Emerging market woes and the possibility of Brexit have caused much angst of late, but a variety of high-profile strategists have also been urging investors to buy into the most stressed markets, the reasoning being that fear results in low valuations and low valuations ultimately drive stellar long-term returns.
So what’s cheap and what’s not? Which international equity markets should value-minded investors be eyeing, and which should they be avoiding?
JPMorgan is keen on the UK, recently saying British stocks looked “outright cheap versus the rest of the world” after significantly underperforming in recent years. Underperformance has been even more stark in many emerging markets, and the “exodus” from the region over recent months “is a wonderful opportunity – and quite possibly the trade of a decade – for the long-term investor”, according to high-profile California firm Research Affiliates.
Cheapest indices
Those sentiments are largely echoed by German firm Star Capital, which recently issued a detailed report examining global equity valuations.
For the most part, value is most easily found in emerging and European markets. Russia looks dirt cheap, as it has done for some time, while Star Capital estimates that indices in Hong Kong, Singapore, Norway, Italy and Spain are all poised to deliver inflation-adjusted annual returns ranging from 9.5 to 10.9 per cent over the next decade.
The outlook is less favourable in the world’s biggest equity market; the S&P 500 continues to be one of the most expensive markets in the world, and is priced to deliver real returns of around 4.8 per cent (or less) over the next 10 to 15 years.
A precise forecast is not given for Ireland, although below-average returns seem likely, given that Irish stocks appear to be even more expensive than their US counterparts.
This valuation analysis is partly arrived at by looking at countries’ cyclically adjusted price-earnings (Cape) ratios. One-year price/earnings ratios tend not to be reliable measures of valuation due to the volatile nature of corporate earnings. Anyone relying on trailing or forward earnings estimates in 2007 might have concluded stocks were relatively reasonably priced but it turned out those earnings were unsustainable.
Similarly, the earnings collapse in early 2009 resulted in indices trading at more than 100 times profits, masking the fact that stocks had actually fallen to levels unseen in a generation. In contrast, the Cape ratio averages earnings over a 10-year period, thereby smoothing out the effect of artificially high or low earnings.
Research indicates that Cape, which was first developed by iconic value investor Benjamin Graham in the 1930s and popularised in recent years by Nobel economist Robert Shiller, has merit. Star Capital, which looked at 17 major international markets, found the lowest Cape readings were followed by real average annual returns of 13.3 per cent over the subsequent 10 to 15 years. The most expensive markets, in contrast, saw average real returns dwindle to 0.5 per cent.
Not perfect
Nevertheless, Cape is not a perfect indicator. Sceptics note Cape has signalled overvaluation in the US for almost all of the last 20 years. The explanation partly lies in the fact that US companies historically distributed two-thirds of their earnings as dividends, compared to an average of 39.4 per cent since 1990. This change in dividend policy partly explains the escalation in US Cape ratios in recent decades.
Secondly, Cape is of little use in an index undergoing major structural change, like Ireland in 2008.
Today’s Iseq is almost unrecognisable from the Iseq of 2006, when it was dominated by the banks (AIB, Bank of Ireland, Anglo-Irish Bank and Irish Life & Permanent). Nevertheless, Cape takes into account earnings over a 10-year period, meaning Irish Cape ratios in recent years have been utterly distorted by the irrelevant bank earnings of yesteryear.
There are specific circumstances, then, when Cape readings can mislead, necessitating an alternative valuation metric. One such approach is to look at a country's price/book ratio. Book values, which compare company share prices with the value of their assets, tend to be more stable than Cape ratios. That aside, Star Capital finds the relationship between index book values and subsequent long-term returns to be similar to that of Cape, with low valuations invariably being followed by much healthier returns than high valuations.
To arrive at its estimate of long-term returns, Star looked at both a country’s Cape ratio and its book value, in both cases comparing current readings to their historical average. Sometimes, a divergent picture emerges. Japan, for example, has a Cape ratio of 24, which is even higher than that of the US (23). However, Japan’s price-book ratio of 1.3 appears low; indeed, the US book value of 2.6 is twice as high.
In agreement
Generally, however, the two valuation metrics tend to agree as to whether a country’s stock market is cheap or expensive. Russia, as mentioned earlier, looks extremely cheap – worryingly cheap, some might say – on either metric. Italy and Spain both have low Cape ratios – indeed Shiller said last year that he had begun to migrate his funds out of the US and into Spanish and Italian indices on account of their low Cape readings – as well as low price-book ratios.
Both metrics suggest British equities are quite cheap relative to history, with Star Capital estimating long-term real returns of around 8.5 per cent for UK shareholders. Among emerging markets, equities look cheap in South Korea, Turkey, China, Singapore and Brazil.
The US, however, is likely to underperform, as is Ireland. With a Cape ratio of 27.4 and a price/book ratio of 2.6, the Irish market appears to be one of the most expensive in the world.
A similar conclusion is reached by US money manager Mebane Faber, who recently ranked 45 countries across a range of valuation measures (Cape, book value, dividend yield and cash flows). Faber found only three countries – Switzerland, the US and Denmark – were more expensive than the Irish market.
Overall, global equities trade on a Cape ratio of 18.4 and a book value of 1.8. Unsurprisingly, developed markets are much cheaper than emerging markets on both metrics, although developed European indices appear reasonably priced, sporting an average Cape ratio of 14.7 and a price-book ratio of 1.7. The once fashionable Brics (Brazil, Russia, India and China) are now very much unloved, trading on a lowly Cape ratio of 10.5 and a book value of 1.3.
The same conclusions are reached by Mebane Faber: “US stocks are expensive, but not terribly so and certainly not in a bubble. Foreign stocks on average are fair-to-cheaply priced, with emerging cheaper than developed. The cheapest 25 per cent of global stock markets are very cheap.”
Drawdowns
Cheap can always get cheaper, of course; indeed, cheap has gotten cheaper in recent years, while the seemingly expensive S&P 500 has continued to outperform. Star Capital notes there have even been periods where the cheapest indices went on to lose more than 50 per cent over a three-year period.
The consolation for value investors is that the steepest declines tend to occur in highly valued indices, which registered “disproportionately higher setbacks of -76.8 per cent”.
Quite simply, higher valuations mean higher downside risks, with average drawdowns in the cheapest markets tending to be nothing like the drawdowns endured by investors in pricier markets.
Is today’s environment different? Are there very good reasons why the cheapest markets are cheap? Research Affiliates admits current fears are “understandable”, given slowing growth in China and tumbling commodity prices. “While markets are not efficient,” it adds, “neither are they irrational.”
At the same time, bargain prices “cannot exist in the absence of fear”, says Research Affiliates. Star Capital’s analysis appears to confirm this picture: markets tend to price in a country’s woes and a few extra for good measure, ultimately creating opportunities for long-term investors with strong stomachs.
