There’s lots of room for growth in international small caps, particularly from developed markets such as Japan and Europe, says asset manager Brien O’Brien. However, he says there’s still too much risk in emerging markets, so he avoids those areas.

Kate Stalter: Today, our guest on the Daily Guru is Brien O’Brien of Advisory Research.

Brien, one of the areas that you invest in is international small caps. So maybe you can start out today by telling us a little about your philosophy in that area.

Brien O’Brien: Advisory Research has been a specialist in small-cap value investing going back to the mid-70s. In 2006, we started our international small cap product (ADVIX) to take advantage of some of the same trends that we saw outside of the US that had worked so well for our clients over the years in the domestic stock markets.

So what we’re seeing there is tremendous opportunity to buy companies at attractive prices below their tangible book value.

Kate Stalter: Tell us a little about some of the specific regions that you like right now.

Brien O’Brien: There are particularly attractive opportunities in Japan right now. Japan has been kind of suffering from economic malaise for a number of years. However, Japanese companies have been very successful in moving their manufacturing and distribution offshore.

So while the economy in Japan itself is stagnant, there’s some tremendous value opportunities over there. Additionally, we’re getting dividend income, which is a real benefit in this economy, in these markets, north of 3% in the Japanese portfolios.

Additionally with the recent activities in Europe and the economic crisis over there, a lot of names from Europe are also starting to show up on our attractive buy sheet, and are gradually making their ways into our portfolios.

Kate Stalter: Now you just mentioned a couple of markets, Brien, that obviously are developed. What’s your investing philosophy when it comes to some of the emerging markets?

Brien O’Brien: We tend to avoid emerging markets. The opportunity for tremendous gains is very much present in emerging markets, but so is the opportunity for tremendous losses.

One of the hallmarks of Advisory Research is, we specialize in working with our clients’ assets to try to protect their assets in down markets. So the volatility of emerging markets is a bit scary to us. Much of that volatility is associated, Kate, with the lack of transparency into the balance sheet and income statements of those companies.

Yet, in the more developed markets we find very high-quality data and very high-quality companies. That’s not to say that the companies we own don’t participate in emerging markets—they very much do from a sales perspective, but we just prefer to avoid companies domiciled in the emerging markets.

Kate Stalter: Let’s shift gears and talk a little about some sectors. Any particular sectors where you’re seeing strength right now?

Brien O’Brien: One of the areas that maybe that has caused us to pull back in recent years has been financials. This is an area that we’ve historically made a lot of money on, but for the last three or four years, we’ve really downplayed our emphasis there. So what that has done has forced us to look into other regions where we’re seeing tremendous opportunity.

One of those is in energy. This has been a real moneymaker for us over the years, both domestically and internationally. We see tremendous opportunities to participate in the development and growth of emerging energy markets and we’re looking for future opportunities there to be quite significant.

Kate Stalter: Before we got on the phone, you had mentioned increasing holdings in certain sectors, certain areas of the energy market, or maybe pulling back your holdings in the natural gas area. Can you say anything about that?

Brien O’Brien: One of the things that has very much happened, especially here in the United States, is there has been tremendous successes in the natural gas area.

Natural gas, as you know, was an area that 50 years ago was literally blown off of oil wells. Then about ten years ago, it started to become a very valuable commodity.

However, in more recent years, as natural gas exploration has really climbed significantly, there’s tended to be a plethora of it out there. It’s being found. It’s being found successfully and it’s being found at attractive pricing, and so that has brought down the pricing of natural gas.

What we specialize in at Advisory Research, though relative to energy, is finding very attractive companies with tremendous values of assets in the ground. We’re finding a lot of those right now in the oil paths.

So traditional oil, in the small- and mid-cap companies, is creating great opportunities for our clients. We’ve made a lot of money there in the last 12 to 18 months.