Stocks Worth Searching For

If you want to experience the authentic taste of Italian food, don't go to the Olive Garden -- go to Italy.

Likewise, if you want the authentic diversification benefits of international exposure, look for foreign small-cap stocks -- not large multinationals based overseas.

The breadsticks are innocent
As global markets converge and become more correlated, investors looking for a free lunch need to dig a bit deeper these days for stocks that will add diversity to their portoflios.

Simply owning a market-weighted foreign fund -- such as the iShares MSCI EAFE Index, with top holdings in multinational heavyweights like BP (NYSE: BP  ) and Toyota (NYSE: TM  ) -- isn't enough, because these companies are already well-ingrained in the U.S. economy. Nor is it enough to own U.S.-based blue chips with global operations such as Cisco Systems (Nasdaq: CSCO  ) , Coca-Cola (NYSE: KO  ) , and Hewlett-Packard (NYSE: HPQ  ) .

Go to the source
If you seek pure international exposure, you need companies that primarily deal in local markets and have little or no exposure to the U.S. economy. In other words: foreign small caps.

Before I scare you off, consider that a 1995 study by Dimensional Fund Advisors co-founder Rex Sinquefield found that "International value and international small stocks diversify U.S. portfolios more than EAFE." The reason is that isolated foreign small caps typically trade independently from U.S. markets and thereby "reduce the standard deviation of a domestic portfolio" while simultaneously increasing expected returns.

Where's Waldo?
The problem many U.S. investors face in hand-selecting foreign small caps is finding them listed on major U.S. exchanges. According to Capital IQ, only 427 foreign businesses capitalized below $2.5 billion (out of many more thousand) trade on the NYSE or NASDAQ, including Shanda Interactive (Nasdaq: SNDA  ) and Solarfun Power Holdings (Nasdaq: SOLF  ) . The main reason for their absence may be due to substantial costs associated with trading in the United States, including Sarbanes-Oxley and exchange regulations.

But that doesn't mean you should give up. One option is to invest in a mutual fund that invests specifically in foreign small caps, such as Vanguard International Explorer (currently closed) or First Eagle Overseas. Unfortunately, many of these funds charge a pretty penny for their services. According to Morningstar, the average expense ratio on a foreign small- and mid-cap value fund is a pretty pricey 1.57% -- a number that gives rise to significant incurred and opportunity costs.

Given those figures, it's worth your while to research some individual foreign small-cap stocks on your own. If you'd like some ideas for getting started, the Motley Fool Global Gains service can help. Among the 30-some stocks they've recommended are small caps from Argentina to Macau. On average, their picks are outperforming the S&P 500 by 15 percentage points.

To see what foreign stocks the team is recommending right now, a free 30-day trial gives full access to all of their picks. To get started, just click here.

Fool contributor Todd Wenning is the man who will fight for your honor. The Fool's disclosure policy is the hero you've been dreaming of. Todd does not own shares of any company mentioned. Coca-Cola is a Motley Fool Inside Value pick. Shanda Interactive is a Rule Breakers recommendation.