MCD - AVDV: An International Solution To An Overpriced U.S. Market?

2023-03-08 16:23:51 ET

Summary

• In a recent article I suggested international stocks as an alternative while the cap-weighted S&P 500 completed a downward rerating of high-priced growth stocks.
• The Vanguard FTSE Europe ETF with little tech or overpriced growth might serve as a direct alternative to the S&P 500.
• An excellent and aggressive idea is actively managed Avantis International Small Cap Value ETF (AVDV), which is absurdly cheap by all statistical measures.
• AVDV focuses on low price-to-book ratios (excluding Goodwill) and a high cash-backed measure of profitability.
• Risks include a rising dollar which moves inversely to international stocks while some legendary investors dispute the need for international investments, but the price differential is currently large.

In this recent article , I expressed doubt that the U.S. could begin a new bull market from its present level. While generally expensive, the S&P 500 ( VOO ) seems particularly burdened by the downward rerating of a dozen or so large growth stocks which have a powerful influence on the price of the overall index. In the conclusion I mentioned a few alternatives. The easy one was bonds, which are quite cheap compared to stocks. The last alternative I added - international stocks. In the comment stream I mentioned that I might expand on this idea in a future article. At the time I made that commitment the idea of diversifying away from an overpriced U.S. market to international markets looked easy. It proved to be everything but. Exact equivalents for comparison (U.S. to International) proved harder to find than I had expected. It took quite a bit of thought but I finally found two international ETFs which might serve as alternatives to the S&P 500 Index as well as the Vanguard Total Stock Market ETF.

Is it really necessary to diversify internationally? Many intelligent and well respected investors have not thought so, John Bogle among them. Bogle thought foreign stocks added currency risk, economic risk, and societal instability risk. To the best of my knowledge, Warren Buffett has never tackled the subject in theory but has voted with his feet, staying away from foreign commitments except for 5% each of five Japanese trading companies bought in 2020. So far Buffett's one foray into international investing has been a winner. The late Fayez Sarofim, a famous investor in U.S. blue chips, dismissed international investments as unnecessary because many large American companies made half or more of their profits overseas.

International allocation also has its advocates. The model portfolio of the late David Swensen, the Yale endowment guru, had a permanent 25% foreign equity allocation (10% emerging), just 5% less than his suggested U.S. percentage, while the value firm Research Affiliates often pushes for international value and especially deep value. The same is true of Jeremy Grantham's GMO which produces those seven-year return tables which are always early but almost always right. Its latest such chart has grim prognostications for all future return categories except international small caps, emerging, and emerging value.

EXHIBIT 4: GMO 7-YEAR ASSET CLASS FORECASTS*

Source: GMO

It's hard to miss in the above chart that there may be a strong second motive for international investing at the present moment. The only four asset categories which appear currently attractive (U.S. bonds might be upgraded on the next chart) are all international with a particular focus on small cap and value. Small cap and value are often linked, and to significant degree the recent tilt toward U.S. value has been accompanied by U.S. small caps. A combination of International Value and International Small Caps should heighten this potential for outperformance. If that's the case, one might seek to combine a large cap international ETF with value characteristics and combine it with a small/mid cap ETF with perhaps greater risk but certainly greater potential.

What I Looked For And The Problems I Ran Into

The first real problem was the currency issue raised by Bogle. It's true that international markets don't generally do well when the dollar is strong. It has been strong now for about a decade and over that period U.S. stocks have crushed most categories of foreign stocks. That's good news and bad news, of course. The good news is that dollar strength and weakness tends to come and go in cycles lasting roughly 10 years. Dollar strength has reached the point where it's like Mighty Casey, Babe Ruth, or whatever legendary slugger coming to bat after striking out three straight times. Unfortunately a dollar decline looked likely three years ago when I bought a few emerging market ETFs and wrote about it on this site. Dollar weakness didn't kick in as I had expected and I escaped with very small profits that I didn't really deserve. The chart below shows how exactly inverse the dollar trend has been as measured against the price action of the Vanguard FTSE All-World ex-US ETF ( VEU ):

Emerging markets, however cheap they might be, didn't look like the solution as long as the direction of the dollar is uncertain. It's a very meaningful headwind that will keep foreign stock positions tacking against strong resistance. The extreme sensitivity of international markets to the dollar was clear in the way international markets leveled exactly as the dollar did in the far right of the chart above.

