So far, 2011 has been a year to forget for most markets in Asia. Japan is down 18% year-to-date. Hong Kong is off 17%. India has fallen 19%.
But this is not just an emerging market rout. Germany and France are down 24% and Italy is 30% in the red. Those numbers make the S&P 500’s 7% drop look almost respectable.
After an indiscriminate sell-off like this, investors can usually find value somewhere. So this week, I’ve taken a look at some of the cheaper and more expensive markets around. Interestingly, while Asia looks decent enough value, the real bargains might lie elsewhere…
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A simple measure of long-term value
Regular readers will know that I like to use price/book as a quick measure of how expensive a market is. The main reason for using price/book rather than the price/earnings ratio is that book value is much less affected by the economic cycle than earnings. Using price/book, we don’t need to worry so much about whether we’re at the peak of the cycle, the trough of the recession or somewhere in between.
The chart below shows price/book for the MSCI Asia ex Japan index since 1995. As you can see, price/book is currently 1.64, which is below the median over the period of 1.85. So on this measure, Asian shares are slightly cheap, though not outstandingly so.
Of course, price/book isn’t perfect and there are a few problems with using it like this. One is whether the history we’re comparing it over is long enough and typical enough to be valid.
I’d prefer to have several decades of data – but unfortunately, that’s as far back as this series goes. With many emerging markets, we’re lucky to have even that much.
However, some analysts have reconstructed longer-term data going back to the early 1970s (when Asia ex-Japan was essentially Hong Kong, Singapore and Malaysia from an international investor’s perspective). This shows a similar picture to the more recent data, with a long-run average price/book of around 1.7-1.8.
Another question is whether there has been any structural shift in corporate profitability that would change what the price/book should be. Price/book alone does not tell us what we should pay; that also depends on what earnings those assets can generate. A market with a return on equity (ROE) of 20% is obviously worth more than one with an ROE of 10%.
So has there been any change in Asia ex-Japan ROE that would justify a higher or lower price/book than in the past? We only have data since 1995 and that period includes the Asian crisis, which makes comparisons awkward. But looking at the chart, it seems that ROE is approaching a cyclical high but isn’t out of line with the past.
Thus if we assume that through-cycle ROE has remained roughly constant over time, we’re probably not being too optimistic. In fact, I would be inclined to think that’s slightly conservative, since many firms in Asia ex Japan are becoming better run and more efficient.
Only Southeast Asia is on a premium
So overall, Asia is looking slightly cheap. But what of individual markets? The chart below shows price/book versus the 15-year median price/book for various Asian markets and a few from elsewhere in the world. Those to the left of the red line are currently below their average, while those to the right are above.
Something interesting is immediately apparent. The expensive-looking markets are mostly in Southeast Asia – note Indonesia in particular way out on the right.
These countries were former favourites with international investors until the Asian crisis struck. After that, they were out of favour for a long time. But very clearly their rehabilitation is now complete if they can trade on premium valuations at a time like this.
The turnaround of Indonesia is especially remarkable. This is one of three markets in Asia that’s showing gains year-to-date (the other two are the Philippines and Sri Lanka).
Most other markets are looking cheap compared to recent history. In particular, India is towards the top – as discussed last week, corruption scandals have badly affected investor confidence.
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Japan might be cheap – the US is not
But to show the perils of looking at price/book or any valuation measure in isolation, let’s look at a few of the other markets on the chart. First, take Japan.
I frequently get told that Japan is cheap because its price/book is exceptionally low – currently a little below one. This misses one important caveat: Japan deserves a low price/book anyway because overall return on equity there is so poor compared to most of the rest of the world.
Still, the present price/book is exceptionally low, at more than 40% below its average since 1995. The problem is that it’s continued to plumb new lows for the past two decades.
Japan was extremely expensive in 1990. It’s taken a long time for valuations to come down. By now, I’d say it’s starting to look cheap. But it’s impossible to say how much further valuations might compress before they eventually hit the bottom.
And that brings us onto the USA. Looking at the chart above, the American market is apparently cheap relative to its history. Unfortunately, this is misleading because its recent history is of being exceptionally expensive.
The price/book ratio for the US peaked at over five in the final stages of the dotcom mania. And while it derated after that, it remained around three from 2003-2007; by comparison the MSCI Asia ex Japan has never had a price/book ratio over three at any point in its history.
Clearly, the recent average is distorted. For the US, we’re lucky to have much more data than for most markets and so have very long-run valuation measures to put the current situation into more context.
These include the cyclically adjusted p/e ratio (which attempts to smooth out the earnings cycle) and equity q (which, crudely put, is an improved price/book ratio with assets valued at replacement cost). And both suggest that the US market is around 40% overvalued.
By contrast, almost 40 years of price/book data implies that the MSCI Asia ex Japan is reasonably valued. You might wonder if valuations for Indonesia can be justified in the long run – and in the last few weeks, there have been signs that the market has lost some of its momentum. But there are plenty of other markets that are cheaper than they’ve been in a while.
Is there value in Europe?
This sell-off also seems to be bringing out value elsewhere in the world. Take a look at the three eurozone countries I’ve included in the chart above: France, Germany and Italy. All three are apparently cheap relative to history.
Again, 15 years isn’t a lot of history here. But for a longer context, let’s take a look at the cyclically adjusted p/e for both Germany and France. The chart below comes from a recent note by Dylan Grice of Société Générale.
As you can see, these measures are approaching the lows seen in the global financial crisis and the 1970s. So in contrast to the US, they are looking cheap by historical standards.
When it comes to Italy, I can’t say I know the market well. But however badly run the country is and however much trouble it is in economically, a price/book of 0.67 for a major industrial economy seems quite low and makes me wonder whether investors are starting to overreact.
Certainly looking at a chart of Italy's benchmark index, the FTSE MIB over the last few months, the eurozone crisis seems to be driving Italian shares lower and lower.
The problem with saying “Europe is cheap” is obvious: the banks. Many major european banks are in serious trouble if the eurozone’s struggling debtors default. Their market value now probably doesn’t reflect these risks – many may need to be bailed out by their governments, potentially wiping out shareholders.
So investors need to be selective. But I was surprised to see quite how badly shaken Europe looks compared with emerging Asia. It’s yet another sign of how the distinction between safe developed markets and risky emerging ones has become more blurred in the last few years.
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