The recent market jitters in the U.S. that were triggered by rising bond yields and related inflation fears once again proved that it is quite a smart idea to keep an eye on cheaper equities overseas that are, in theory, should be less sensitive to these factors.
Today, I would like to take a deeper look at the iShares MSCI Switzerland Capped ETF (NYSEARCA:EWL), a fund that is trading at just ~20x Price/Earnings, with a standardized yield of 1.6%.
In short, EWL is a solid long-term investment worth considering since it is overweight in defensive sectors (namely healthcare and consumer staples), and the Swiss franc is a safe-haven asset, thus the risk that the dollar-denominated ETF will suffer from the FX headwinds is minuscule, especially if compared to less developed economies that I have discussed last month.
However, the ETF's cumulative returns are anything but bright. For example, while the SPY investors enjoy a ~114% 5-year total return, EWL delivered TR slightly north of 68%. I also see no reason for EWL's outperformance in 2021.
The Swiss economy is not on a shaky footing, but risks do exist
The data that the State Secretariat for Economic Affairs published on February 26 illustrate that the Swiss economy is clearly not on a shaky footing. Despite the ripple effects of lockdowns, real GDP expanded by 0.3% in 4Q20. Economists surveyed by Bloomberg expected a stagnation.
Certainly, that rate marks a deceleration if compared to a 6.7% expansion in 3Q20 and reflects the economic toll of the reimposed restrictions. The preliminary data show that the annual real GDP contraction of 2.9% had been the worst since 1975.
But there is a silver lining. While services were under strain, "other industries continued to recover." For example, in 4Q20, construction expanded by 0.4%, while manufacturing benefited from robust demand from the Asian markets that secured a 1.4% growth.
To minimize the economic consequences of the pandemic, the government has recently decided to ease some restrictions this month. But certainly, there is a risk that lagging immunization will dent the economic recovery this year.
The Swiss franc question
The story behind the franc's 2020 performance is a complicated one.
First and foremost, it seems the Alpine country does not want its currency to become even stronger if compared to the U.S. dollar, which looks somewhat surprising. The problem is that Switzerland is an export-oriented country, and if the national currency becomes too expensive if compared to the euro and the dollar, domestic companies will suffer. I will address this issue in greater depth below in the article discussing the case of Nestlé (OTCPK:NSRGY).
That is why the Swiss National Bank intervened a few times in the FX market to keep the franc appreciation at bay last year, especially in spring, when investors rushed to safe-haven assets. In September, the central bank reaffirmed its commitment to the interventions to stave off the CHF rally.
But that resulted in the repercussions. In December, the U.S. labeled Switzerland a "currency manipulator." Commenting on this decision, Thomas Jordan, a central bank President, said that
Switzerland or the Swiss National Bank, we are not currency manipulators... Without these interventions, Switzerland would have gone into an outright deflation.
In February, in an interview with a broadcaster SRF, the SNB President clarified that "U.S. censure won't stop his institution's purchases of foreign exchange to fend off deflation."
What does that mean for the EWL investors? Most likely, they should not expect solid FX tailwinds that can bolster price returns, as the SNB clearly does not want the stronger CHF to cause troubles for the economy. At the same time, I also do not anticipate the franc to depreciate sharply, since the market considers it a safe-haven asset.
The underlying index
The exchange-traded fund tracks the MSCI Switzerland 25/50 Index; the benchmark was designed to measure the performance of the upper- and mid-echelon of the Swiss stock market.
As of March 1, there were 48 holdings in the EWL portfolio, 40 of which were classified as equities. The top ten names have a combined weight of over 68%, which implies the fund has poor risk dispersion.
The ETF is overweight in healthcare, consumer staples, and financials. These three sectors account for 72.5% (33.7%, 20.9%, and 17.9%, respectively). The large exposure to defensive names makes the fund less sensitive to the economic downswing but also reduces its ability to benefit from the recovery phase.
The top five constituents
1. Nestlé is a prominent consumer staples sector giant. Its USD-denominated ADR has delivered a 1.4% one-year return, while the Zürich-quoted stock is down ~8.6%. The stock is EWL's most expensive asset with an 18.8% weight.
As I said above, in some cases, the too strong franc is not necessarily a boon for a Swiss company. Nestle's case illustrates that vividly, as in 2020, the appreciation of the CHF crimped its IFRS revenues. While organic sales (adjusted for FX and divestitures) were up 3.6% (slide 4), the reported revenues were down 8.8%. As CFO François Roger clarified during the earnings call,
Foreign Exchange reduced sales by 7.9%, reflecting the continued appreciation of the Swiss franc versus most other currencies.
But though IFRS sales declined, Nestle maintained healthy margins and FCF conversion. Its profit margin was 14.4% vs. 13.6% in 2019, while ~82% of net income was converted into FCF. So, it is explainable why its dividend easily weathered the pandemic.
2. Roche Holding (OTCQX:RHHBY) is a pharmaceutical industry heavyweight.
Since multiple share classes are eligible for inclusion in the underlying index, both bearer shares (those with a ticker RO on the SIX Swiss Exchange) and non-voting equity securities (they have a ROG ticker) are presented in the EWL portfolio. The weight of the bearer shares is diminutive, only 0.19%, while the non-voting shares have close to 13.8% weight.
Precisely like in the case of Nestlé, the stronger franc also resulted in the IFRS sales decline. In the investor update, Roche said its CHF-denominated revenues fell 5%, while group sales at constant exchange rates rose by 1%.
The company's ADR, RHHBY, has delivered a one-year price return of (0.4)%. The Zürich-quoted ROG is down ~10.5%.
3. Novartis (NVS) that has an 11.3% weight in the EWL portfolio is another prominent player in the healthcare sector. The company uses USD as reporting currency (see the 4Q20 presentation), so the CHF appreciation had only a limited impact on its financial performance.
Assuming the share price in Zürich, its one-year return is (2.8)%; the ADR price is up ~1.5%.
4. Zurich Insurance Group (OTCQX:ZURVY) has a 4.3% weight in the portfolio. It operates globally and reports revenues in USD. Its ADR delivered an over 5.5% one-year return, while its share price in CHF is down ~1.4%.
5. With a 4% weight, shares of UBS Group (UBS) are the 5th largest asset of the fund. The group operates via four divisions: Global Wealth Management, Personal & Corporate Banking, Asset Management, and Investment Bank. In 2020, UBS delivered on all of its targets, namely Return on CET1 capital, the cost/income ratio, PBT growth, etc. (see slide 7).
Regarding capital appreciation, UBS has been one of the most lucrative EWL's investments given its close to 38% one-year return.
Final thoughts
EWL is relatively cheap if compared to the iShares Core S&P 500 ETF (IVV) that is trading at 28.9x P/E.
Its large exposure to defensive names, in theory, should protect its price performance from steep corrections; however, it also reduces its ability to benefit from the economic recovery.
Also, EWL has a slightly inflated expense ratio of 0.51%, which is above the average of 0.44%.
In sum, I am neutral.
