Digging Deeper For Market Valuations by Robert McConnaughey, ColumbiaManagement
- When discounted for index composition, U.S. equities are not trading at a significant premium to Europe.
- One can draw some very misleading conclusions about any disparate group by only looking at the aggregates.
- Those who draw broad conclusions based on index valuations may be creating opportunities for those who can dig deeper for them.
Nobody buys a house without looking inside. And nobody should make investment decisions without doing their due diligence on the underlying fundamentals. But that is exactly what happens in an investment world increasingly driven by high-level asset allocation and utilization of passive, index-based products or strategies. Pundits look at aggregate index data and declare one country cheap (or some other action-inducing characteristic) vs. another. Maybe they are right, but maybe they are missing something too.
Index valuations tell one story, but digging deeper can tell another. For example, investing in Chinese state-owned or heavily influenced companies differs greatly from investing in independent entities that are incented by profits and treatment of their equity owners. Government-related businesses remain a huge influence on Chinese indices when weighted by market cap; these businesses trade at significantly lower valuations than their independent competitors (Exhibit 1). Based on economic performance, this discount seems justified. Growth and returns on capital have been far superior where government influence is less of a factor. This specific issue (stripping out SOE influence to compare like-for-like independent companies) carries over to many other countries and regions, particularly in emerging markets.
Exhibit 1: Government-related businesses trade at significantly lower valuations than their independent competitors
Source: CLSA
Another issue is that index composition can shift over time, making historical comparisons less relevant. For example, there have been growing calls for increased weight to Europe based on valuation and that region’s recent underperformance. After examining the data, we are not convinced that this is the right conclusion to draw. Yes, Europe has underperformed and yes, it trades at a lower current P/E multiple than the U.S. But how does that compare with history and, how might the details of the two regions’ corporate constituents matter? In fact, valuations are at average relative levels vs. recent history, despite the significant recent underperformance of European equities (Exhibit 2).
Exhibit 2: MSCI eurozone 12-month forward P/E relative to U.S.
Source: IBES
Digging a little deeper, one can also see that after accounting for index composition differences, the valuation disparities seem even less compelling. The table below examines valuations of trailing P/E ratios for the regional constituents within the MSCI All-Country World Index. The more one lines up like-for-like sectors and industries, the closer the valuations appear.
Source: Columbia Management Investment Advisers, LLC
In only a few areas does there appear to be much disparity. The biggest driver of aggregate differences is financials, almost 25% of the European index (vs. 18% in the U.S.), where at first glance, the U.S. names appear to be garnering a high premium. Again, digging slightly deeper, one finds that the disparity is also a function of sector composition. U.S. financials include a growing percentage of REITs, which are very high P/E names (not really the appropriate way to value them). Segmenting the sector ex-real estate makes the distinctions clearer and shrinks the differences considerably when one compares banks to banks, insurance to insurance, etc.
Source: Columbia Management Investment Advisers, LLC
One can examine many other factors to compare issues such as “core” Europe to U.S. as opposed to the peripheral names (Portuguese banks, Greek utilities, etc.) , but hopefully the broad point is clear. One can draw some very misleading conclusions about any disparate group by only looking at the aggregates. The real inefficiencies are far more likely to be down several less-examined levels. In our view, those who draw broad conclusions may be creating opportunities for those who can dig deeper for them. Those sorts of opportunities exist across the world.
Finally, I read this data as ongoing evidence that when discounted for index composition, U.S. equities are not trading at a significant premium to Europe on their current trajectories of EPS. The debate regarding cyclically-adjusted valuation ratios (such as the Shiller CAPE), is worthy of another discussion (the U.S. appears more expensive on these 10-yr rolling metrics based on recent superior margin performance that some observers see reverting). I am less concerned on that front in the intermediate term, but again, to properly research the question requires digging below the surface to understand the fundamentals beyond the superficial averages.
