Digging Deeper For Market Valuations

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Digging Deeper For Market Valuations

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

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