How to Properly Value a Country's Equity Markets
A Guide for International Investors
Suppose that you’re interested in buying an exchange-traded fund (“ETF”) covering a given country’s equity market and have to choose between one country with a 2.2% gross domestic product (“GDP”) growth rate and another country with a 7.7% growth rate. You may be tempted to evaluate a country based on its economic growth since an economy growing at a faster rate should theoretically house companies growing at a faster rate.
It's More Than the GDP
Unfortunately, evaluating a country’s investment merits often has little to do with its economic growth rate. The first country in the aforementioned scenario is the United States, where the S&P 500 (NYSE ARCA: SPY) rose 6.75% in the first part of 2016. China is the second country mentioned and its FTSE Xinhua 25 (NYSE ARCA: FXI) rose just 2.8% over the same timeframe – or roughly a third of the performance despite nearly three times the economic growth.
In this article, we will take a look at how international investors should go about valuing a country’s equities in order to maximize their risk-adjusted returns.
Many investors are familiar with the concept of a price-earnings ratio, which measures a security’s valuation based on its price and earnings per share. Lower price-earnings ratios are associated with undervalued securities since investors are paying less per share for a given unit of earnings.
Value investors believe that purchasing undervalued equities will produce returns in excess of those generated from purchasing a broad basket of securities.
These same metrics can be applied to entire equity markets by determining the average price-earnings ratio for a group of securities. For instance, the S&P 500’s price-earnings ratio stood at approximately 25.17x, as of August 2016.
Countries may be deemed overvalued or undervalued depending on their aggregate price-earnings multiples, which might make them more or less attractive than other countries investors may be considering.
In addition to the price-earnings ratio, there are a number of other metrics that investors can look at when valuing equities and countries. Investors may also want to normalize these ratios between countries by accounting for things like inflation and currency fluctuations. Metrics like book value could also take a look at tangible discounts to fair value, while others like the P/E to growth (“PEG”) ratio account for growth rates in valuation.
Most companies in the S&0 500 may have a fairly established risk profile, but when it comes to international investing, risk plays a large role in determining fair value. For example, emerging markets may trade at a discounted price-earnings multiple compared to developed markets, but the greater risks associated with these markets may justify the discounted valuation since investors are facing a greater risk of loss from these countries.
Investors must adjust their valuation models based on these risk factors using any number of different techniques.
While some investors look at these factors from a qualitative lens, there are a number of quantitative measures that can be used, such as the beta coefficient that measures a security’s volatility over time. These risk measures can be used build an equation that adjusts valuations in a standardized way across various countries.
There are also a number of valuation metrics that build in these factors. For example, the Sharpe Ratio measures the average rate of return minus the risk-free return and divides that by the standard deviation of return on an investment to yield a risk-adjusted measure. These kinds of measures can be used as a standard of comparison across countries and asset classes and include a ‘proven’ technique to assess common risks.
The Bottom Line
Investors must look well beyond a country’s economic growth rate when evaluating whether or not to commit capital.
Rather than looking at headline economic indicators, it’s important to take a closer look at its stock market valuation and adjust the valuations based on the risks involved with the given country. It’s not uncommon for fast-growing countries to have overly risky equity markets and/or excessive valuations given their future growth potential.
The best starting point may be using a number of common metrics that account for both valuation and risk factors, such as the Sharpe Ratio.