2023-04-25 15:50:26 ET
Summary
- Undervalued industries, regions, and equity market segments, offer investors the potential for strong, market-beating returns.
- There are ETFs tracking most of these.
- An overview of these follows.
Author's note: This article was released to CEF/ETF Income Laboratory members on April 14th.
The J.P. Morgan Guide to the Markets is exactly what it says on the tin: a comprehensive, in-depth guide to global investment markets. It includes a treasure trove of quantitative information regarding U.S. and international equities, bonds, and other investment securities, as well as broader macroeconomic conditions. The guide includes detailed information concerning equity valuations, including comparisons across industries, regions, segments, etc. I thought an article looking through the most undervalued of these, including relevant ETFs, would be of interest to readers.
Cheapest U.S. equity market segment is small-cap stocks, especially small-cap value stocks. These have performed quite well in the recent past, but remain undervalued, so further gains are possible.
The cheapest industry is communication services, due to specific issues with some of the larger names in this space, including Facebook ( META ) and Google ( GOOGL ). Energy looks cheap on an earnings basis, less so on book value or price per share.
International stocks are much cheaper than comparable U.S. stocks.
Finally, leveraged loans sport particularly strong yields in the fixed-income space. Still, more or less all bonds and fixed-income securities sport strong yields right now.
As a final point, I wrote a similar article to this last year. From what I've seen, these have outperformed since, with the notable exception of the Global X Russell 2000 Covered Call ETF ( RYLD ), my top picks at the time.
Most Undervalued U.S. Equity Market Segments - Small and Cheap
U.S. growth stocks always trade with comparatively high valuations, as investors are willing to pay premium prices for strong growth prospects. Growth stocks are, on average, 47% more expensive than value stocks. Right now, growth stocks are 68% more expensive, quite a bit more than average.
In general terms, large-cap growth stocks are the most expensive, while small-cap value equities are the cheapest.
Considering the above, focusing on U.S. small-cap value stocks seems like a good idea.
The Vanguard Small-Cap Value ETF ( VBR ) is a cheap index fund providing broad-based exposure to these undervalued securities. It is a simple, straightforward play on U.S. small-cap value stocks, and should outperform as valuations normalize. I last covered VBR here .
The Avantis U.S. Small Cap Value Fund ( AVUV ) is an actively managed fund in the same space. AVUV is a more aggressive play on the same securities, with a stronger performance track-record, but also somewhat riskier. I last covered AVUV here .
Small-cap value stocks have been undervalued since at least mid-2020. They have tended to outperform since, but inconsistently so. Most small-cap value funds suffered outsized losses in March 2023, due to bearish investor sentiment following the collapse of Silicon Valley Bank (SIVBQ). Still, their performance these past few years has been quite good, and they remain cheaply valued.
I'm not aware of any small-cap value dividend equities out there, but the Global X Russell 2000 Covered Call ETF is close. RYLD focuses on U.S. small-cap equities, sells covered calls on its holdings, and yields around 12.0%. I think that RYLD would somewhat benefit from cheapness in the small-cap segment, and think the fund is a fantastic investment opportunity. On the other hand, RYLD's performance has been materially weaker than that of VBR and AVUV for years, and the fund has somewhat underperformed expectations. For reference, RYLD has underperformed since mid-2020.
RYLD's fundamentals remain strong, and I remain bullish, but the fund's performance has been below-average for quite a while now.
Most Undervalued U.S. Equity Industry - Communications Services
Most U.S. equity industry segments are overvalued relative to their historical averages, with some exceptions. Of these, the communication services industry stands out. Said sector sports a forward PE ratio of 16.1x, which is 13.9% lower than its historical average. For reference, the S&P 500 sports a PE ratio of 17.8x, around 14.8% higher than its historical average. Table for reference.
The Communication services sector is currently undervalued due to specific, idiosyncratic issues in some of the larger companies in the space.
Google, the largest industry component with a 24.3% allocation in relevant indexes, has seen its share price stagnate for around a year. This was due to bearish investor sentiment, renewed competition from Bing, and the advent of AI chatbots including ChatGPT. AI could, potentially, disrupt Google's moat, as some of these services could, potentially, become plainly superior to Google search. In my opinion, ChatGPT can't replace Google yet , but the service is improving quite rapidly, and the situation could easily change in the coming years, perhaps even months.
Facebook, the second largest industry component with a 22.2% allocation, saw significant losses in early 2022, due to weak 4Q2021 earnings, slowing growth, and an unpopular pivot towards the metaverse. Mr. Zuckerberg has since paired back metaverse CAPEX and spending, with Facebook significantly outperforming since late 2022. Recent results remain subpar, however.
Google and Facebook account for a sizable portion of the communication services industry, and explain a sizable chunk of its undervaluation. Said industry could outperform moving forward, contingent on valuations normalizing.
Investors interested in said industry could consider investing in a simple communication services index ETF. Of these, the Fidelity MSCI Communication Services Index ETF ( FCOM ) has the lowest expense ratio of 0.80%.
