What or where in the world is cheap?

- High beta/highly leveraged/speculative names seem to be performing best at the moment, especially in developed markets.
- Sentiment, at least as evidenced by ETF flows, seems to have turned in favor of GEMs since early Q2 and perhaps has begun to sour vis-a-vis Europe (although it's a little early to tell)
- Smarter people than me seem to think US high quality and perhaps EM equities offer value from here.
- On a PB basis there appears to be value in LatAm, Central and Eastern Europe and AXJ.

It’s worthwhile looking at what has and hasn’t been doing well at the moment. Goldman’s kickstart series shows that US style-wise companies with weak balance sheets, high beta and high operating leverage have done best YTD. “Quality” companies – i.e. those with strong balance sheets, high revenue growth… and notably low HF concentration (in the US, at least) – have been the worst performers, alongside those companies that generate significant revenue from the BRICs and EM.



It was also interesting to listen to Stanley Druckenmiller in this interview (about 17 minutes in) –
“As for IPOs we are right on the border of where were in 1999; 83% of IPOs that went public had not earned a dime, today that is 80%. It’s the only other time in history we’ve approached that”

To me that is also another facet of the move into more speculative, high beta names. I actually came across a good visualization of this a few months back in an investor letter I was sent by a friend.



Interestingly, the IPO market seems to breaking down a bit according to Renaissance Capital
US IPO Pricing Recap: 15 IPOs in the most active week since 2007; 66% ended at or below IPO price

Now admittedly, Alibaba IS extremely profitable, but I think it is worth keeping an eye on the company as a barometer of IPO and more general market sentiment: it’s huge (so will test appetite to take down lots of new issuance), and symbolizes a lot of what is ‘hot’ right now – E-Commerce and also it is Chinese (although it seems sentiment with China has been volatile of late).

Looking at the GMO forecasts one can see that they think US High Quality and Emerging Market equities offer the most promising seven-year returns. That to me is kind of the mirror image to what is currently hot (i.e. not US high quality! And BRIC/EM sales). Moreover, I would flag this – albeit dated – set of notes from a Seth Klarman speech at the Grant’s conference in October 2013 where Klarman notes big funds should be putting money into big blue chips (I take this to be roughly equivalent to GMO’s ‘US High Quality’ bucket).



So basically, with America high quality would be the way to go.

Meanwhile, Europe also shows a similar trend to the US in terms of stocks with EM exposure have underperformed with a performance bias towards the PIIGS and financial leverage, albeit nowhere to the degree that leverage has worked in the US. (Admittedly this is for peripheral Europe on reasonably well-deserved valuation and macro bounce factors – see Mark Yusko talking about it all in depth here)



Up until July European equities certainly seem to have been a reasonably consensus trade among institutional money, at least. (If one assumes ETFs tend to track institutional fund flows while mutual funds represent retail.) I guess one could argue that European equities then have some way to run as the retail money hasn’t got fully involved yet, although that reasoning (as opposed to valuation and MoS) is something of a greater fool line of thought TBH.




Now if one looks at trailing twelve-month ETF fund flows YTD then the Vanguard FTSE Europe ETF (VGK) has seen about $715mn in net inflows this year until end-July. HOWEVER, this actually masks a net 471mn outflow for July - the first time this year VGK saw a net monthly calendar outflow, and shortly after the Euro Stoxx 50 hit its YTD high in late June. So perhaps we are seeing some money starting to come off the table in Europe and a breakdown in the IPO market as some indication of a turning point? Or maybe it is just peeps unwinding positions going into les grand vacances? Who knows, but flows appear to have been very supportive of Europe so far this year I would observe.




So where is out-of-favor and could potentially represent good value?
Going back to the ETF fund flow data: Market Vectors Agribusiness has seen $2.6bn in outflows. This is quite incredible, as even GLD has finally managed to attract 263mn in inflows YTD! Now I am not sure if this means the underlying equities in MOO are cheap or not, but this probably warrants a look given pretty much every other asset class has seen net inflows YTD.

