- Swiss equities are probably fundamentally undervalued at present, given earnings growth expectations and a likely low cost of equity.
- Rate hikes in 2022, likely to happen in major economies such as the United States, could take the wind out of the sails of richly-priced U.S. equities.
- Regardless, Swiss equities could serve as a value-oriented safe-haven trade throughout this year.
- On the basis of current undervaluation and negative fund flows over the past twelve months, EWL represents an attractive opportunity for international investors looking to diversify.
iShares MSCI Switzerland Capped ETF (NYSEARCA:NYSEARCA:EWL) is an exchange-traded fund that enables investors to access direct exposure to mid- and large-cap Swiss equities. Switzerland's economy is sophisticated, ranking third among 146 countries in 2019 for economic complexity. However, the local Swiss equity market is not as developed as plenty of other economically sophisticated countries, and as such, EWL maintains only 41 holdings in total as of December 31, 2021.
I last covered EWL in July 2021, in which I thought that upside was probably capped at 10%. Since then, EWL has risen by 6.44% according to Seeking Alpha, while the S&P 500 index has risen by 9.01%. I also did note that I thought EWL would not out-perform. So far then, I have been correct, but it has been less than twelve months, and EWL should still potentially beat my supposed forward cap of 10%. Notably though, the exchange rate for USD/CHF has not changed by much at all since my last article, which makes for a fairly stable trading environment for EWL.
EWL invests in accordance with its benchmark index that it seeks to replicate, the MSCI Switzerland 25/50 Index. The 25/50 methodology tries to ensure that no single issuer represents 25% or more of a fund, and the positions that each sum to at least 5% of the portfolio do not together exceed 50%. There are, therefore, some minor differences in the "portfolios" of the 25/50 version and regular version of the MSCI Switzerland Index, but we will use the latter's most recent factsheet as more data is available. We can also check these numbers later against an alternative data source.
The MSCI Switzerland Index carried a price/book ratio of 3.42x as of November 30, 2021, with a trailing price/earnings ratio of 21.03x and a forward price/earnings ratio of 18.55x. The implied forward earnings yield is therefore 5.39%, while the implied forward return on equity is 18.44%. The return on equity here is strong; while the portfolio is concentrated, any ROE above 15% for macro-oriented ETFs is impressive. While there are funds, especially in the United States, have offer higher underlying ROEs than this (even above 20%), those funds are also often expensive as a result. The forward earnings yield for EWL is reasonable at 5.39%, especially given negative long-term rates in Switzerland.
The Swiss 10-year yield is currently -0.18% at the time of writing. Negative rates mean that the opportunity cost on long-term investment is very slim. This means that the main components of the cost of equity fall back on the equity risk premium and the country risk premium (the latter really being an extension of the former, but we should include it). In this case though, we have no country risk premium (at least, following guidance from Professor Damodaran). This makes sense though, as Switzerland is viewed as a politically stable country with high economic complexity. Indeed, the Swiss franc (the national currency) is viewed as a safe haven in the FX world. So, it makes sense that we only really have the mature market equity risk premium and negative risk-free rates to calculate the cost of equity.
Using Damodaran's current ERP estimate of 4.77%, and the Swiss 10-year, we have a tight net cost of equity of just 4.59%; this is the discount rate, or required return, we would demand from Swiss equities. We can also use Morningstar data to check two points: firstly, the forward price/earnings ratio, and secondly, earnings growth expectations. For EWL, the forward P/E is set at 18.51x as of December 29, 2021 (timing is an issue here, but this is close enough to the regular MSCI Switzerland Index). And the three- to five-year average earnings growth rate expectation is 7.96% (I will use this as inspiration). We finally arrive at the simple short-term valuation gauge below.
The fund is potentially undervalued, with upside of about 42% implied. However, I always comment on these deviations.
The first point I would make is that while we have no country risk premium, this can be justified as outlined before (given that Switzerland is viewed as a safe haven, and is a highly developed country). Further, EWL does not seem to demonstrate higher levels of volatility (or "beta") relative to the broader markets (including U.S. equities).
The only possible change I would make is to the long-term risk-free rate; you might argue that we should use a normalized figure rather than a prevailing negative rate. However, as you can see below, Switzerland has had to contend with deflation in the past; it does actually make sense that risk-free rates are either zero or negative.
But if we assume a risk-free rate of nothing, it only reduces the upside from 42% to 36%. Actually, to solve for the 42% upside potential, the implied cost of equity here is about 6.43%. So, rather than expecting a revision upward with over 40% upside, EWL is basically priced for 6% returns.
Now, EWL does have a strong underlying return on equity of over 18%. So, the real return is going to likely fall within the bounds of 6% and 18% in the longer run (returns tend to converge on the underlying ROE over time). Recent performance since my last article, of 6.44% in 176 calendar days, would represent an annualized return of about 13.8%, which is close to the midpoint of 6% and 18% (so far, so good).
But it is also possible that EWL's heavy Health Care sector exposure will see the fund under-perform "post pandemic" (34.39% of the fund as of December 30, 2021). A further 23% of the fund is allocated to Staples; traditionally a defensive sector, not known for out-performance. Financials also represented 15.09% of the fund as of recent, which is a sector that has to struggle to contend with negative local rates (which generally compress net interest rate margins of financial businesses).
Nevertheless, while the sector exposures leave me with some doubt, there is probably still some room for EWL to bounce-back as the European business cycle matures. See for example the chart below from Fidelity, for Q4 2021. The Eurozone is a little behind the United States, potentially, and therefore it is possible that U.S. equities could ease off on their pace against more value-oriented European stocks (especially with three U.S. rate hikes forecasted for 2022, which could take some wind out of the sails of richly-priced U.S. stocks).
Flows into EWL have been negative over the past year, too (see chart below), which could be viewed as bullish from a contrarian perspective. At least, it might support the view that investors have (unduly?) priced in a more expensive equity risk premium into their calculations. While capital is finite, for a developed "safe haven" like Switzerland, it is possible that the uncertainties that we face in 2022 will provide Swiss stocks with some support.
On the whole then, I would change my view on Swiss equities from neutral to bullish, on the basis that Swiss stocks have an attractive underlying ROE, could benefit from safe haven flows into 2022, and look fundamentally undervalued given low local risk-free rates (and a relatively low but reasonable mature market equity risk premium, at present). Swiss equities are quite close to the idea of the "European value stock" theme, but this is not a bad thing, especially as we head into a year of likely rate hikes (notably in the West).
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