Stocks throughout the world have performed very well as of late on renewed hopes for an economic recovery, fears of inflation, and paltry bond yields. Yet stocks are generally overvalued. The S&P 500 trades at nearly 20X earnings and 4X book value; the S&P 600 small cap index trades at over 25X earnings and at nearly 3X book value. Other major stock markets such as those in Australia, Brazil, the United Kingdom…etc. are hardly cheaper. While stocks are generally cheaper than bonds this is not a good argument for owning them.
In my article Buying and Owning Gold I suggest gold as an alternative choice. While I believe that investors should hold a significant amount of gold (and silver) in their portfolios, stocks are a cornerstone of any portfolio as well. Stocks represent companies capable of creating real value, of expanding, and of paying dividends.
With this in mind I decided to look for inexpensive global stock markets. In this article I will focus on small-cap single country ETFs. I screened several single country small cap ETFs and weeded out those trading above their Graham Number valuation. A stock's or fund's Graham Number (GN, hereon) is an approximation of its fair value based upon its price to earnings ratio and its price to book ratio. While it is a fairly simplistic method of valuing a stock it provides a starting point for choosing just a few investments given thousands of possibilities. It is calculated as follows:
GN = square root (22.5 * Earnings * Book Value)
In what follows I discuss the 6 ETFs which made the cut. All GNs were calculated based upon the P/E and P/B data given on the ETFs' websites. This data is out of date by a month or two and I point this out. Generally, however, these ETFs were trading at a steep enough discount to their GNs that 2013 price appreciations would not change the fact that they offer good value.
1--Guggenheim China Small Cap ETF (HAO)
HAO traded at just 9.6X earnings and 1.2X book value on 12/31/2012, giving it a GN of $33.53 at the time. The fund currently trades at $24.17 which means that it trades at more than a 25% discount to its GN value. This is an incredibly inexpensive fund that consequently has limited downside risk and leverage to China's development into a global superpower.
While there are perpetual fears that China is "slowing" (what is really meant is that they are not growing as fast) or that their government lies about their statistics (What government doesn't?) the fact remains that long term the Chinese economy is going to be the most significant in the world. Unlike in the developed world its citizens save a significant portion of their income, and it is a net creditor nation. While I don't agree with China's socialist policies supporting government handouts, these handouts are used for infrastructure and developing energy sources while in the U.S. and Europe government handouts go predominantly to bankers. The Renminbi is slowly yet surely appreciating against the U.S. dollar, and given that China is rapidly accumulating gold I suspect that the Renminbi will be backed by gold in a few years. While I expect setbacks in the Chinese economy and in Chinese stocks they will perform extremely well long term.
2--Market Vectors India Small-Cap Index ETF (SCIF)
SCIF traded at 10.2X earnings and 0.9X book value as of 1/31/2013, which gives it a GN of $17.27. With the fund at just $9.03 it trades at a nearly 50% discount to its GN value. India has numerous problems such as a falling currency, surging government spending, and rising poverty. While the country has a young, growing population this is not a benefit as is the case elsewhere as India faces overpopulation issues. The fund is heavily weighted towards financials, industrials and consumer discretionary stocks, and given the problems with India's economy I list above it is no wonder the fund has performed so poorly, having lost 30% of its value over the past year. Furthermore SCIF essentially pays no dividend. That being the case it might be time to be greedy while others are fearful, as SCIF is far too cheap to ignore, if only for a mean reversion trade.
3--WisdomTree Japan Small Cap Dividend Fund (DFJ)
DFJ traded at 16.1X earnings as of 12/31/2012, but at 0.7X book it has a GN of $61.75. Despite the recent run-up in DFJ shares to $46.24, they still trade at a nearly 25% discount to their GN value. Japan is currently in a recession, and it has severe long term problems such as an aging, decreasing population and a skyrocketing national debt. Furthermore the Bank of Japan is committed to devaluing the Yen.
Like with SCIF, DFJ focuses on industrials, financials and consumer discretionary stocks. If I were to bet on a downtrodden economy I prefer SCIF to DFJ as the former is cheaper and India doesn't have the demographic issues Japan does. Still, I will keep an eye on DFJ and would consider buying it if the P/E ratio contracted. Unlike SCIF, DFJ pays a dividend, although it is only slightly higher than 2%.
4--Market Vectors Indonesia Small-Cap ETF (IDXJ)
IDXJ traded at 11.4X earnings and at book value as of 1/31/2013, giving it a GN of $22.55. The fund has risen steeply over the past month, although it still only trades at $17.32, which is approximately a 25% discount to its GN. While this isn't the bargain basement price that SCIF trades at, the Indonesian economy is incredibly strong with a rising GDP, a rising GDP per capita, and a growing population which is very young.
Finding a fund such as IDXJ trading at just over book value and at a reasonable P/E ratio seems almost too good to be true. The one issue I have with this fund is that it is heavily weighted towards financials at 40%. Even if Indonesia's demographic trends are favorable for its credit markets 40% is a lot of exposure for any sector, especially one I don't particularly like. Nevertheless at current valuations IDXJ will remain on my watch list.
5--Market Vectors Germany Small-Cap ETF (GERJ)
GERJ traded at 13.1X earnings and 1.5X book value as of 1/31/2012 giving it a GN of $25.51. It currently trades at $24.16 per share, or about a 5% discount to its GN. This is by far the most expensive fund that made the cut, but it is the only ETF I could find that was cheaper than its GN that had exposure to a (relatively) strong, developed economy. Germany is currently in recession, although it is the strongest major economy in Western Europe. But while Germany has one of the strongest economies in Western Europe it suffers like most developed nations from an aging population. Furthermore, while Germany does not have a serious debt problem now it may be on the hook for the debt of other EU economies.
That being said GERJ has 26% of its assets in industrials, which should benefit from Germany's export-based economy. However I am not thrilled with the fund's 20% exposure to financials, yet this is the only drawback. If I ever decide to buy stocks in Western Europe I will probably look to this fund first. I would not buy it now because turmoil in Italy, and potentially in Spain, should drag the shares lower. However it is worth considering on a pullback. I should also note that GERJ is fairly illiquid and the fund's assets are just $6 million.
6--Market Vectors Russia Small-Cap ETF (RSXJ)
RSXJ traded at 8.8X earnings and 1.2X book value as of 1/31/2013 giving it a GN of $23.19. It currently trades at $15.22, which is about a 35% discount to GN. Despite this incredible valuation Russia's GDP has been soaring, and it has virtually no national debt. Furthermore, like China, Russia is embracing capitalist ideals more and more while the West sinks into socialism. One clear sign of this is its commitment to a strong Ruble. Russia imports more gold than any other country, which bodes well for the Ruble, which is another candidate for a gold-backed currency in the future. Furthermore, at the most recent G20 meeting, Russian finance minister Anton Siluanov spoke out against the policies of currency devaluation currently upheld by developed nations. Russia would be the ideal place to invest except for their horrible demographics. Russia is one of the oldest countries in the world and its population is declining. If it weren't for poor demographics Russia would be undoubtedly my favorite country to invest in, and given the valuation of RSXJ this one issue can be overlooked.