What about GEMs?
Flows and performance here has been interesting, while flows into DM has been solid and had been lifting markets there, GEM as a whole has performed remarkably well despite a large outflow of funds from the space. The table below is slightly old but you can see that EMs in general have suffered about a $20bn outflow, according to EFPR, while DM has seen about $86bn coming through the door as of mid-July.

Despite all this though the Vanguard EM ETF (VWO) is up 12% YTD; Europe (as represented by VGK) is flat  at -0.6% and SPY is up 6%.

Now the YTD outflows mask a turnaround in fortunes (at least as seen through ETFs) since Q2. A net $3.7bn outflow for VWO in Q1 swung to a net 1.3bn inflow in Q2 and a net $1.2bn came tumbling in through the gates in June alone.

That certainly suggests some change in sentiment to GEM on a broad basis is underway. Now how much value is there in the space left? CS releases a table of countries’ five-year average PBRs weekly in their Asian Daily note, culled from that and in order of biggest discounts below:

	Current P/B	5-year average	Discount
Brazil	1.5	1.6	-6.25%
Poland	1.3	1.4	-7.14%
Indonesia	3.6	3.9	-7.69%
Singapore	1.4	1.6	-12.50%
Korea	1.1	1.3	-15.38%
Colombia	1.6	1.9	-15.79%
Hungary	0.9	1.1	-18.18%
China	1.5	1.9	-21.05%
Chile	1.8	2.3	-21.74%
Czech	1.4	1.8	-22.22%
Morocco	2.7	3.8	-28.95%
Russia	0.7	1.0	-30.00%
Peru	2.3	3.5	-34.29%

As the table shows, the place is mainly full of central/eastern European, LatAm and AXJ names with Russia and Hungary the only two below book. GS research also shows a similar story of Sing, China, Korea and HK trading at the bottom of their 5-year PB bands. I would also note interestingly this table from the GS AXJ Kickstart last week.

Now I am not sure if global rates are going to go up but the Korean market is certainly cheap - check out Samsung, for example, and this would be an added bonus for Korean exposure.

Anyway, in conclusion, it looks like on a relative basis US High Quality/Blue Chips would be the place to go in DM; and in GEM value potentially exists in LatAm, parts of AXJ and central and eastern Europe.

Russian Equities

"Even after last week’s 2.5 percent rally, Russian equities have the cheapest valuations among 21 emerging economies tracked by Bloomberg. The Micex Index’s 12-month estimated price-to-earnings ratio was at 4.3 today, compared with a multiple of 10.7 for the MSCI Emerging Markets Index."

Berg September 23rd

The Oriental Speculator has been looking around for bargains globally and TBH finds itself hard pressed to get too excited about much. The one market that looks potentially appealing from a valuation perspective is Russia. 

Now there are many good reasons for Russia to trade at a discount to developed markets - see here for an incredible exchange between Russian management and a fund manager working at an overseas shop. Russian demographics are also horrible (and people complain about Japan!), corporate governance is non-existent, the state is run by thugs, they hate paying out dividends and the oil companies are going into slow run-off mode.

But 4.9x times earnings? That's cheaper than Pakistan (8.0x earnings - Pakistan is actually trading at a premium to it's five-year average!) and on par with where Korea traded at during the Asian Financial Crisis. Things may be crappy in Russia but they are not 4.9x earnings miserable, and Russia is far less of a failed state than Pakistan. Moreover, unlike Pakistan going into Lehman (or even now), or Korea going into the Asian Crisis, Russia runs a current account surplus. As discussed in the previous post, Russia is about 30% below it's five-year average book value, its currency looks cheap (see here for one view on why Russia would let its currency appreciate, I am not sure I totally buy the rationale but there is a logic to it) and the country is just very cheap on about every metric. 

Source: Credit Suisse

The OS was also intrigued to hear on a podcast with Mebane Faber (go to around 28 minutes 30 seconds in - skip the first 20 minutes of drivel, and focus on the interview. Some smart points made by Meb and actually the interviewer from time-to-time) that Russian energy companies were among the cheapest sub-segments globally in the equity universe - on par with Greece! Jim Grant was also on CNBC a month and half back fielding the usual repertoire of silly questions from the interviewers, but he touched on the issue of he Russian oil plays.