The dollar isn't the only problem in international investing. In September 2021, I published this article - as far as I know the first on this site - arguing that China is uninvestable for the foreseeable future. Over the past four decades China has extraordinary growth which lifted the standard of living for most of its citizens. That story was enough to boost China stocks for decades, but the truth is that China was never a very good investment for foreigners. While China's relationship with the U.S. was positive it was easy to ignore problems with corporate governance, property rights, and rule of law. Under the leadership of Xi Jinping these problems have worsened.

Tencent ( TCEHY ) and Alibaba ( BABA ) still have major weights in large cap international indexes. Some of the best small cap value ETFs have large China positions, including highly rated WisdomTree funds which I bought and then had to sell three years ago. Taiwan also is prominent in Asia funds and ETFs, and its valuation earned by excellence in technology does not seem to fully reflect the risk of an effort by mainland China to absorb it. You can see my reasoning about China in the earlier article, and I fully acknowledge that over two centuries the U.S. did its part in alienating China. As an investor, however, the problem is putting together an international portfolio not burdened by additional risk because of China holdings. My personal rule is to own nothing with more than a minuscule percentage of China - less than 1%.

What realized was that a narrowing down process was necessary to find approximately equivalent foreign stocks for domestic stocks held in U.S. ETFs. I thought of using individual stocks and attempted to use the Tweedy Brown international portfolios as a screen. I found several interesting small companies and a couple of larger companies which could be looked up on the web but there was little hard financial data that I could use. A couple that did have data available on Seeking Alpha did a lot of business that didn't match up closely enough for proper comparison of valuations. An example was the comparison of the European medical care company Fresenius ( FMS ) with the closest U.S. equivalent DaVita ( DVA ) in which DVA is a close equivalent to only one of four business units. I reluctantly gave up on one-to-one stock comparisons and reluctantly turned to international index ETFs.

What I looked for was addition by subtraction. What international index looked the most like the S&P 500 would look after a valuation adjustment had reduced the weight of the popular tech stocks which had been so helpful to the S&P 500 Index on the way up and were now likely to drag that index down? What small cap portfolio came closest to the characteristics that models like the seven-year GMO forecast used? It came down to finding a large cap blue chip portfolio that had no China and no overpriced growth stocks and combining it with a small/mid cap portfolio which was equivalent to the 20% or so small/mid caps in total stock market portfolios. Putting the two together would create a cheap international version of domestic total market value indexes. The next two sections propose the solutions.

A Less Pricey Version Of The S&P 500

After looking at a few funds I found that it came down to Vanguard FTSE Europe ETF ( VGK ) and the Vanguard FTSE Diversified Developed Markets ETF ( VEA ), which contains more than 4,000 individual stocks and thus more closely resembles the Vanguard Total Stock Market Index ETF ( VTI ) than the S&P 500. While this might provide an international ETF equivalent to the total U.S. market at a low cost, the 2,500 or so added companies were selected by a cap weighted index and do not reflect the selectivity needed to produce the outsized results suggested by the GMO seven-year forecasts. The small and mid-cap elements might well outperform but not enough to lead and pull up the larger caps. For this reason I settled upon VGK, which was limited to European stocks as weighted by the FTSE Europe index. It looks very much like the S&P 500 without the high-priced growth stocks.

