By VIRGINIA MUNGER KAHN

Published: July 14, 1996

OVER the last six months, small-company international stock funds have come into their own. While the average foreign stock fund has risen 9.2 percent in the first half of the year, the small-company stock funds that invest primarily abroad have returned 14 percent. Over the last 12 months, they have also outperformed an index of larger-company stocks, the Morgan Stanley Europe Asia Far East index, 19 percent to 13.3 percent.

Despite these gains, small-company international funds remain a relative backwater in a rushing tide of cash toward stock mutual funds. Of the 37 small-company international stock funds followed by Morningstar Inc. just three have more than $1 billion under management — Templeton Global Smaller Companies, Acorn International and Capital Research and Management’s Smallcap World Fund.

That few investors have found their way into this sector is not surprising. As a result of recessions, tight monetary policies and emerging-market blowups, small-company international investing left much to be desired in the first half of the 90’s. From January 1990 to December 1995, small-capitalization, or small-cap, foreign stocks underperformed large foreign stocks by more than 15 percent on a cumulative price basis, according to Acadian Asset Management, a small-cap international money manager in Boston.

Yet in the last three years, mutual fund companies in the United States have rolled out almost two dozen small-company international stock funds. And within the last 12 months, these funds have taken off.

To be sure, a fair number have benefited from the big gains in small-company domestic stocks. Six of the top 10 small-company international funds are world, or global, funds that invest in both American and foreign stocks. At one time or another over the last year, these world funds have had just 40 percent of their portfolios invested abroad.

AMONG the funds is Fontaine Global Growth, which has led the group over the last year with a total return of 52.7 percent. Heavily invested in North American mining stocks, it has had as little as 37 percent of its portfolio in foreign investments in that period. But the list of top performers also includes some exclusively foreign small-company funds, like Invesco European Small Company, Twentieth Century International Emerging Growth, Founders Passport and Montgomery International Small Cap.

The main impetus behind this performance has been the improving world economy. Small-company stocks typically perform better in stronger economic environments, said Nitin Mehta, senior portfolio manager in London for Seligman Henderson, a money management firm. When economies are slowing, investors often seek larger, more stable companies. Because Europe and Japan have been showing signs of new economic life and all major world economies are expected to grow next year, Mr. Mehta said, investors have been putting money to work in smaller companies.

An equally important factor has been demand from United States money managers. Looking for diversification, they have found a wealth of good, fast-growing small companies abroad that are still relatively unknown and undervalued. Managers cite Fresenius of Germany, a supplier of kidney dialysis equipment; Laox, a Japanese electronics retailer, and JBA Holdings, a British software company.

Indeed, these small-company funds tend to invest in different market sectors than typical United States small-cap funds do. Instead of relying heavily on technology and health services, the foreign portfolios generally have greater concentrations in cyclical industrial stocks, consumer durable goods and even financial stocks. Henrik Strabo, lead manager for the Twentieth Century International Emerging Growth fund, likes a German bank, Marchollek Lautenschlager, which he described as very service-driven.

The small-cap arena is where the real growth is coming from, said Michael Gerding, manager of the Founders Passport fund, which has investments in Salomon, a French manufacturer of ski and golf equipment, and Grolsch N.V. the midsized Dutch brewery group. On average, company earnings in the small-cap international fund group tracked by Morningstar are growing 17 percent a year, compared with 9 percent for all foreign stock funds.

Even more excitement has been created by what Mr. Strabo described as a whole transformation going on in how the capital markets work in Europe. Companies formed after World War II as family enterprises and financed primarily by banks have been finding that they can finance their growth at less cost and attract new managerial talent by raising capital in the equity markets, he and other managers said. Governments in Europe and Japan have also encouraged small companies to raise money in public markets, according to money managers.

People like me are jumping up and down with joy, said Allan Raphael, co-portfolio manager of the First Eagle International fund, which invests in both small- and mid-cap foreign stocks. Investors used to find small, fast-growing public companies primarily in the United States and Britain, he said. Now, he added, people have the ability to invest in these types of companies elsewhere. Among Mr. Raphael’s favorites is Pagnossin, the Italian ceramic company whose brightly colored dishes are sold at Bloomingdale’s and other department stores.