Identifying overseas-traded small caps for the Oberweis Opportunities Fund (OBIOX) is what Ralf Scherschmidt excels at, and today he shares some of his top picks with MoneyShow.com’s Kate Stalter, although he cautions investors that it requires a tolerance for volatility to remain in these investments.

Kate Stalter: Today I’m on the phone with Ralf Scherschmidt. He’s the manager of the International Opportunities Fund at Oberweis.

Ralf, one of the things that I was very intrigued about regarding this fund is some of your emphasis on smaller and lesser-known stocks. Can you tell us a little bit about the fund’s objectives?

Ralf Scherschmidt: Sure, our fund’s objective is to provide investors with exposure to international small and mid-size companies. We found that even though international small-caps make up about 7% of the global investable universe, most investors don’t have that exposure, and in that segment of the marketplace most people tend to be underinvested.

International small-caps is actually a pretty good place to invest…there is more growth abroad, and then small caps generally tend to be less covered by sell-side analysts, as a result of which there is more opportunity to discover undiscovered or mispriced securities.

Then within that, with the Oberweis International Opportunities Fund, we try to identify the best companies within that to provide investors with some outperformance beyond the international small-cap marketplace.

Our strategy really focuses on three things. First of all, as you mentioned, the small-cap space. With less analysts covering companies, on average, there is more opportunity to find undiscovered securities and under-covered companies.

Secondly, our investment process, we believe, is strongly enhanced by insights gained from the emerging field of behavioral finance, which says that human psychology can actually play a role in finding investment opportunities.

Traditional economics says that most of the investors are pretty much always rational, or at least as a group, always rational. The growing field of behavioral finance has found that it’s not so, that often people are driven more by short-term considerations than long-term considerations, are often driven by emotions, and are driven by cognitive biases, like overconfidence, in their prior beliefs, or anchoring through prior estimates.

As a result of which, there are in fact mispricings in the stock market, and we take advantage of that. In particular, when we find a company’s fundamentals improved significantly, as a result of which, future earnings improved significantly, investors often struggle to immediately accept positive underlying fundamental changes as their bias by their previous testaments.

Then we take advantage of this behavior, this often temporary irrational behavior, by buying company stock before other investors adjust their prior expectations to reflect those new fundamentals.

The third leg of our investment process is really to get to know the companies that we invest in, see what the new fundamentals are really like, compare that with the old outdated beliefs in the investment community. And when we see significant difference between our future earnings estimates and the current estimates in the marketplace that are based on those outdated prior beliefs, that’s an interesting opportunity for us.

The way we do fundamental research is to get to know our companies, get to know new technologies, get to know the competitive market situation, sometimes speak to management or talk to other people that are knowledgeable in the industry.

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Kate Stalter: Within an entire portfolio that an investor might have, would this style of investment, your particular fund, balance out, say, some larger caps they might have? Is that the way you might advise approaching this, in general?

Ralf Scherschmidt: Yes, we believe that investors should have a well-diversified portfolio that should include a good portion of domestic large-caps, a good portion of international large-caps, and then some exposure to domestic small-caps, and then some exposure to international small-caps.

We just find that most investors do not have a sufficient exposure to international small-caps, so we’re hoping that our product can help those investors close that gap in their portfolios.

Kate Stalter: I want to talk a little, Ralf, about some of the specific holdings in the portfolio. I did happen to notice that Morningstar was reporting you had some European investments among the top holdings. Is that still the case?

Because a lot of advisors I talk to suggest avoiding Europe, but others suggest not. Obviously if you were invested there, your take would be not to avoid it.

Ralf Scherschmidt: Yeah, so we generally will have exposure to most developed-market countries, which is a large percentage in Europe, a large percentage in developed Asia, and then some exposure to Canada.

We are still finding opportunity in Europe, as we are finding opportunities throughout the world that we believe will do well, regardless whether the economy will grow or shrink by a few percent.

Those can be either very much bottom-up ideas that are economically relatively insensitive, or companies that are actually in economically sensitive businesses, but where the current slowdown is helping them in the long run, in that smaller competitors of theirs are going out of business. Which then in the long-run will help them gain market share, gain pricing power, and will help their earnings in the future.

Maybe just to give you an example of two European companies, one for each criteria. The first company is a Swedish company called Pricer (PCRBF) that develops electronic shelf labels. So for example, in a grocery store, they’re used instead of printed labels on each product, although switches on labels are programmable and can be changed on the fly from a central location.

Some of the benefits of using those electronic shelf labels over printed labels is that it reduces the cost of price adjustments, so that you don’t have to have a store clerk going through thousands of items on a weekly basis and updating them. So that reduces labor costs. It also reduces printing costs.

It also ensures the same price on the shelf and at the checkout counter. So a customer might misplace a price label, and then another customer might go to the checkout counter and find out there is a different price on the item, So it just keeps up customer satisfaction.

Firms can respond faster to competition, firms can implement more effective promotions. Some of the Japanese clients are starting to use happy hour, which is a pricing strategy to reduce prices during slower hours during the day to drive traffic through the store during those times. It also has strategic pricing, as it makes it easier to determine optimal price of product in response to supply and demand.

