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European Small-Cap Stocks Are Roaring Back

Stocks in this article: DFEVGKSCHCVEAIWMHEDJUNDDAIF

NEW YORK ( TheStreet ) -- European small-cap stocks are soaring.

During the past year, Wisdom Tree Europe SmallCap Dividend Fund (DFE) returned 48.1%, according to Morningstar, while Vanguard FTSE Europe ETF (VGK), a large-cap fund, returned 23.4%.

Boosted by the strong European showing, broad international small-cap exchange-traded funds also excelled. Schwab International Small Cap Equity ETF (SCHC) returned 20.8%, while Vanguard MSCI EAFE ETF (VEA), a large-cap fund, returned 15.1%.

Small stocks often shine in rallies. But the current outperformance is unusually pronounced because of the circumstances in Europe.

First, small stocks fell hard during the financial crisis. As investors worried that the euro would collapse, they dumped small shaky companies that could face trouble in a recession. Blue-chip multinationals were relatively resilient because much of their revenue comes from outside the troubled eurozone.

"The domestic European stocks were beaten down because there was so much fear that the eurozone was going to break up," says Dennis Hudachek, an analyst for ETF.com.

The rebound began in July 2012 when European Central Bank President Mario Draghi promised to do whatever was necessary to save the euro. The bold statement gave investors the confidence to begin buying stocks that had been pummeled.

While multinationals climbed during the recovery, the biggest gains went to small companies that rely on European domestic economies, which no longer seemed to be on the verge of collapse.

After the big rally, have foreign small caps become too pricey? Not necessarily. The forward price-earnings ratio for the WisdomTree Europe fund is 15, compared with a multiple of 19 for iShares Russell 2000 Index (IWM), a U.S. small-cap fund.

"If you think that the European economy will continue to grow, then you should consider holding the small stocks," Hudachek says.

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