Foreign Stocks: Looking Beyond Index Valuations

There is a lot of talk in the financial sphere about how much cheaper foreign shares are than their American equivalents.  On an index-level basis, this is somewhat beyond dispute; by every metric, the MSCI EAFE Index (EAFE = Europe, Australasia, & Far East) is considerably “cheaper” than the S&P 500:

(data from Morningstar as of April 2016)

That the EAFE should be considerably cheaper than the S&P is little surprising given that, over the last ten years through April, the S&P 500 generated a cumulative return of ~95%, whereas the EAFE generated a cumulative return of roughly 14.5%.

You can see from this JP Morgan chart below that while this century has at times been frustrating for US investors, foreign investors have generally fared much worse with the EAFE being below levels of sixteen years ago:

But looking at the EAFE Index doesn’t tell the whole story of foreign equity valuations.  For one, it is heavily weighted in financials (~23.33%), which have the lowest P/E of any global sector at just above 10 times the last twelve months’ earnings.  In the S&P 500, financials are also the cheapest sector at around 13.65 times earnings, but they make up a smaller part of the market at around 16%.

Considering the difference in sector weights, I wondered what the various global sectors would look like in isolation from a valuation perspective.  The best way to do that was by using the SPDR sector ETFs and plugging them into Morningstar.  Here were the results as of April:

Obviously, you can see that certain sectors such as consumer staples and healthcare are considerably more expensive than the index as a whole.  What’s more is that, at least on a P/E basis, they are not valued much lower than their American counterparts (again, as of April):

It’s not surprising that valuations for consumer staples and healthcare are at a premium to the market both abroad and domestically; they have been top performers globally since 2008 through April:

Note:  I excluded Telecom from this table as the data I have go back only to 2011.

So, yes, foreign shares are generally cheaper than American shares.  However, in my opinion, it behooves investors to look beyond simple valuation metrics to understand better exactly how their allocation to foreign markets are invested and to what headwinds they may be exposed.  Simply declaring an asset class such as foreign equities “cheap,” in my opinion, is insufficient.  Consider that foreign financials (using the IPF ETF) seem alluringly cheap, but they come with elevated risk; the 5-year standard deviation for IPF is 18.28.  Going back to July 2008, IPF’s worst 3-year performance was -7.6%.  Compare that to the relatively “expensive” foreign consumer staples using the IPS ETF.  For IPS, the worst 3-year performance since July 2008 was 4.39% with a standard deviation of 12.23, a third less than financials.