VEA - VEA: Value Outside The U.S.

2024-01-04 13:16:25 ET

Summary

• The S&P 500 has rallied 17% in just over two months, and US stock valuations are "stretched."
• The rest of the world is lagging the US in terms of inflationary trends, central bank policy and valuations.
• Investors may start looking for a catch-up play outside the US, considering ETFs like Vanguard FTSE Developed Markets ETF and Vanguard Total International Stock Index Fund ETF.
• Vanguard FTSE Developed Markets ETF is the winner in terms of performance and offers exposure to a well-diversified portfolio of foreign stocks.

The easing in financial conditions and huge stock rally in Q4 2023 has stretched valuations in the US through multiple expansion. Many investors will feel stocks are just too 'expensive' with PE ratios (reported earnings) on the main stock indices all north of 25 and in the case of the DJI ( DIA ), Nasdaq ( QQQ ) and Russell 2000 ( IWM ) all above 30.

Rather than chase this rally any higher, investors may look elsewhere where valuations are lower. PE ratios in Europe and other regions are much less than the US, and the FTSE 100 index in the UK has a PE ratio of only 11. Moreover, there are reasons the rest of the world could outperform (or at least catch up) with the US. This article will look at those reasons and why the Vanguard FTSE Developed Markets Index Fund ETF ( VEA ) is a good way to gain exposure to the potential upside.

Why Go International?

Valuations in the rest of the world are not as stretched as the US. Indeed, the Dax 40 index in Germany has a PE ratio of just 12.8, while the FTSE in the UK has a PE ratio of 11. That is around a third of the Nasdaq.

Obviously, the index composition is a major factor and European indices tend to contain large-cap mature stocks rather than growth stocks. Even so, there is plenty room for growth or, perhaps more likely, multiple expansion.

Multiple expansion has been the driver of the rally in the US in Q4 2024. As rate cuts have been priced in, investors have been prepared to pay more for the same amount of earnings.

Arguably, the rest of the world has been lagging the US in terms of inflationary /disinflationary trends and central bank policy. A simple chart of CPI shows how the US led the EU in the first wave of inflation and how it reversed lower four months before it did in the EU.

Central bank policy has also lagged and the ECB and BoE have tried to maintain a hawkish stance even while the Fed has pivoted. This is from Reuters last month :

" The U.S. Federal Reserve was left in a camp of its own on Thursday when a host of Europe's central banks stuck to plans to keep policy tight well into next year, dashing any hope that the Fed's pivot towards rate cuts marked a global turning point."

The RBNZ may even raise rates again and the forecasts from their last meeting in November showed the average OCR (cash rate) rising to a peak of 5.69% from their previous forecast of 5.59%.

"... ongoing excess demand and inflationary pressures are of concern, given the elevated level of core inflation. If inflationary pressures were to be stronger than anticipated, the OCR would likely need to increase further," the central bank said in its statement .

Equity markets in many regions have therefore been reluctant to reflect a full dovish pivot like they have in the US. Even so, most of the G7 central banks will likely follow in the Fed's footsteps as the disinflationary trends are simply lagging.

My point here is that foreign equity markets may be behind the US in pricing the cuts in and the multiple expansion seen in the US could still happen in the rest of the world. Even if the banks don't cut as much as the doves hope, foreign stocks could be better insulated from a turn down.

Foreign Exposure

There are a number of ways to own foreign stocks. Constructing a portfolio is possible but will involve multiple broker fees and would require complicated currency hedges for US investors. ETFs are an easier way to own foreign exposure and one ETF can contain over 4000 socks in many different regions. But which ETF is best for foreign stocks?

The Best ETFs

"Foreign Large Blend" ETFs typically include a diverse selection of major international stocks across numerous developed markets. They neither lean heavily towards growth nor value characteristics and are therefore well-balanced and relatively safe.

This article will concentrate on the largest three Foreign Large Blend ETFS, which are by far the largest in size with AUMs of over $100bn.

The Vanguard Total International Stock Index Fund ETF ( VXUS ) is the largest fund and is similar in composition and performance to the others but with one key difference: it has exposure to China.

The Vanguard FTSE Developed Markets Index Fund ETF and the iShares Core MSCI EAFE ET ( IEFA ) have very similar top ten holdings and regional exposure. Indeed, their performances are so similar there is little to tell them apart. VEA has a slightly smaller expense ratio and slightly higher AUM so for this reason I will pick VEA over IEFA, but they are more-or less interchangeable.

VEA and VXUS have similar performances, but VEA is the clear winner since the 2020 low.

Both funds pay dividends, with the 3.24% yield on VXUS slightly higher than VEA's 3.15%, but the total return of VEA is still superior over multiple timeframes as shown below (courtesy of Vanguard).

The difference in performance is mostly due to the 7.49% exposure to Chinese stocks in VXUS, with Tencent the seventh largest holding.

VEA Fund Specifics

VEA is the winner in terms of performance and avoids the unwanted underperformance of Chinese stocks with exposure primarily to Europe as shown below (courtesy of Vanguard).

"Pacific" in the table is weighted mostly to Japan with 21.3%, Australia with 6.5% and South Korea with 4.8%. There is a 1.9% exposure to Hong Kong.

VEA is designed to track the performance of the FTSE Developed All Cap ex US Index. Its total net assets are $170.5bn and its expense ratio is a very low 0.05%.

The largest holdings look like this on the fund site :

With over 4000 holdings, the fund is hugely diversified and no holding is larger than 1.5%. There are, perhaps, some "frothy" valuations in the top ten, with Novo Nordisk having a forward PE ratio of 31.55. However, as a whole, the fund has a very decent PE ratio of just 12.9. This compares very favourably with US indices and other international ETFs.

Earnings growth is defined by Vanguard as, "The average annual rate of growth in earnings over the past five years for the stocks in a portfolio," and comes in at a healthy 11%. As mentioned earlier, the immediate catalyst for price appreciation is multiple expansion, but earnings could also grow faster if the slowdown in the EU and UK recovers.

Risks

While VEA is very well diversified over stocks and sectors, it does have a large exposure to Japan at 21.32% and the UK at 12.95%. With the Bank of Japan now attempting to unwind its ultra-loose policies and gearing up for a rate hike this year, there is a risk its stocks could underperform. As we know, the Fed is veering the other way and gearing up for rate cuts, so the US could still outperform despite stretched valuations.

The other risk - at least for underperformance versus the US - comes from the sluggish economies of the EU and UK. Germany manufacturing has slowed significantly and many EU countries are in or near a technical recession. The US has been stronger and this supports higher valuations.

Conclusions

US multiple expansion has created lofty valuations and these may be off-putting for some investors looking for better value at the start of 2024. Foreign stocks are "cheaper" and could catch up with the US as foreign central banks are yet to pivot dovish like the Fed did in December. There is plenty of room for multiple expansion.

My preferred way to action this idea is through the Vanguard FTSE Developed Markets ETF. It offers exposure to a very well diversified portfolio of over 4000 foreign stocks with a total PE ratio of just 12.9. It has a very low expense ratio and a dividend of 3.15% and beats the competition in terms of performance.

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