Country Valuation Differences Often Caused By Sector Structure

by: Norbert Keimling

Summary

Country valuations differ significantly across countries due to individual sector structures.

About half of the current US overvaluation is based on low exposure to attractively valued financials and overweight of expensive technology sector.

Investors should scrutinize undervaluations, particularly in smaller countries or in countries with a very divergent sector structure.

An attractive equity market does not always include attractive equities.

The old business adage "the profit lies in the purchase" also applies to financial markets. Numerous studies show that undervalued equity markets appreciate significantly more than highly valued ones over the long term. For investors, it is therefore an obvious step to compare the valuation levels of different countries and then to commit themselves to investments primarily in countries with attractive valuations.

For example, if one compares all established equity markets based on the price-to-book ratio, Asian markets such as Singapore and South Korea currently stand out due to their particularly attractive valuations, while Denmark and the US seem expensive. But is it really the case that all countries are comparable with each another in equal measure?

In particular, the case of Denmark raises doubts since the healthcare sector dominates the country's equity market in an exceptionally strong way. While this sector accounts for just 9 percent of the global equity market, it represents almost half of the Danish market (see Chart 1).

Denmark is dominated by the healthcare sector - StarCapital, Keimling

The fact that the global healthcare sector has consistently traded at a significant premium - 86% on average - to the global equity market in the past few decades raises the question of whether the Danish equity market with such a high weighting in a traditionally expensive sector will ever return to an average valuation level (see Chart 2).

Healthcare sector valuations have been steadily higher - StarCapital, Keimling

Assuming that different sectors - e.g. due to industry-specific balance sheet structures - will also have different valuation levels in the future and that the sector structure of a market won't change dramatically in the medium term, it appears worthwhile to analyze the extent to which Denmark's overvaluation is simply the result of a higher healthcare weighting.

This effect can be quantified by comparing Denmark's valuation level with that of a sector-adjusted benchmark. For example, if the global equity market had the same sector composition as Denmark - including the high healthcare weighting - its price-to-book ratio would rise from 2.1 to 2.5. The Danish equity market would no longer be valued 46% higher than the global equity market, but only 23% (see Chart 3). As a result, half of Denmark's overvaluation is attributable to a divergent sector composition.

Valuation comparison - classical vs. sector-adjusted - StarCapital, Keimling

For all other established equity markets, it can be concluded that undervalued markets generally show undervaluations even after a sector adjustment, and vice versa. However, some undervaluations must be put in perspective, for example in Singapore, whose low PB ratio is largely due to a high weighting of financial stocks (with historically attractive valuations) (see Chart 4).

Systematically lower PB ratio in the financial sector - StarCapital, Keimling

In the seemingly attractive markets of Norway, Canada and Australia, the undervaluation actually turns into an overvaluation after a sector adjustment due to their high weightings of basic materials stocks and financial stocks. This means that equities in these countries are even valued higher on average compared to their competitors from other countries. However, this remains concealed in a classical PB country comparison.

The sector structure also has an effect on the high US valuation. Lower exposure to attractively valued financial stocks and an overweighting in comparatively expensive technology stocks inevitably cause the valuation of the US market to rise (see Chart 5).

Sector structure of the US market - StarCapital, Keimling

If the global equity market had the same sector structure as the US market, its PB valuation would rise from 2.1 to 2.5. As a result, about half of the overvaluation is attributable to a divergent sector composition. This effect is similar for other valuation indicators (see Chart 6).

Sector-adjusted valuation of the US market - StarCapital, Keimling

Investors should therefore scrutinize undervaluations, particularly in smaller countries or in countries with a very divergent sector structure. An equity market with a comparatively attractive valuation does not always include attractive equities.

Note: MSCI. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI's express written consent.

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. I have no business relationship with any company whose stock is mentioned in this article.

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