Now, Pricer is the dominant player in this space, with over 50% market share. They grew revenue at over 50% in the most recent quarter, so definitely a very high growth rate in the context of a slowing economy. The way they’re able to do that is they’ve lowered the price on the electronic shelf labels, and it’s really reached an inflection point, where the cost/benefit to their customers is very positive.

Existing customers have been using more and more of the product. They’ve been able to expand geographically and to gain more customers abroad, in the Americas, in Asia.

And then in the past they have only focused on marketing to grocery store customers; now they’ve started talking to electronic retailers, pharmacies, chains, and the addressable market is still more than 100 times bigger than where they’re currently at.

So they’ll be able to continue to grow for a very long time before they will reach market saturation, and we believe this is a company that will do well regardless of the economy.

A second European example, a company that perhaps should be negatively affected by a slowing economy, but in fact it’s not. A German company called Duerr (DUERF). They engineer and build plants, and make factory machinery for the automotive industry, in particular paint shops.

With a slowing economy, one could think that they might see slowing growth—as there is less consumer spending and cars are certainly a big consumer spending item, that that business might slow down. But in fact, that’s not what’s happening at all.

Their growth is being driven by two things. First, new automobile plants are needed to build in emerging markets, to feed demand for cars in countries like Brazil, China, and India. Also, in developed markets, their customers have been underspending over the past few years as a result of the financial crisis, and those developed-market car manufacturers now have to catch up in upgrading their machinery.

Interesting enough, Duerr came out a few weeks ago with a earnings release where revenue grew north of 40%, operating profit grew north of 100%, and the order book was up over 130% year-on-year, so just on an absolute basis, fantastic growth rates. But particularly good, in the context that some people were expecting a slowdown in that space.

The way they can do that is, they have a 65% global market share and an 80% market share in emerging markets, and those markets are still growing and they are benefiting from that.

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Kate Stalter: Now those sound like a couple of names that if US investors are interested, the best way for them to get exposure to those companies would be through a fund?

Ralf Scherschmidt: That is correct. Many US investors, it’s quite difficult to buy securities abroad, especially small-cap securities. Also, the benefits of any fund is really, that it of course provides some diversification over just owning one or two or three individual names.

Kate Stalter: Any other regions? You mentioned some of the developed regions in Asia. Can you say anything about that today, Ralf?

Ralf Scherschmidt: Yeah, so a developed region in Asia of course is Japan, and we own a few investments there. One space we’re particularly interested and excited about is the smartphone space, in particular as it relates to the increasing demand and need for bandwidth and data-download capabilities.

As you can probably imagine, there are more and more people around the world using smartphones, and there are more and more applications on smartphones. There is a statistic that just a few years ago, there were only 500 apps available for the iPhone, and now there is over 500,000 apps available for the iPhone. And applications become larger and larger over time, and therefore need more data download capability.

It’s estimated that the current percentage of mobile devices that use 3G or 4G, right now is 27%; that will grow to 80% by the end of the decade. On top of that, you will have probably half a billion tablets like the iPad by the end of the decade.

All that put together just shows there’s a massive increase for data-download capability and bandwidth. So we own a few small companies that in a sense are the pick-and-shovel suppliers through the larger telecom carriers, and in particular companies that put network infrastructure in the ground, put up wireless towers to help the large telecom carriers meet that increased need for bandwidth.

One specific company we own in that space is a Japanese company called Anritsu (AITUF), They make the measurement and testing equipment for smartphone manufacturers, as well as mobile communication companies.

So as we talked about, more and more people around the world are using smartphones. They make the testing equipment that helps those smartphone manufacturers make sure that during the development process of the smartphones and the production process of the smartphones, those products actually work.

And they make testing equipment also for mobile communication companies and for infrastructure companies, so as those companies put the backbone for the telecommunication companies into the ground, they make sure that works as well. So Anritsu is benefiting from the overall growth in the smartphone space.

Kate Stalter: Let me just wrap up today, Ralf, by asking you what would be your advice for individual investors who manage their own portfolios? What would be your advice for them if they did want to get more into the small-cap or international space? How should they go about that?

Ralf Scherschmidt: Well first of all, they should take a look at their overall portfolio and see if they have sufficient exposure to the international small-cap space.

We believe it’s an interesting space for three reasons. First, because we believe there’s more growth abroad internationally than domestically, an investor should be able to benefit from that.

Then secondly, in the small-cap space, for an active fund manager like ourselves it’s relatively easier than compared to the large-cap space to find undiscovered companies, so there is some potential also associated with that.

And then the investors should think about their investment time horizon and their ability to withstand short-term volatility, as the international small-cap space is certainly a space that can be a little bit more volatile in the short-term.

We believe the benefit to investors is that there is potentially higher returns in the long run, but they just need to be honest with themselves that they withstand the short-term volatility. Sometimes investors tend to sell at the low points when the market is under the most pressure, which often can actually be the best investment opportunity.

People just need to understand there is a little bit more volatility associated with that, and in turn there’s potential higher returns. Just to be sure they can withstand that short-term volatility.