European Small-Cap Stocks Are Roaring Back

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.

The WisdomTree fund did especially well because it holds big stakes in industrial and technology companies, cyclical sectors that snapped back as the economy improved. The ETF also benefited from its holdings in Italy and Spain. Stocks in those troubled countries have soared as the economies showed signs of life.

Make no mistake, Europe still faces headwinds, including high unemployment and sluggish growth. But WisdomTree research director Jeremy Schwartz argues that the European recovery is likely to continue. Analysts forecast that small caps will report double-digit earnings growth this year.

"The Europeans are still in the early stages of the economic recovery," Schwartz says.

The WisdomTree fund is the only small-cap European ETF. Another way to bet on a small-cap revival is with Schwab International Small-Cap Equity, which has 57% of its assets in Europe. The Schwab ETF has big stakes in cyclical sectors, including industrials and technology.

Schwartz concedes that a decline in the euro could pose a hazard. When a currency declines, the value of foreign stock holdings drops for U.S. investors.

Draghi has talked about the euro being overvalued, which makes European goods more expensive and punishes exporters. If Draghi takes action to weaken the currency, investors in the WisdomTree European ETF could pay a price.

For protection, Schwartz suggests holding both the WisdomTree European small-cap ETF and Wisdom Tree Inter Eq Fund (HEDJ). Using currency contracts, the hedged fund shields shareholders from declines in the euro.

By combining the two WisdomTree ETFs, investors can be broadly diversified. While the small-cap ETF emphasizes retailers and other businesses that focus on domestic sales, the hedged fund emphasizes large-cap exporters. The big exporters can benefit from currency declines that make products cheaper for foreign customers.

Holdings in the hedged ETF include such global powerhouses as consumer giant Unilever (UN) and Daimler (DDAIF), maker of Mercedes-Benz cars.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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