Swedish Fish

Are cheap Scandinavian valuations a sweet red herring?
 

By: Brian Chingono

Sweden, the land of ABBA, meatballs, and, of course, the iconic Swedish Fish candy, may not be the first country that comes to mind when you think of global investment opportunities. Yet a new report from quantitative research firm Research Affiliates identifies Sweden as the developed market with the highest 10-year expected returns. And while the Swedish market is small, our internal valuation screens are also finding disproportionate opportunities in the land of lingonberries.

Europe generally is cheap. Today, Europe’s CAPE ratio is 20.4x versus 28.2x in the US, according to data from Barclays. This means Europe’s CAPE valuation today is 28% below the US, a discount that is nearly double the 15% historical average discount since 1981. On the right axis of the figure below, we measure the European discount in percentile terms, as illustrated by the gray line. Today’s European discount of 28% is in the 76th percentile of recorded history since 1981, having recently narrowed from the 95th percentile in October 2022.

Figure 1: European Discount Relative to the United States (1981—2023)

Sources: Barclays and Verdad analysis

Wide valuation spreads have historically presaged high future returns. Over four separate two-year periods beginning in September 1992 and June 1996, 1999, and 2003, Europe outperformed the US by 5.7 percentage points per year, on average, as valuation spreads narrowed over the course of two years. And over the six months between October 2022 and March 2023, the European equity market has returned 31.8%, more than double the US market’s return of 14.8%, according to data from Ken French.

Sweden isn’t the cheapest market within Europe. That distinction goes to Poland, another place we believe value investors are finding attractive bargains. Sweden’s CAPE ratio of 20.1x today is slightly below the European market at a 2% discount. But Sweden usually trades at a significant premium to the broader European market. Sweden has a highly skilled workforce, a stable political environment, and a business-friendly regulatory framework, as well as a number of market-leading global companies like Volvo (which today trades at 8x EBITDA), Ericsson (which trades at 5x EBITDA), and H&M (which trades 11x EV/EBITDA). Sweden is also the original home of IKEA (which is privately traded), and the country remains a core element of the company’s brand. In the table below, we present a valuation spread analysis where CAPE ratios for each major European country are measured relative to the 20.4x CAPE ratio of the overall European market. The table is ranked by valuation percentile relative to recorded history since 1981.

Figure 2: Valuation Spreads Within Europe, Ranked by Percentile (March 2023)

Sources: Barclays for CAPE ratios, Research Affiliates for expected returns, and Verdad analysis

In light of the geopolitical events of 2022, we think it’s relatively obvious why Poland and Germany are trading at a discount to the European market, given Poland’s proximity to the conflict in Ukraine and Germany’s unprecedented recalibration of energy supplies. But none of those arguments apply to Sweden, which is located in northern Europe and generates 91% of its electricity from nuclear, hydro, and wind power. Instead, the uncertainty in Sweden appears to stem from unique imbalances in its housing market, where roughly 71% of new mortgages are issued with floating interest rates (for context, only about 14% of new mortgages in Germany are issued with floating rates). The uniquely high sensitivity of Swedish households to rising interest rates has economists concerned that a decline in household spending could tip Sweden into recession this year, with a 0.8% expected contraction of GDP in 2023, making Sweden the only country in the 27-member European Union likely to see negative GDP growth for the full year, according to the European Commission.

But we think these uncertainties are already priced in, and we believe investors will be compensated for bearing these uncertainties over the long term. Research Affiliates breaks each country’s expected equity return into dividend yields, real earnings growth, and expected changes in valuation.

Figure 3: Components of 10-Year Expected Returns (March 2023)

Source: Research Affiliates

Sweden’s expected real growth rate is the highest among European countries, which appears to be driven in part by a recovery from the current economic doldrums caused by rising mortgage costs. The country’s expected valuation change is second only to Poland, given how cheaply Sweden trades relative to its own history. And Sweden’s 3.1% dividend yield is close to the average for European countries.

Overall, we think that the low valuations in Europe relative to the US warrant a consideration of overweighting Europe in a global asset allocation today. And one doesn’t have to enjoy eating fermented herring or ice swimming to be attracted to the historical discounts on offer in countries like Sweden.