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An EAFE Triple Play.


Much has been written about the investment opportunity in Emerging stock Markets. Even more has been written about Euro problems affecting European stock markets. And the Japan stock market saga continues. In combination, these three make EAFE (Europe Australasia and Far East … developed markets outside of North America) an interesting investment opportunity.

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Emerging Markets have seen a flood of inflows into stock (and bond and infrastructure) securities. As desirable as Emerging Markets might be longer-term, further investment at present might seem bold for the cautious investor.

European stock markets can be expected to see further uncertainly and volatility as recent French and now Greek elections (again) seem to reverse course rather than offer a clear fiscal direction.

And the Japanese stock market continues to be deeply out of favour (even so it remains a full 10% of the MSCI World index).

Investors haven’t seen headlines that read Buy Europe or Buy Japan for some time.

What makes EAFE so interesting is that it offers exposure to all three: Europe, Japan and thereby Emerging Markets. And at this point Euro and Japan valuations are becoming relatively more attractive. While hardly a new idea, an EAFE investment currently offers inexpensive exposure to Emerging Markets.

Valuations.

The constituent countries of EAFE are U.K. and Japan with 22% each and France, Germany, Switzerland and Australia with 9% each. (Per MSCI.com).

The Wharton School of Business says the U.K. and many European countries will slip into recession this year if they aren’t already there.  JP Morgan research says that’s what makes valuations relatively more compelling.

Kim Shannon of Sionna Investment Managers recently said Japan is in single digit PE (Price/Earnings) territory. Single digit PE is a signal that a bottom is forming. (I know, Japan has been bottoming for 21 years).

MSCI indexes put the EAFE PE around 13.5x.

The point is that value buyers buy and portfolio managers rebalance into asset classes that have done relatively less well. EAFE, Europe and Japan have done less well as EAFE lingers at roughly 2005 prices. (While Canada and EM seem relatively expensive).

EAFE Relative Performance 2005 - 2012

Chart Source: MSCI.com

Furthermore, EAFE offers relatively less expensive Emerging Market exposure.

While macro factors continue to drive markets (especially in Europe) investors will want to own those mega companies that can deliver earnings in any market environment. Some of the constituent companies in the EAFE index may look defensive as they are from traditionally defensive sectors like consumer staples and health care. These companies are instead globally oriented growth companies.

EAFE constituent companies include Nestle, the Swiss consumer staples giant which is about 2.1% of the EAFE index. 40% of Nestle’s revenues come from Emerging Markets. Bayer, the German pharma giant (0.6% of EAFE) and HSBC, the U.K. banking giant (1.6%) are … everywhere. HSBC lists over 100 companies on their global web site. British Gas BG (0.7%) is a play on Brazil energy exploration.

The bonus is that these companies offer exposures to sectors that Canadian investors simply cannot get in their domestic markets.

Plenty of Risks.

Buy Europe and Japan because they are cheap … only sounds good if you say it real fast. Nearly every research piece indicates that Europe will get worse before it gets better. Many see a longer sideways drift … at best. Using Sionna’s single digit PE criteria, European markets need to drop by 30% to bottom out.

Timing and Disclosure.

I own the Vanguard MSCI EAFE Exchange Traded Fund VEA and will add to VEA should EAFE experience a sharp correction or rebalance to EAFE as it continues to correct.

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Next time? More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan

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