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%.
Geritz is particularly keen on India. Besides featuring a rapidly expanding middle class, the country boasts more than its share of companies with conservative balance sheets and experienced managers, she says. Many holdings in the fund provide basic products for the new generation of consumers. A favorite stock is Colgate-Palmolive (India) ( ( COLGATE.BO). India is still a poor country, and consumers are just starting to buy toothpaste, says Geritz. She says that Colgate is the market leader with a strong distribution system. "The company can grow 15% to 20% annually for years to come," she says. Another holding is Bata India ( BATA.BO), a shoe retailer with 1,200 stores. Geritz says the chain can grow rapidly as it takes market share from small competitors. Geritz is also investing in stock exchanges in emerging markets. These are typically monopolies that are recording growing profits as trading volumes increase. Holdings include JSE ( JSEJF.PK), which operates the Johannesburg Stock Exchange in South Africa, and Bolsa Mexicana ( BOLSAA.MX), the Mexican exchange. Another solid fund is DFA Emerging Markets Small Cap, which has returned 19.6% annually during the past 10 years, outdoing 98% of diversified emerging-market funds. The DFA fund buys stocks with market capitalizations of less than $2.3 billion. The fund is sold through financial advisers. ETF investors can try S&P Emerging Markets Small Cap ( EWX), which has returned 20.5% in the past year, outdoing 45% of peers. Another ETF option is WisdomTree Emerging Markets SmallCap Dividend ( DGS), which has returned 9.0% annually during the past three years, outdoing 99% of peers. For a limited dose of smaller stocks, consider Causeway Emerging Markets ( CEMVX), which buys stocks of all sizes. The fund has 35% of assets in small- and mid-cap stocks. During the past three years, the fund has lost 0.8% annually, outdoing 70% of peers. Using a quantitative system, the Causeway portfolio managers favor unloved stocks with improving earnings. "For us, the ideal stock is reporting growing earnings, and the earnings are projected to continue growing," says portfolio manager Arjun Jayaraman. A holding is Gazprom ( OGZPY.PK), a Russian natural gas producer. With investors worried about the stability of Russian capitalism, the stock has a P/E of 5. Jayaraman concedes that Russian stocks can be risky, but he argues the market is cheap. "We prefer names where the risk has already been discounted," he says. Another holding is Great Wall Motor Company ( GWLLF.PK), a fast-growing Chinese car maker. Sales climbed 77% in the last quarter, but the stock has a P/E of only 14.