Reflecting upon this then, it shouldn't be too surprising then that the Russian market itself is dirt cheap as the MSCI Russia index is very commodity-heavy at 64% (basically, energy); then banks at 17% and telcos at 9%.

 

source: MSCI

However, given the lack of Russian language skills (the Oriental Speculator studied - if it could be called that - Russian for one year at high school and was frankly horrible at it) and a detailed understanding of the politico-economic dynamics in Mr. Putin's playground, the Oriental Speculator is a little wary of going for single name picks and is leaning towards the funds route. 

So far, the attention of the OS has been focused on the ETF channel and the MSCI Russia Capped Index ETF options. The MSCI Russia Capped Index is basically the same as the MSCI Russia Index except MSCI try to prevent any one stock becoming disproportionately overweighted in the index make-up. Which in Russia's case is probably quite sensible as Gazprom alone is 23% of the index and Sberbank is 14% (basically, Sberbank IS the financials sector in Russia). 

For the MSCI Capped at construction and at each rebalancing, if the weight of the largest company in the sister MSCI Russia Index is greater than 30%, its weight in the MSCI Capped gets stopped out at 30%. The weight of the remaining Group Entities are then increased in proportion to their weight prior to such capping. The remaining stocks are capped at no more than 20% weighting and so on. So basically, the two largest names in theory will never exceed 50% of the index. Further deats here.

There are, at least, two ETFs out there doing this index:

1.  ishares MSCI Russia Capped (ERUS)

2. db x-trackers MSCI Russia Capped Index ETF (3027.HK)

The Oriental Speculator has after decided the db option is probably the more favorable of the two given it trades in HK and thus does not get hit by capital gains. As far as the OS is aware, this is the only Russian ETF listed in HK (HKEX has a list of the ETFs that trade on the exchange available here.)

Within the framework of the capped index, the db ETF tweaks things a little further, and caps an individual company's weight to 25% and quarterly at 20%. That actually means at present the capped index and db's etf is exactly the same as the normal MSCI Russia index, which itself is basically very similar to the MICEX index (albeit, it appears to be a bit higher beta).

iShares takes a slightly different tack as it then uses a 25/50 strategy on the capped index:

"The MSCI 25/50 Indices take into account the investment limits required of regulated investment companies, or RICs, under the current US Internal Revenue Code. One requirement of a RIC is that at the end of each quarter of its tax year no more than 25% of the value of the RIC's assets may be invested in a single issuer and the sum of the weights of all issuers representing more than 5% of the fund should not exceed 50% of the fund’s total assets."

This - the Oriental Speculator presumes - gives rise to the slightly different constituent weights for the ETFs and thus valuations. For while the 25% rule doesn't appear to be breached in the iShares case, the sum weight of all 5% constituents breaching the 50% mark does appear to be.

Source: iShares

Now, the OS is not sure how iShares actually compute the weightings for the stocks over 5% in the actual underlying, but given the capped index is already messing with the original index then iShares is layering in more voodoo on top; and the OS is not a US citizen so doesn't care about the RIC code, the OS doesn't see the iShares as having a compelling selling point over DB's etf in the composition field. (That having said, OVERALL sector weightings are similar for both, it's just what they've chucked in there to get the weightings is different.)

Source: iShares

Source: Deutsche

An obvious problem though is that the iShares ETF is also SUBSTANTIALLY more expensive than the index - although this is probably be due to iShares favoring growthier shares in its rebalance. Now the below data points are from August 30th but the market has rallied since then so I am guessing the iShares ETF is probably MORE expensive than it was back in late August. (Note also the MSCI Russia is not quite the MICEX but tracks it pretty well, albeit it seems to fall more on the down-legs than the MICEX.)

Source: Deutsche

Source: iShares   

Meanwhile the db ETF/capped index's PE went for 5.1x back on August 30th. So you're getting cheaper and more faithful exposure to the Ruskies via ze Germans. 