Here's a table with important ratios comparing VSK, VEA, and the S&P 500, showing how similar the VGK and VEA are and how both differ in major ways from the S&P 500 ETF and the Vanguard Value ETF ( VTV ):

The first obvious fact is the similarity of statistical measures for the European ETF and the Developed Markets ETF. It would be a huge surprise if this were not so. The second fact which jumps out of the table is that the U.S. large cap market trades at about 160% the price of the US international large cap market. So yes, international large caps and European large caps are, on the face of it, very cheap. The other ratios, however, show that the cheapness is debatable. The S&P 500 has a much higher growth rate and return on equity. One could argue that it deserves its higher P/E and P/B multiples. It's likely, however, that the higher growth rate and ROE come from a few stocks which can scale up their earnings exponentially with little additional capital required. For that reason they continue to be awarded high price to earnings and price to book ratios which pull up the valuation of the Index as a whole. They may be helped by companies which have radically shrunk their equity capital with buybacks - think McDonald's ( MCD ).

Is the relative cheapness of VGK and VEA enough to overcome the superior return on equity and faster growth? Seeking Alpha Quant Ratings give VGK a Buy Rating with 4.32 points out of 5.00. It ranks #9 of 24 European ETFs but all but one of the ETFs ranked higher are individual company ETFs so that one could reasonably assume that at any given moment that number of company ETFs would be ranked higher (although not the same country ETFs). It's ranked 29 of 0f 407 international ETFs. Its dividend yield is 2.96%, almost double the 1.6% yield of the S&P 500. International yields of course come with some nuisance when it comes to tax filing.

One last observation: The valuation and performance numbers of the Vanguard Value Index falls fall about halfway between the numbers for the S&P 500 and Value part of it. One could argue that when it comes to large caps, John Bogle has a point. He would probably argue that switching away from U.S. large caps implies switching into international companies which function within slower growing economies.

AVDV Meets The GMO Criteria For Small Cap Categories With Highest Projected 7-Year Return

As a broad international small/mid cap fund, the American Century Trust - Avantis International Small Cap Value ETF ( AVDV ) is actually focused more on mid-caps than its name implies, although it does not have a stated focus on emerging markets and thus does not belong to the emerging value category, it has a good chance to achieve the GMO projection for emerging value which leads all categories by a wide margin. It seems very likely to achieve GMO's expected return for international smalls caps (5.2% real) and emerging markets (5.6% real) while the valuation of its total portfolio makes the emerging value real return of 9.8% real appear within reach. Because it's composed of companies based almost entirely in countries with superior corporate governance, respect for property rights, and rule of law, it also has less risk. (All GMO projections are for seven-year compounded returns.

FactSet and Morningstar both provide reports on ETFs to Fidelity with the Morningstar Report being more detailed. Some numbers and ratios differ a bit because of slightly different methodologies. The description of AVDV's process below departs from the usual boilerplate and aggressively commends the AVDV approach:

Avantis International Small Cap Value ETF looks beyond the stature of small cap stocks to gain an edge. It holds shares in a diverse collection of smaller companies trading at low multiples relative to their profits. Incorporating profitability into the selection process should prove advantageous over the long run, earning the fund a Morningstar Analyst Rating of Bronze. The portfolio managers at Avantis select this portfolio’s holdings from the bottom 8% of foreign developed markets by market capitalization. They sort this cohort by their price/book ratios (adjusted to remove goodwill) and a cash-based measure of profitability—two fundamental characteristics associated with high expected returns. The managers target the top quarter of stocks with the most attractive combination of relatively low multiples and high profitability, and they weight them in a way that further emphasizes the cheapest and most profitable names. Each stock receives a market-cap multiplier that scales its market-cap weight...

The result is a diverse portfolio of small profitable stocks with lowly valuations. Its average price/book ratio typically lands near the MSCI ACWI Ex USA SMID Value Index, but its profitability, as measured by return on invested capital, has consistently been higher. An acute emphasis on smaller and cheaper stocks has paid off over the fund’s short existence. It outperformed the MSCI ACWI Ex USA SMID Value Index by 2.8 percentage points per year from its launch in September 2019 through June 2022. Avantis levies a 0.36% expense ratio for this fund—a lower fee than many of its competitors."

