The VGK ETF Could Remain In Bear Territory For The Foreseeable Future

|
About: Vanguard FTSE Europe ETF (VGK)
by: Sankalp Soni
Summary

The VGK ETF is down by about 22.85% from its 52-week high.

UK equities have the largest weighting in the ETF, which means Brexit uncertainty could continue to undermine its performance.

ECB President Mario Draghi is relatively less dovish considering the persistently weakening Eurozone economy.

The Vanguard FTSE Europe ETF (VGK), which tracks equities from 16 European countries, is down 22.85% from its 52-week high, and is currently trading at about $49. European economies, together with the global economy, are experiencing a notable slowdown, which has been undermining equity performance across the continent. This has resulted in valuations coming down to more attractive levels, though this article assesses the factors that could continue to suppress the performance of the ETF for the foreseeable future.

Source: Yahoo Finance

Prospectus Review:

The VGK ETF tracks the Spliced European Stock Index, which represents equities from 16 European nations, out of which the UK has the largest weighting. The strategy of the fund involves an indexing investment approach by aiming to invest all its assets into all of the 1,258 stocks that make up the underlying index. The strategy has been successful in tracking the underlying index relatively well. The fund has an expense ratio of 0.10%, which is significantly lower than the 0.44% average of all ETFs that offer exposure to European equities, making it a very cost-effective investment vehicle.

The holdings of the fund include:

Risk note from VGK prospectus:

The Fund’s ETF Shares are listed for trading on NYSE Arca and are bought and sold on the secondary market at market prices. Although it is expected that the market price of an ETF Share typically will approximate its net asset value (NYSE:NAV), there may be times when the market price and the NAV differ significantly. Thus, you may pay more or less than NAV when you buy ETF Shares on the secondary market, and you may receive more or less than NAV when you sell those shares.

The chart below demonstrates the tracking differences between the performance of the VGK ETF market price and the underlying benchmark:

Source: Vanguard

It is worth noting that the ETF tracks the underlying benchmark relatively efficiently. The chart above shows how it outperforms its underlying benchmark during positive-return periods, and does not lose as much as the underlying benchmark during negative-return periods. This is a rather favorable characteristic of the ETF.

The reason I have distinctly chosen this ETF is because according to data from ETFdb.com, VGK has one of the highest Assets Under Management (AUM) out of all ETFs that offer exposure to European equities, currently standing at $13.2 million. I consider AUM as a good indicator for how successful the fund has been in implementing its strategy to deliver on its objectives for investors. The higher its AUM, the more investors have allocated their capital towards the fund due to effective management. Moreover, it also has one of the highest average daily trading volumes, currently at 5.11 million. Hence this means that the ETF has a relatively healthy level of liquidity. This is a good indicator for how easily investors can buy and sell shares in the ETF. Therefore, the higher the trading volume, the lower the liquidity risks.

Valuation

As global equity markets witness a considerable correction, the VGK ETF has actually fallen into bear market territory. Given the deeper declines, valuation multiples are also more attractive compared to the US and global equities. The table below compares the valuation multiples of the VGK ETF against those of the Vanguard S&P 500 ETF (VOO) and Vanguard Total World Stock ETF (VT).

Valuation Metric

VGK

VOO

VT

Price to Forward Earnings Ratio

13.3

17.02

14.76

Price to Book

1.61

3.01

2.03

Price to Sales

1.12

2.22

1.5

Price to Cash Flow

4.3

12.95

7.3

Data Source: Morningstar

European equity valuations, represented by VGK, are undoubtedly much cheaper than the US and international equities. However, while they are cheaper, European equities also have major headwinds to confront.

Brexit uncertainty

Equities from the United Kingdom make up 29.25% of the VGK ETF, and hence have the largest weighting in the fund, as shown by the chart below.

Source: ETF.com

A vote on the Brexit deal by the UK parliament had recently been delayed due to widespread unpopularity on both sides of the political spectrum. A new vote will take place during the week of Jan. 14, 2019. While Prime Minister Theresa May has returned to Brussels to renegotiate, the President of the European Commission Jean-Claude Juncker has emphasized that there is "no room" to renegotiate. Given that there is only one month left for producing a new deal for Parliament to vote on, and EU’s to renegotiate, the chances of a no-deal Brexit are only increasing. Investors should beware that if a no-deal Brexit materializes, then volatility in UK’s equities will spike and stocks could plummet. And considering the UK equities hold nearly a 30% weighting on the VGK ETF, this event would drag the entire ETF down as well.

A no-deal Brexit would pose a great deal of uncertainty for British businesses, and would discourage large-scale capital expenditure and other expansionary activities being carried out. As economic growth would take a hit, it would drastically alter the sales revenue and profitability profiles of UK listed entities. Hence while valuations may appear attractive, a plunge in earnings as a result of a no-deal Brexit could make valuations a lot less attractive. Therefore, this significant downside risk offsets the current attractive valuation multiples.

Draghi not dovish enough

While the UK represents nearly 30% of the ETF, the remaining 70% represented by the other 15 European nations do not offer much positivity either. Eurozone GDP grew at a mere 0.2% in the third quarter, marking the slowest growth rate in fours years. In fact, the German (14.18% ETF weighting) economy contracted by 0.2% in the same quarter.

While the President of the European Central Bank (ECB), Mario Draghi, addressed these economic weaknesses following monetary policy meeting on Dec. 13, I believe he did not offer as much dovish guidance as is needed to stimulate the economy. Prior to the meeting, the ECB stated that rates would remain low until at least summer of 2019. However, regardless of the recent further weakening in the Eurozone economy, Draghi maintained the same guidance during the meeting last week. The fact that the ECB did not adjust its guidance certainly did not support equities across Europe as they continued to slide, together with global equities.

Bottom Line

While the VGK ETF may appear attractively valued in comparison to global peers, the economic headwinds certainly pose notable downside risk. The chances of a no-deal Brexit continue to rise, while the ECB fails to deliver on the extent of loose monetary policy guidance required to provide support to European economies and markets. I do not recommend buying into the VGK ETF until headwinds show more promising signs of clearing away.

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.