Source: CapIQ

Now the one issue that could be a wrinkle, is the db option is a synthetic etf. What is a synthetic etf I hear you ask? Some deats on these here. The issue with synthetics is that you are generating your returns via a swap agreement, and thus are exposed to counter-party risk. 

However, there have been a number of improvements in ensuring that investors are protected from the counter-party blowing up. The principal form being a funded swap model and the Russian Capped appears to be one of these - see page 24 of this Morningstar document. So the OS suspects that this is actually not a huge concern and DB is generally considered too big to fail (although one wonders if things get really sticky would Fraulein Merkel care that much about saving overseas investors in a Russian ETF... probably not).

Thus, out of the ETF names the OS can find that allow one to play Russia, the HK ETF is probably the better option: no CGT, and it represents a more faithful and cheaper way to play in Mr. Putin's playground (assuming one is comfortable with big exposure to commods and banking). Still the OS is gonna take a poke around to see if there are any closed end funds out there trading at interesting discounts.

A more granular look at some of the cheaper countries

Countries that are at a price to book well below their own average typically do better than average going forward.” Steve said. “I’ve found that almost all countries come back within six years, absent confiscation.” A country’s current price to book value relative to its historical average — normalized to adjust for changes in sector mix and political risk over time — became the model’s most heavily weighted factor."

	Current Trailing PBR	5-year Average	DISCOUNT/PREMIUM
Morocco	2.1	4.3	-51.2%
Peru	2.1	3.7	-43.2%
Czech	1.2	1.9	-36.8%
China	1.4	2	-30.0%
Russia	0.7	1	-30.0%
India	2.3	2.9	-20.7%
Hungary	0.9	1.1	-18.2%
Brazil	1.4	1.7	-17.6%
Chile	1.9	2.3	-17.4%
Korea	1.1	1.3	-15.4%
Egypt	1.5	1.7	-11.8%
Poland	1.3	1.4	-7.1%
Turkey	1.6	1.7	-5.9%
Indonesia	3.5	3.7	-5.4%
Colombia	1.9	1.9	0.0%
Taiwan	1.8	1.8	0.0%
Malaysia	2.2	2.1	4.8%
Mexico	2.9	2.7	7.4%
South Africa	2.5	2.3	8.7%
Thailand	2.3	2	15.0%
Philippines	3.2	2.7	18.5%
Pakistan	2.6	1.9	36.8%
Source: Credit Suisse

Using the Truffle Hound strategy and the Credit Suisse weekly valuations one can see that Russia, China, the Czech Republic, Peru and Morocco are all cheap. More broadly, using earnings and their 5-year average multiple, Taiwan and Korea look cheap as well as Europe (specifically France, Italy, Spain, Norway and Germany).

"mean reversion of even the most undervalued country could be offset by declines in that country’s currency... two factors that worked well and were relatively easy to calculate. The first was a country’s current account balance. “Bad things tend to happen to countries with large current account deficits, and good things tend to happen to countries with large current account surpluses,” he said. The second was its currency’s purchasing power parity (PPP) relative to other currencies... Steve started out by simply using the Big Mac Index to measure a country’s PPP, but he later switched to IMF statistics, adding a linear adjustment for GDP per capita."

Here's the Big Mac Index, with the relevant countries flagged and then a closer look at the trends in PPP over/undervaluation. For the full-blown cool interactive graphics try here


Now I'm unsure what the linear adjustment TH uses to the data to adjust for GDP/capita is - I may try and reverse engineer this at some point. But one can eyeball the countries and offset this in one's head against GDP/capita vs. the US to come up with a crude adjustment

MOROCCO

For some annoying reason, while Morocco does have MacDonald's The Economist doesn't calculate le Big Mac du Maroc's PPP and the Moroccan MaccyD's doesn't say what the effing things cost either!! However, it does look like a Big Mac cost about 47 dirhams back in April 2012 and perhaps as much as 65 dirhams in April 2013, according to Twitter. 

At the current (as of 12/08/2013) FX rate a $4.56 Big Mac should be 38.2 dirhams. Whichever way you cut it a 47 or 65 dirham Big Mac looks very overvalued, either about 23% or 70%, and this is more problematic when you consider that PPP should in theory understate the value of a lower GDP-capita country due to the non-tradeable goods sector. Indeed back in 2006 - when The Economist actually did put the Moroccans in the index - the Dirham actually seemed reasonably valued/slightly undervalued.

