Homeland Securities

Does the value premium stop at border crossings?

By: Brian Chingono & Dan Rasmussen

Reams of studies suggest that consistently holding the cheapest and most thinly traded stocks within a country’s market provided investors with a healthy premium in the long haul. Purchasing pessimism (as reflected in low prices) pays off on long horizons. But does the same apply between countries?

Several recent studies suggest that it does.

In their 2018 article in the Financial Analysts Journal, two researchers, after testing 23 developed markets based on relative value since the 1980s, found that “a portfolio based on country indexes with favorable factor exposures significantly outperforms, both economically and statistically, the world market capitalization portfolio.” A more recent paper in the Journal of Portfolio Management, testing 73 developed and emerging market equity indexes according to various valuation characteristics, found similar results, with the best valuation metric for predicting country-level relative returns being TEV/EBITDA.

We ran this through the simplest check we could think of on the three largest developed equity markets where we are able to obtain good monthly accounting and valuation data going back as far as 1997: North America, Europe, and Japan. Did consistently following an allocation strategy of owning the cheapest markets perform better than a naïve 1/N (equal diversification)? And did owning the cheapest stocks in the cheapest markets perform better than that?

The “cheapest country” allocation model invested 100% in the below regions over time based on relative TEV/EBITDA valuations at the end of the prior month.

Figure 1: Exposure by Region to Cheapest Market (by Median TEV/EBITDA Multiple)

Source: Verdad, Compustat. All listed stocks in each market >$25M, excluding REITS and financials. Growth and Value measured as the top and bottom 30% of each market. Our “Developed Europe” index excludes most of the cheaper eastern European countries.

As in the studies cited above, the valuation premium did not appear to stop at border crossings. Consistently holding a diversified basket of all stocks spread across all regions (1/N) returned about 9%, holding all stocks in the cheapest region returned about 13%, and holding the cheapest stocks in the cheapest region returned 19.5% as shown below.

Figure 2: CAGR of 1/N vs. Intra- and Inter-Country Value (TEV/EBITDA) Tilts since 1997

Source: Ken French 5x5 quintiles on price/book since April 1997. By contrast, buy-and-hold equal-weighted returns to the market in each region on this horizon were 9.9%, 8.9%, and 5.5% for North America, Europe, and Japan, respectively.

Consistently holding the cheapest and most thinly traded stocks in the cheapest region compounded more than 2x a regionally diversified portfolio or a buy-and-hold small value strategy in any single region. And given that the model required that you switch geographic allocations relatively infrequently, as shown in Figure 1, the turnover and incremental trading costs behind those premiums weren’t that far off from that of a buy-and-hold small value strategy that stayed within a single geography for almost three decades.

This may be surprising as the model is quite extreme, with Japan being your only exposure after April of 2007, when the median stock valuation in Japan dropped below the other regions.

And on an analytical level, popular narrative economic history would suggest that this would be a poor allocation model, given that we know (ex-post) that economic growth rates in the US dominated Japan’s nearly 0% real GDP growth in the latter half of the horizon and US multiples expanded during this horizon while Japanese multiples contracted.

Indeed, the headwinds from relative multiple compression for Japanese stocks have been quite extreme since 2007, as shown below.

Figure 3: Multiple Expansion (Compression) Since April 2007 (TEV/EBITDA)

Source: Compustat. Calculated as in Figure 2. Deep Value is the cheapest 10% of each region.

But even with these headwinds since 2007, consistently investing in the least crowded and cheapest stocks in the cheapest developed market (Japan) outperformed holding the cheapest stocks in the more expensive regions for the next 10 and even 15 years, according to the Ken French indexes.

Changes in relative multiples explain the vast majority of shorter-horizon relative returns, but over longer horizons, entry prices (at ~40% lower in Japan since 2007) appear to have mattered more.

It may be tempting to think that one region is predestined to dominate the others, making their equity markets more attractive. In the 1970s and ’80s, Japan looked quite undefeatable. In the 1990s and since 2018, the US has given a similar impression. And, analytically, when it came to consensus predictions of metrics like GDP growth, trade strength, technological development and population increase, this was quite often correct. But in the meta-analytical world of markets, prices appear to have trumped accurate technical forecasts.

Below are the trailing and forward five-year returns to the international small value portfolio (Japan and Europe) versus the North American small value portfolio. We show all of the data for the MSCI factor indexes going back to 1994.

Figure 4: International Minus North American Small Value (5Y Relative Returns)

Source: Compustat. MSCI factor indexes. International is 50% Japan and 50% Europe.

Trailing five-year returns were inversely correlated with future five-year returns, and it usually paid off to bet on the region that had worse trailing performance.

Indeed, in the simple model shown in Figure 1, you switched to a cheaper region 16 times since 2000. And the model loved yesterday’s “losers.” Only one time did you switch to a “winning” geography, as judged by three-year trailing excess returns. 15 of those 16 switches required that you buy “loser” regions that had underperformed the best performing region by 48.4% on average over the last three years! This is because blazing relative outperformance by “winning” regions was often accompanied by dramatic increases in relative multiples.

Recent talk of the “death” of international stocks after a bout of underperformance seems off to us. This is because, historically, this logic would have served you poorly as a long-term investor. And because, once again, relative multiple expansion has accompanied the recent relative outperformance of the “winning” region.

2022 has kicked off with some harsh reminders of the real downside risk implicit in multiyear valuation increase trends. The MSCI growth indexes are solidly down another 10–20% in all developed markets relative to value stocks. China, a case study in high growth accompanied by ever higher valuations for a decade, has now lost almost half of its value on the MSCI China index since February of last year. Some of the biggest titans of wide moats and dominant market penetration (Facebook, Netflix, and Snapchat) have all lost about half of their value in the last year. What just yesterday seemed almost undefeatable on an analytical level has very rapidly succumbed to yesterday’s buildup of valuation risk.

And in the long haul, where irreducible uncertainty trumped analytical predictability time and time again, outperforming the market required that you repeatedly avoid valuation risk and discount predictive inferences based on what John Bogle called the “speculative return”: one driven predominantly by the short-term impact of multiple expansion.

This appears to have been true both within and among markets. For the long-term investor, recent commentary on the “death” of international stocks among global markets may be as premature as the “death” of value was within regional markets just two years ago. Valuation risk and the valuation premium do not appear to have stopped at border crossings.