To complement your large-cap S&P 350 ETF holding, we sorted through dozens of Europe funds looking for one that offered small- and/or mid-cap expertise. As we discuss below, Europe’s mid- and small-cap companies are currently cheaper and have higher growth rates than their large-cap counterparts. Furthermore, in any market, smaller, less-liquid firms generally provide greater opportunities for sound stock picking to produce significant outperformance. At the end of the search, one fund ruled the waves.

The AIM European Small Company fund (ESMAX) is a small- and micro-cap growth-oriented Europe-only stock fund. It’s pretty much your only choice in this area. Even Fidelity doesn’t have one, though it’s got 18 international equity funds, has had a Japan Smaller Companies fund since 1995, and is coming out with an International Small Cap fund this fall. There is an FTI European Smaller Companies fund (FESCX); it’s slightly newer and smaller than the AIM fund, and so far has a weaker record.

AIM European Small Company will normally invest at least 80% of its assets in equities of small-cap European companies. The prospectus legally defines “small-cap” as no larger than the largest stock in the U.S. Russell 2000 small-cap index, which according to Russell is defined as a market cap of $1.4 billion. Jason Holzer, the AIM fund’s manager, told us this rule is “not really a factor” since he’s sticking to firms smaller than that anyway, with a median market cap barely exceeding $500 million. The remaining 20% of the fund can be in larger-cap stocks.

European Small Company normally diversifies across at least three countries–the top three at the moment are U.K., 32%; France, 19%; and Sweden, 13%–and can invest up to 35% of assets in developing countries (not currently a factor unless you count 0.6% in Portugal). Recently the fund had 88 stock holdings.

The fund’s A-class shares (ESMAX) have a 5.5% sales charge and a 2.01% expense ratio. Class B and C shares (ESMBX, ESMCX) have no front-end charges, but their higher expense ratios (2.71%) and redemption fees make those share classes cost about the same. (For a prospectus and other information on the fund, travel to www.aimfunds.com.)

AIM European Small Company has officially been managed by Clas Olsson and Jason Holzer since its August 2000 inception, but Olsson has primarily been running the somewhat larger-cap AIM European Growth fund (AEDAX) since its 1997 inception. Named the AIM European Development fund until July of this year, AEDAX is a solid mid-cap growth offering. Olsson has also been serving as leader of the firm’s Europe/Canada investment group. Effective June 28, 2002, Jason Holzer became the lead manager of European Small Company. In early July I talked with Olsson and Holzer, who work out of AIM’s Austin, Texas, offices.

Your European Small Company fund is unusual in that it combines small-cap and Europe–and earnings momentum–as a big part of your stock-picking strategy. Olsson: Yes, we think it’s an overlooked area that provides good investment opportunities. Our investment strategy has always worked extremely well in small- and mid-cap stocks, pretty much no matter where you look. But specifically in Europe, we felt the market had become deep enough to warrant a small-cap fund. We also thought that as the European markets continue to grow, at some point the U.S. investor will start looking abroad again. And this is an area of the market where you don’t have to go to an emerging market, but you can still get higher returns than you would on a large-cap fund.

You recently remarked that U.S. investors have been putting less than 5% of their money into international equity funds. A decade ago, at exactly the wrong time, they were putting in nearly 15%. Do you think the herd is generally going to be wrong on this sort of thing? Olsson: It always is, because the herd chases performance. And there is no reason why it shouldn’t be so this time. That doesn’t just go for international funds, it goes for domestic and sector funds, whatever you’re talking about.

The Small Cap fund is very tiny still, about $24 million a few months ago. Do you think that has been helpful in terms of buying the micro caps? Olsson: It always makes a fund more flexible when it’s smaller, but we play in an area where we wouldn’t mind seeing the fund go up to about $500 million or so. It would still be flexible enough. Importantly, we think there are enough opportunities.

What sort of fund flows and cash levels do you see? Olsson: We really don’t try to time the market, because we don’t know how to do that. We aim for about a 5% cash level. But it does depend on which day you look at it, because the fund has been so small, and from time to time we have gotten a significant inflow on a particular day.

How growthy or expensive are the holdings you own, given that Europe is cheaper than the U.S., especially for small caps, but also that you’re clearly on the growth half of that market? Holzer: Over all, European small caps are trading at about a 30% discount on price-to-book and about a 20% discount on price-to-earnings to the large caps. Now for our fund, just to give you an idea of that profile, the median expected growth rate for the next 12 months is 25%, and that compares to a median next 12 months’ P/E of 16. These are IBES numbers, and I think that’s a pretty good profile. From our standpoint we are basically finding growth companies at very attractive valuations in this universe.

Stocks that come to mind? Holzer: One of the things that’s been nice is that some of our largest holdings have been the best performing stocks. We can speak freely about any number of them. But one area that has worked well for us this year is the consumer area, both on the discretionary side and the consumer staple side. You have things like Puma and Merloni [Merloni Elettrodomestici makes household appliances], obviously consumer discretionary. Puma is a well-known company, great order momentum, great earnings momentum, cheap relative to Adidas and Nike, the big companies. It’s about a $1.1 billion market cap. I think that gives you an idea of the brand power relative to the size of the company. It has been a great performer for us, and it continues to show pretty terrific momentum. As with all fashion-oriented stocks you have to be very nimble, but for the time being everything looks bright.

Does your fund complement a position in, for example, the iShares S&P 350 IEV? Holzer: Yes, and for anyone who is heavily invested in the U.S., this would have minimal correlation to the S&P and, I would venture to guess, minimal correlation to the vast majority of mainstream international funds out there. It’s a good diversifier in that respect. You are getting into stocks that aren’t found in but 1% or 2% of funds out there. On paper, the fund will seem to be more aggressive than a European fund, which would in turn be more aggressive than a diversified international fund. But the actual experience is that the fund has not really been all that volatile. That could change over time. I think the fund is suited for someone who is comfortable with foreign investing and wants a differentiated niche.

What does the lack of small-cap Europe funds tell you about the market for this niche? Is it too exotic? Holzer: At first blush, yes. But when you place the idea of the European small-cap fund in the context of how large Europe is, and how deep the equity markets are there, and when you think about how many U.S. small-cap funds there are, it doesn’t look so exotic. And I would venture to guess that over time, as people here return to foreign investing, you’ll see more of them.

Do you think there is an argument to be made that Europe is too stodgy, and thus the small-caps would precisely be the areas of most interest, and one might want to bypass the large caps altogether? Holzer: Absolutely. Plus the fact that, in this market, the odds of something that we own showing up in a scandal article on the front page of the Wall Street Journal, as opposed to all of the large-cap stocks out there, is tiny. You’re talking about simpler-to-understand companies, typically higher management ownership, greater transparency.

They’re not conglomerates, and they haven’t been growing through frequent takeovers. Holzer: Exactly. Another angle is that a lot of U.S. commentators now are pushing large caps versus small caps domestically, because of the currency, saying that it’s the larger export-oriented multinationals that can take advantage of dollar weakness in seeing an export benefit. The exact reverse is true in Europe, where euro strength is to the benefit of small caps vs. large caps. These tend to be more domestically oriented companies. The main small-cap points: Under-valuation, unique opportunities, currency benefit, non-correlation to major markets and funds. It’s interesting from many different viewpoints.

Let’s hope it’s profitable, too.