The overvaluation appears to be primarily due to the Moroccans pegging the dirham to a basket of currencies (page four - Natixis does some pretty decent research on Morocco btw). As you can see from the 10-year USDMAD chart the Dirham hasn't really moved over the time frame. My calculation off the Big Mac index implies the currency should be either at 10.31 or even 14.25 to the dollar. Even the lower estimate is way above where the MAD has traded at over the past decade.

Having not looked at their FX reserves I wonder how long the authorities can keep this up for? Moroccan stocks better be cheap to compensate for this, I am tempted to file in the wastepaper bin for now... (on a side note I've always found it puzzling how Arisaig can be comfortable in investing in things like Central Laitiere and Brasseries du Maroc at such high multiples, especially if the macro looks so rickety)



PERU

Peru is slightly harder to pin down, they've clearly been running higher current account deficits since 2006, but this has been offset by brisk economic growth. However, I suspect a fair amount of the growth has been due to it being reasonably levered into the Chinese commodity supercycle, which is probably drawing to a close so there is scope for the current account to deficit to deteriorate as a % of GDP. That having said, the market is clearly cheap, on a PPP-basis the currency looks undervalued (unlike Morocco); and the CA deficit as a % of GDP doesn't appear to be insanely onerous at this point.

CZECH

The Czech Republic is notable for both its undervaluation on a historical PBR  basis (-37%) and the PPP undervaluation against the dollar. They do run a current account deficit, but the thing seems to hauling its ass out of the pit, making successively lower lows (sound like a bit of a chartist there) of late as it trends back to surplus. Indeed, the deficit seems to be reasonably cyclical. Not knowing anything about their economy I wonder if they are continuing to climb out of the current account deficit pit or are about to fall back into it?


RUSSIA

The ruble seems to have been constantly cheap on a PPP basis over the past decade, and seems to be nearer the lower end of its historic PPP-trading band, for what that's worth. Current Account surpluses though have been coming in smaller as a % of GDP for a while, although the actual current account expressed in USD is pretty volatile and seems (to my eyeballs, at least) afflicted by a good deal of seasonality. That having said, they still run a solid current account surplus, have an undervalued currency and their stock market is not just cheap in real terms (i.e., less than book and low single-digit earnings) but also on a relative historical basis.

Here are two interesting pieces on Russia:

1. The market being cheap here at ETF Trends

2. The country being a source of relative calm vs. other GEMs as noted by the FT

“The glory of Russia is that it runs a current account surplus and the fiscal deficit is very low. Moreover, as a result of developments in the Middle East, oil prices are holding up” said Kingsmill Bond, chief strategist at Russian state bank Sberbank’s investment banking arm. “Consequently the rouble is able to avoid the pressures faced by other currencies.”

EUROZONE

The Economist's Big Mac index flags the Euro as at approximately fair value, although it doesn't say what they took as the Eurozone average burger price in their data set. Although it would appear to be the cost of ein Big Mac in Deutschland is EUR3.64.

Thankfully for me Bruegel have a done a lot of the heavy lifting and analysis in  a series of interesting posts here and here. The basic thrust seems to be prices in Italy and France require some adjustment (i.e., the French and Italian Euro/prices are overvalued relative to the rest of the zone). Spain and Greece seem cheap, and Germany fairly valued. 

There seems to be quite a lot happening in the Eurozone so I am going to handle the place in a separate post looking at the current account deficits and try and get some historical data on the PBR discounts there. 

TAIWAN 

Taiwan runs some pretty punchy current account surpluses and has been sporting a very undervalued FX rate for a while too. If anything, it looks to be on a long-term downtrend. On a PBR basis though it looks reasonably valued. 

KOREA

Korea on the other hand, is trading well at the bottom of its five-year PBR band based on GS' kickstart data and it's been running some decent surpluses with a consistently cheap FX rate. This could be quite a promising market.