all over the globe. That requirement leads to some fairly innovative companies.

Even so, U.S. investors neglect international small-cap stocks. Only 1% of U.S. mutual fund assets, for example, are invested in international small-cap stocks. Exploring why institutional investors ignore international small-cap stocks is beyond the scope of this article, but it is worth commenting on why individual investors commonly exclude them.

Look Out for Familiarity Bias

Despite the merits of international investing, it ranks among the hardest things an investor can do. For one thing, it means confronting something known as “familiarity bias.” Familiarity bias describes the tendency people have to prefer what is familiar to them. Marketing departments spend a lot of time and money on establishing their brands because of the familiarity bias. Familiar things feel less risky, even when they aren’t, and consumers will buy what they recognize.

The familiarity bias doesn’t just influence what type of cereal we buy for breakfast, though; it even influences how we invest. Studies show that citizens of any given country (not just the US) tend to invest more in companies from their home country. So for most U.S. investors, international stocks (including small-cap) feel riskier than U.S. stocks — even when they’re not.

The overwhelming majority of publicly-traded international small companies are profitable. In fact, of the constitutive stocks in their index, 83% of them pay dividends. By the same measure, less than half of U.S. small-cap stocks do the same. Only about 10% of constitutive international small-cap companies lose money. In the U.S., the percent of constitutive small-cap companies losing money is closer to 30%. Despite the financial health of international small companies, familiarity bias still works against them. When U.S. stocks suffer a short bout of poor performance, disappointment is ameliorated by the accepted wisdom of taking a long-term perspective. A similar short bout of poor performance from international stocks is often taken as evidence that they should be avoided.

Familiarity bias seems to be a part of human nature. In his book Thinking, Fast and Slow, Daniel Kahneman — winner of the 2002 Nobel Prize in Economic Sciences — wrote: “A reliable way to make people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth.” In every area of our lives, including money matters, we should be conscious of how familiarity can affect our decision-making.

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