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Top Emerging-Market Small-Cap Funds

Stocks in this article: WAEMX DEMSX EWX

NEW YORK ( TheStreet) -- Investors have been pouring into emerging markets, and emerging-market small-caps have been particularly hot. During the past year, the MSCI Emerging Markets small-cap index has returned 26.3%, compared with 14.4% for the S&P 500.

Some emerging-markets mutual funds have done better than the benchmarks. Wasatch Emerging Markets Small Cap (WAEMX) returned 41.2%, while DFA Emerging Markets Small Cap (DEMSX) returned 30.7%.

Have small-caps become too rich? Maybe not. Small-caps sell with a price-to-earnings ratio of 12.3, compared with 14 for emerging-market large-caps, says Laura Geritz, portfolio manager of Wasatch Emerging Markets Small Cap. The S&P 500 has a P/E of 15.5.

The valuations in the emerging markets are especially intriguing because in the U.S. small-caps are more expensive than their large-cap brethren.

Why are emerging-market small-cap stocks so cheap? The emerging markets are still immature in some ways, says Geritz. Not many analysts follow small-caps yet. And when U.S. money managers shop in the emerging markets, they tend to stick with the best-known blue-chips.

Besides being relatively cheap, the small stocks also offer some of the most compelling growth prospects in the emerging markets, says Geritz. She says that the small-cap index is full of the kind of retail and service businesses that are benefiting from the booming growth of consumer spending. In contrast, the MSCI Emerging Markets large-cap benchmark emphasizes banks and energy companies, which are growing at slower rates.

To try small-caps, consider Wasatch Emerging Markets Small Cap, which returned 9.7% annually during the past three years, soaring past the average emerging-markets fund, which lost 2.3%. Wasatch seeks companies that can grow steadily for the next three to five years. Typical holdings have secure niches, solid balance sheets and very high returns on equity. "We want companies that can survive and grow during periods when the economy turns down," says Geritz.

To limit risk, the fund seeks stocks with P/E multiples that are lower than the growth rates. Based on next year's earnings, the portfolio currently has a P/E ratio of 13, a moderate price for companies that should grow at annual rates of more than 20%.

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