That's a rare endorsement for a relatively new ETF, but that 2.8% outperformance vs. the index would appear to validate it. The sector allocations may have played a role in this. While similar to other small/mid cap value funds in the heavy weighting of industrials and financials, AVDV is about 50% overweight in materials and 67% overweight in energy. In country terms there's the overweight in Canada, which may have bumped up its positions in materials and energy. The materials/energy overweight is common in emerging markets.

AVDV actually is invested 99.9% in developed markets, and thus has a minuscule amount in China or other emerging markets. It has 1,282 holdings. That's more than a third fewer than the indexed 4,267 in Vanguard FTSE All-World ex-US Index ETF ( VSS ) and about 15% fewer than the international small/cap index number of 1,489. In simplest terms the outperformance of AVDV is the result of addition by subtraction as the AVDV managers pruned the index of available stocks along the lines described above looking for the combination of relatively low multiples and high profitability. Here are the key ratios as presented by Morningstar (via Fidelity):

• Price Earnings Ratio (P/E): 7.88
• Price To Book Value (P/B): .86
• Price To Sales Ratio (P/S): .47
• Price To Cash Flow (P/CF): 2.64

All of the above ratios are stunningly low, especially given that no emerging markets stocks are included, but the one to focus on particularly is price to cash flow, which is about half the number of most comparable international small/mid cap companies.

What seems clear is that it should both increase return and reduce risk to replace the small and mid-cap portion of VEA - the equivalent of the same small and mid-cap portion of Vanguard's Total Stock Market ETF. Small and mid-cap stocks contained within VEA and VTI may perform well in the present environment, but an actively managed version with a good stock selection process might well do better.

For years I looked for an ETF containing the characteristics of the GMO emerging market small/mid cap value category, and failed to find one. While asking the question about switching some funds into international stocks I realized that I had finally found one. The kicker is lower risk for AVDV which has less than 1% of its holdings in emerging markets stocks. It's in fact a diversified, actively managed, international small/mid cap value ETF, but the principles applied by its managers make it closely resemble the statistical measures one might expect from emerging markets deep value. It does not, however, in any way resemble the geographic aspects of the GMO category. Japan, the UK, Canada, Australia, Sweden, Switzerland, Germany, and France together make up almost 80% of the AVDK holdings.

SA Quant Ratings Have ACDV as #2 of 9 in the Foreign Small Mid Value Category and #33 pf 407 in the International Category.

Conclusion

The premise of this article is that international markets are cheaper than the equivalent U.S. markets and should perform relatively better while the US market struggles. There's also some uncertainty as to whether one should choose the Vanguard FTSE Europe ETF or the domestic Vanguard Value ETF has higher growth to keep up with higher valuation as well as a competitive dividend yield of 2.53%.

While there's a reasonable chance that the tide has turned from domestic to international large caps, I have more conviction about absolute performance when it comes to small/mid-caps. Actively selected international small and mid cap such as those chosen through the AVDV process seem much more strongly positioned to outperform and do well in the absolute and prove to be good investments over the next 7-10 years.

There are three options:

1. Stick to domestic stocks.
2. Combine international large caps through an ETF like Vanguard FTSE Europe ETF with a small-mid cap fund like Avantis. Hold the total international commitment to 20% and perhaps overweight AVDV to as much as 10%.
3. Maintain large cap value positions in U.S. stocks but commit up to 10% to international small caps via AVDV.

Most U.S. and international large cap options, including those mentioned in this article, are a close call for risk-adjusted return compared to U.S. Treasuries of varying maturities now yielding 4%-5% with the possibility of rising in the course of 2023. That makes both VGK and VTV very cautious buys. Avantis International Small Cap Value ETF is worth consideration separate from the question of diversifying internationally and is a Strong Buy up to 10% of your equity portfolio.

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