- FEZ's valuation would indicate probable under-valuation, as judged by a higher-than-expected equity risk premium.
- Investors are probably under-weight European equities, and in part this is understandable given lower returns on equity as compared to the United States.
- Nevertheless, given how low interest rates are regionally, FEZ seems to indicate that Eurozone equities are regionally attractive.
- All considered, Eurozone equities could potentially benefit from a geographical rotation in equity holdings among global investors.
- Regardless, in a base case scenario, I would expect returns of at least 8% per year for the next few years at present prices.
The SPDR Euro Stoxx 50 ETF (NYSEARCA:NYSEARCA:FEZ) is an exchange-traded fund that enables investors to get exposure to Eurozone stocks. The fund's benchmark index is the well-known EURO STOXX 50 Index, which is designed by STOXX (a Swiss index provider). The index is primarily comprised of French and German stocks. The index's most recent factsheet explains:
The EURO STOXX 50® Index represents the performance of the 50 largest companies among the 20 supersectors in terms of free-float market cap in Eurozone countries. The index has a fixed number of components and is part of the STOXX blue-chip index family. The index captures about 60% of the free-float market cap of the EURO STOXX Total Market Index.
Also from the factsheet, we see the major constituent sector exposures preferencing Technology (18.4%), Industrial Goods & Services (14.9%), and Consumer Products and Services (10.3%). Overall, while the fund also has some significant combined Banking, Insurance, and Utilities exposures, there is a fair amount of exposure here to the so-called cyclical and economically sensitive sectors that tend to stand a greater chance of out-performing.
Banks are also considered cyclical stocks, but in a world of low interest rates (especially in Europe), banks have turned into more of a "high risk, low reward" investment. Nevertheless, I have covered some banking ETFs in the past, and there have been some interesting opportunities from a valuation perspective (if not from an earnings out-performance opportunity viewpoint).
And as noted previously, the main geographic exposures are to France and Germany. Also, given these country weightings (of FEZ's benchmark index, and therefore of FEZ itself), the fund is effectively wholly exposed to EUR.
That means if the euro appreciates, FEZ tends to appreciate alongside the euro, although a more expensive euro makes euro-denominated assets more expensive. Just as a rallying U.S. dollar can put pressure on U.S. stock valuations, the same happens abroad, so it is not necessarily the case that a stronger EUR/USD rate would translate into a stronger FEZ share price (priced in USD). Still, there is apparently a positive correlation in general.
You will also notice from the above chart, which compares FEZ (black line) to EUR/USD (orange line) since around 2007, that FEZ is well under its all-time highs (set in late November 2007). The euro is also well under its long-term highs, so this is an important component of the weakness. Still, as shown below in an FX-adjusted version, FEZ is still lower than its 2007 highs in EUR terms.
What matters is the present, not so much the past, but future prospects are always in context of the past. In this case, it is worth noting the return on equity of the fund. On a forward basis, using Morningstar data, we find a forward price/earnings ratio of 15.13x as of October 1, 2021, with an accompanying price/book ratio of 1.95x. The implication is that forward return on equity, at least based on Morningstar's adjusted earnings expectation, is 12.89%.
In my experience, this would place the fund (on average) above certain focused low-ROE geographies like Japan, but slightly below countries like the United Kingdom, and significantly below countries like the United States. With a price/book above 1.00x (roughly 2x at the moment), you are looking at a forward earnings yield of 6.6%.
The general idea here is that, while your long-term return in a company or fund will converge with ROE over time, the more you pay up (on price/book), the longer it takes for that convergence to happen. And what's more, the long-term ROE could well fall (depending on long-term technology improvements, demographics, regional total factor productivity, etc.). But as it stands, your annual return is likely to be between 6 and 13% (at most) as a rough estimate and at present prices. More than this would require notable out-performance in earnings growth via increased productivity, and/or buying on a large dip/crash.
The dividend yield is only slightly over 2% for the fund too, so this cannot explain FEZ's general under-performance. The under-performance since 2007 is a function of over-valuation in 2007, coupled with an inability to achieve stronger returns on equity than major markets like the United States since 2007. It was post-2008 that we saw the tech titans of the United States really come to the fore, taking up a massive proportion of the major U.S. equity index funds. This enabled large earnings out-performance and valuation expansion. FEZ has some tech exposure, but it is limited, and most of the businesses in the FEZ portfolio are lower growth and less exciting.
We can get a feel for FEZ's current valuation by looking at some key metrics. Looking at FEZ's geographic exposures (see below), I calculate the cost of equity using this data combined with Professor Damodaran's equity risk premium and country risk premium estimates for September 2021 and July 2021, respectively.
I also use government bond data from World Government Bonds for 10-year yields that serve as proxies for regional risk-free rates. The sum of the equity risk premium, country risk premium, and risk-free rate, represents the cost of equity in each region. The weighted result is my cost of equity for FEZ.
The net result is that we find a cost of equity of 5.05%, which is low, but this is going to be partially owing to low risk-free rates in the region. Notice that our weighted risk-free rate is only 9 basis points, owing to negative rates in Germany, the Netherlands, and Finland. The rest of the eurozone also "enjoys" very low rates generally, supported by large quantitative easing programs executed by the ECB, as well as a negative deposit facility rate of -50 basis points. Monetary policy is loose and this translates into a "cheap" euro. Indeed prior to COVID-19, the euro was increasingly used as a funding currency to support (leveraged) international carry trades.
In any case, using these inputs, as well as a rough five-year average earnings growth rate of under 13% (Morningstar analysts project up to 14% three- to five-year earnings growth rates for FEZ), I arrive at potential upside of about 75%.
Naturally we should not expect such stark upside. What it tells us is that, in spite of our arriving at a fairly reasonable cost of equity for the region, the market is pricing in a heavier equity risk premium. While the FEZ's underlying portfolio return on equity is decent, investors do not seem to be interested in allowing low regional rates to translate into a lower cost of equity. Either that, or investors are under-weight European equities in general and/or are simply not interested in holding them. Solving for the prevailing market price, the implied cost of equity is not our 5.05%, but more like 8.66%.
So, for the foreseeable future, my best estimate would be that FEZ will return something like 8-9% per year, which nicely fits between the forward earnings yield and the current forward return on equity. This is assuming that investors generally remain about as optimistic/pessimistic on European equities as they are today, and that the return on equity is roughly stable. It also assumes a stable EUR/USD FX rate. Generally speaking, bullish markets correspond with a weaker U.S. dollar, so FEZ could stand to benefit from a tighter equity risk premium as well as a bullish euro, but the relationship should at least logically be inverse (EUR strength vs. European stock valuations), so any effect here could be mostly self-regulating.
In any case, looking back to the chart, over the next three years I would perceive annual returns of at least 8% being possible, which is regionally attractive for European investors. And therefore I do think FEZ stands a strong chance of achieving this. That would take the fund to perhaps $57/share as illustrated in the chart below, by trajectory.
That is perhaps not especially impressive (still a way off 2007's highs). But I think this is a realistic assessment that also allows for some out-performance potential if we see some rotation into Europe from U.S. markets. FEZ stands to gain not just on accruing earnings/compounding book values but also on valuation repricing. FEZ is not exciting, but it is priced for returns of at least 8% per year.
This article was written by
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