I was unable to find a communications services ETF with a reasonably good yield.
Most Undervalued U.S. Equity Industry - Special Mention
The U.S. energy industry is also somewhat undervalued right now, with a forward PE ratio of 10.1x, versus a historical average of 13.7x. Although the industry is quite undervalued on an earnings basis, oil prices are currently somewhat elevated, and I believe that we are on the latter stages of an energy price cycle. As such, I don't think it is appropriate to focus on earnings and PE ratios in the energy industry right now.
Looking at PB and PS ratios would be more appropriate, although I was unable to find historical averages for these. Looking at Exxon ( XOM ) and Chevron ( CVX ), however, it seems quite clear that the ratios for these companies are somewhat above their historical averages.
In my opinion, and considering the above, the U.S. energy industry is not currently significantly undervalued, PE ratios notwithstanding.
Most Undervalued Equity Region - International
U.S. equities consistently trade at higher valuations than comparable international equities, as investors are willing to pay a premium for the strength, resilience, and stability of the country's economy and corporate sector. Due to this, international stocks are, on average, around 15.5% cheaper than comparable U.S. equities. Exact percentages vary, with international equities currently trading with a 29.2% discount, almost twice their historical average.
Economic conditions around the globe are, well, complicated. In most cases, conditions are good , and slowly getting better. Europe, for instance, expects economic growth of 0.8% in 2023 , up from 0.3% in late 2022. Growth is picking up due to declining energy prices, higher government spending, and strong consumer demand. Although growth is positive, and rising, it remains somewhat low. Latin America shows a broadly similar pattern, with analysts expecting good growth and declining inflation for the year, albeit at a slower pace than in the past. Same story for China, with most analysts expecting growth in the mid-single digits for the year, a good figure on an absolute basis, although quite low for China.
Importantly, the U.S. economy is doing similar, as GDP and jobs both continue to grow, but anemic growth and higher rates have many analysts worried about a shallow recession later in the year.
Considering the above, it seems that U.S. and international markets are in similar situations. The U.S. is not doing so great, and international markets are not doing so badly. Both seem to be doing fine , with some risks, and with some probability of a recession. As such, and in my opinion, the sizable valuation gap between U.S. and international equities is unwarranted.
Investors looking for simple, diversified international equity index ETFs have many choices. These include the Vanguard Total International Stock ETF ( VXUS ), and the iShares Core MSCI Total International Stock ETF ( IXUS ). Both provide broad-based exposure to international equity markets and are strong plays on the same.
Investors looking for a bit of income too could consider the Vanguard International High Dividend Yield ETF ( VYMI ), and the Schwab International Dividend Equity ETF ( SCHY ). Both provide exposure to international equities with above-average dividend yields, and are solid choices in this space. VYMI yields 4.5%, while SCHY yields 3.4%. I last covered VYMI here , SCHY here .
International stocks have traded with cheap valuations for quite a while now. International stocks have also tended to outperform more often than not in the recent past, as has been the case for the past year. Outperformance has not been consistent, however.
Most Undervalued Fixed Income Asset Class - Leveraged Loans
Currently, all fixed income asset classes offer compelling yields, as interest rates have risen. Leveraged loan yields are particularly strong at 11.3%, almost twice their historical average.
Leveraged loans are almost always variable rate loans, and so their coupon rates change when benchmark rates change too. Leveraged loan rates increased as the Federal Reserve hiked rates, and would decrease if the Fed started to cut.
In my opinion, above-average leveraged loan interest rates are due to market expectations of lower rates. Meaning, leveraged loans yield a lot today , because markets expect lower rates tomorrow , which would bring leverage loan rates in-line with those of other bond sub-asset classes.
Due to the above, I'm not convinced that leveraged loans will continue to offer above-average yields or spreads relative to peers moving forward. Still, some investors might disagree, and might wish to invest in these securities regardless. As these are almost always variable rate loans, their interest rate risk is quite low, an incredibly important ancillary benefit.
Investors looking for leveraged loan index ETFs could consider an investment in Invesco Senior Loan ETF ( BKLN ). BKLN is the largest ETF in this space, sports a TTM yield of 5.9%, an SEC yield of 8.3%, and would see strong dividend growth if the Fed continues to hike rates. BKLN's SEC yield is much more indicative of the dividends investors can expect moving forward. I last covered BKLN here .
Investors can also consider an investment in the actively-managed SPDR Blackstone Senior Loan ETF ( SRLN ). SRLN sports a TTM yield of 6.3% yield, an SEC yield of 8.2%, and would also see strong dividend growth if the Fed continues to hike rates. As with BKLN, SEC yields are much more indicative of expected dividends. I last covered SRLN here .
Conclusion
Undervalued equity market segments and asset classes offer investors the potential for strong, market-beating returns. The asset classes and funds presented here are all undervalued and could outperform in the coming months and years. Hopefully this article was an interesting, useful, informative starting point for investors interested in undervalued asset classes and funds.
For further details see:
Most Undervalued Asset Classes, Equity Industries, Segments, And Regions