Screening of country ETFs
Using P/E ratios (or some variant thereof, like Shiller PE (NYSEARCA:CAPE) ratio) is perhaps the most common way to compare valuations across stock markets around the world. However, such analysis neglects differences in risk between markets, as well as varying levels of earnings growth. However, it is logical to assume that (all other things equal):
- ETFs where constituents of underlying indices have higher earnings growth should have higher P/E ratios;
- ETFs of less risky countries should have higher P/E ratios.
I conducted a screening for country ETFs with (relatively) low P/E ratios, from (relatively) low-risk countries and having (relatively) high earnings growth. Specifically, I analyzed 47 country ETFs across the world on the following metrics:
- P/E ratio.
- Political Risk Index score, computed by PRS group, which covers a broad range of risks, including "possible equity restrictions, exchange controls, changes to fiscal and/or monetary policy, labor costs and requirements, and external borrowing liabilities" as a proxy for country risk. Higher index values signify lower country risk.
- GDP growth for 2017, based on the latest projections by IMF, as a proxy for earnings growth (I assume no drastic changes in the share of corporate earnings in GDP).
The data for all 47 countries are presented below:
Then I assigned a rank for each country for each metric in the following way:
- the country with the lowest P/E got a rank of 1 for this metric, the country with the second lowest P/E got a rank of 2 and so on;
- the country with the highest PRI score got a rank of 1 for this metric, the country with the second highest PRI score got a rank of 2 and so on;
- the country with the highest GDP growth got a rank of 1 for this metric, the country with the second highest GDP growth got a rank of 2 and so on.
Finally, I summed up the three ranks for each country. Countries with the lowest sum of ranks (i.e. those having the most attractive characteristics across all three metrics overall) are the most undervalued. Below are the rankings:
All three countries have P/E ratio in mid-teens, are among the least risky countries in the world, and are projected to have healthy (for developed countries) GDP growth rate of above 2% for this year. The corresponding ETFs have identical expense ratios (0.48%), and average bid-ask spreads over the last 60 days (0.04%). Both metrics are below averages across all 47 country ETFs:
Thus, on the surface all three ETFs look attractive; however, it would be instructive to look a bit closer at each of the three countries and characteristics of corresponding ETFs to find possible reasons for low valuation or catalysts that could close their relative valuation gaps to other markets.
Hong Kong - iShares MSCI Hong Kong ETF (NYSEARCA:EWH)
Hong Kong has historically had P/E ratio lower than mainland China (partly due to Hong Kong market having more mature, lower growth companies):
Source: Hong Kong Stock Exchange
Another reason for lower valuation might be additional risk premium since companies from mainland China comprise a significant proportion of Hong-Kong stock market.
However, valuation of Hong Kong market could benefit from increased entry of mainland investors - insurance companies, mutual funds, hedge funds, high-net-worth individuals as well as retail investors due to recent establishment of Shenzhen-Hong Kong Stock Connect. UBS estimates that Rmb160bn will flow to Hong Kong market from mainland in 2017, and the amount will rise further in the following years, which could mean rising valuations for Hong Kong market.
The iShares MSCI Hong Kong ETF tracks MSCI Hong Kong Index, which currently has 46 constituents and covers around 85% of total market cap of Hong Kong equity universe. When compared to total market (as represented by STOXX Hong Kong All Shares Total Market Index), the iShares MSCI Hong Kong ETF is also dominated by financials and real estate, but has a significant sector bias towards real estate sector at the expense of financials and telecommunications:
Another factor to consider when investing in the iShares MSCI Hong Kong ETF is that it is not capped, which results in one company (AIA Group (OTCPK:AAGIY) - the largest Pan-Asian life insurance group) having by far the largest weight in ETF (17.5%). Moreover, most of other large holdings are also financials or real estate companies:
In sum, the flow of funds from mainland China will be a crucial factor for Hong Kong shares in general, and for the performance of the iShares MSCI Hong Kong ETF in particular. The dominance of financial (AIA Group in particular) and real estate companies in the ETF is another important factor to consider.
Singapore - iShares MSCI Singapore Capped ETF (NYSEARCA:EWS)
As in the case of Hong-Kong, Singapore stock market is skewed towards financial and real estate sectors, accounting for around 55% of the total equity universe:
At the moment, financial sector in Singapore is facing low loan growth and increases in non-performing loans due to its high exposure to struggling oil and gas sectors. At the same time, the outlook for real estate sector is more positive due to recent easing of borrowing restrictions for home buyers and broadening of tax exemptions.
On the other hand, when looking at the overall stock market, there is at least one metric based on which current valuations seem attractive: the ratio of total market cap of listed stocks to Singapore GDP, which is currently at 113%, not far from the historic low of 92%:
The underlying index of the iShares MSCI Singapore Capped ETF (MSCI Singapore 25/50 Index) has 27 constituents and covers around 85% of total equity universe. It follows the sector composition of total equity market universe quite closely. For instance, the weight of financials and real estate in the ETF is almost the same, currently standing at 57%. The predominance of those sectors in the ETF can partly explain low valuation, and investment in this ETF is largely a bet on the recovery of financial and property sectors:
Sources: FTSE, iShares
In terms of top holdings, the iShares MSCI Singapore Capped ETF is dominated by four largest constituents, which together account for more than 40% of the index. Three of them (DBS Group (OTC:DBSAY), Oversea-Chinese Banking Corporation and United Overseas Bank (OTCPK:UOVEY)) are banks, which further supports the thesis of the importance of future developments of banking sector asset growth and asset quality on the performance of the ETF:
In short, whereas the valuation of Singapore stock market seems attractive both relative to history and to other markets, the outlook for some of the largest sectors is highly uncertain, which certainly weakens the investment case.
Sweden - iShares MSCI Sweden Capped ETF (EWD)
As in the cases of Singapore and Hong Kong, financials dominate Swedish stock market:
Although the projected GDP growth rate of Sweden (2.7%) seems healthy, it is to a large degree fueled by negative interest rates and the accompanying increase in consumption: Swedish Central Bank announced it will keep rates negative until 2018, which at the same time means that financial sector is likely to continue to struggle. It has also been argued that GDP growth is largely attributable to a large increase in household debt:
The iShares MSCI Sweden Capped ETF tracks MSCI Sweden 25/50 Index, which currently has 31 constituents and covers around 85% of total market capitalization of Swedish stock market. The ETF does not exhibit significant sector biases in the largest sectors: the weight of financials is almost identical to their weight in total market, although ETF composition is a bit biased towards technology and industrials at the expense of health care sector:
Sources: Nasdaq, iShares
As one would expect, the top holdings of iShares MSCI Sweden Capped ETF reflect its industry weightings, with financials and industrials dominating and Nordea Bank having the largest weight (almost 10%):
Overall, the future performance of Swedish stock market (and iShares MSCI Sweden Capped ETF) will depend on whether economic growth in Sweden continues once rates leave negative territory, providing a boost to financial sector.
In conclusion, for an investor looking for a region to invest, Asia-Pacific with its largest share of undervalued countries is worth considering. In terms of individual countries, Hong Kong, Singapore and Sweden look most attractive, although the investment case rests heavily on one's views on the success of Shenzhen-Hong Kong Stock Connect (in the case of Hong Kong), the recovery of financial and real estate sectors (in the case of Singapore), or sustainability of economic growth (in the case of Sweden).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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