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Valuations Look Attractive for International Small Caps
By Jafar Rizvi, CFA, Analyst and Portfolio Manager | July 25, 2024
International small caps continue to trade near their cheapest valuations relative to international large caps since the 2009 global recession. Although they are also valued at a discount to US small caps, the spread hasn’t changed much over the last two decades.
Even relative to their own historical valuation multiples, international small caps look cheap, with the MSCI All Country World ex US Small Cap Index trading at a price-to-earnings ratio of 14.8, 19% below its 2021 peak. This indicates there is an attractive valuation opportunity for small-cap investors, especially with respect to some high-quality, fast-growing international small companies.
By Scott Crawshaw, Analyst and Portfolio Manager | July 23, 2024
Investors continue to pour into the Indian stock market. The Nifty 50 Index, up more than 10% year to date, continues to reach new highs. Much of that is due to gains from cheap stocks, including many state-owned enterprises (SOEs) benefiting from government spending. Finding high-quality companies in the Indian market at attractive valuations therefore has become difficult.
One way to understand valuations is the required rate of return, which measures the minimum return for which investors will be willing to allocate capital. An outside view that we refer to is a valuation framework from UBS’ data-analytics platform HOLT that backs out the implied required rate of return investors are demanding from securities in the market, referred to as the market implied yield. At a country level, India’s median market-implied yield of 1.4% is at an all-time low for India and an all-time high premium relative to the broader EM index.
This is underscored when we look at the valuation across sectors. Current valuations are at the extreme point of the five-year range in all sectors, with the sole exception of Financials.
While India’s stock valuations remain high, regulators have highlighted a potential bubble, particularly in the mid-cap segment, and have attempted to limit further domestic flows into these stocks. And with regards to SOEs, we suspect the fundamental weakness of these companies will become apparent over time and that the superior fundamentals of high-quality, fast-growing businesses will once again be reflected in stronger stock prices.
By Ferrill D. Roll, CFA, Chief Investment Officer | July 18, 2024
Examining the 1.2% gain of the MSCI All Country World ex US Index in the second quarter, the biggest style effect is evidenced in Japan where there continues to be a strong bias in favor of cheaper stocks, which outperformed the most expensive stocks there by nearly 700 basis points (bps). That brings the advantage for cheaper stocks over more expensive stocks, which tend to be higher-growth and higher-quality companies, to a 1,500bp difference year to date.
As we’ve explored previously, the performance of certain factors can shift markedly in just a few years. Time will tell if this value rally gives way to better performance for more expensive, higher-quality, faster-growing companies in Japan.
Outside of Japan, there didn’t appear to be strongly defined style patterns. The heatmap above shows that there weren’t consistent headwinds or tailwinds when examining performance by measures of quality, growth, and value. There did, however, appear to be a style divergence between regions.
In the Eurozone, the fastest-growing stocks performed in line with the slowest-growing stocks. In emerging markets, the concentration effect of heavyweight stocks, including TSMC and Tencent, flattered the returns of the highest-quality, fastest-growing cohorts, even while cheaper stocks outperformed. In Asian markets excluding Japan, the most expensive stocks only modestly outperformed the least expensive this past quarter.
By Anix Vyas, CFA, Analyst and Portfolio Manager | April 25, 2024
Japan remains the single-largest country weight in the MSCI All Country World ex US Small Cap Index. However, the country’s weak economic growth, aging population, tight labor conditions, and chronic deflation have long made it a challenge to find high-quality, growing companies there.
Government regulators and the Tokyo Stock Exchange recently introduced a flurry of reforms aimed at improving corporate governance and shareholder returns. As discussed in our fourth quarter 2023 report, these actions have primarily benefited the cheapest stocks, given that they are typically associated with the least-profitable and slowest-growing companies. Additionally, the Bank of Japan has raised short-term interest rates, ending its decade-long era of negative rates. This landmark move boosted Japanese value stocks in the first quarter, further exacerbating the region’s style headwinds.
As the chart above to the right shows, the cheapest stocks in Japan outperformed the most expensive by nearly 1,600 basis points in the first quarter. For the trailing 12-month period, it’s worse: The spread between the most expensive and cheapest quintile was nearly 46%. The left and center charts show that investors also have favored slower-growing and lower-quality companies.
We don’t know how long this value rally will persist. In the short run, some of the changes have clearly exacerbated, and could prolong, style headwinds for higher-quality, faster-growing companies. But over the long term, the changes in Japanese business policy and mindset are positive developments. As more businesses raise their standards, the number of high-quality companies in Japan may increase.
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