Our outlook for Earnings, Quality and Valuation (EQV) was cautiously positive. 2016 marked the first time in five years where earnings forecasts did not collapse at year-end, and an upward bias to earnings forecasts has continued into 2017. Is this the beginning of a new earnings growth cycle?
For years, slowing top-line growth in Asia, combined with an inability to raise prices, had driven consistently negative earnings revisions. So far, 2017 is proving to be different. Earnings forecasts are being revised upward from cyclically depressed levels, and the drivers behind the revisions are more fundamentally sound — see the reasons below:
- After declining for most of 2015 and 2016, Asian exports have begun to rebound.1
- Increased exports are driving increased operating leverage, which improves earnings quality.
- The recent strengthening in commodity prices has provided an economic tailwind for some countries in the region.2
- Improving margins and asset turnover, along with reduced financial leverage, are boosting return on assets (ROA) and return on equity (ROE).1
Some of the best fundamentals in years
Simply put, these are some of the best fundamentals the Asia ex-Japan region has experienced in six years. This sounds exciting, but it is too early to know whether this is a short-term uptick or the beginning of a long up cycle. What we do know is that the region is experiencing improving fundamentals, with earnings rising from a cyclical bottom and reasonable valuations. In contrast, the US market has gone through a prolonged period of economic expansion, expectations are steadily being reduced, and valuations are less compelling.
India: High expectations and high valuations
We get a lot of questions about why we don’t own anything in India. The rationale behind our decision is pretty simple. Indian companies sport high expectations and equally high valuations. India is one of the few markets in Asia where earnings forecasts have been downgraded over the past three months. On top of this, the market is trading at a price-to-earnings (P/E) ratio of 18x — a 26% premium to Invesco Asia Pacific Growth Fund.3 It is easy to get excited about the country’s demographics and strong economic growth, but study after study show that high economic growth does not necessarily correlate with good stock performance. In our minds, Indian equities are a suboptimal opportunity.
Key takeaways
The low-growth environment that Asia experienced until recently resulted in investors seeking the highest growth and highest quality businesses, irrespective of price. The recent cyclical rally has helped close the valuation disparity between high-growth/high-quality companies and early-cycle/low-quality companies. Unfortunately, this has yet to create a target-rich environment for us, as high-growth and high-quality businesses are still two standard deviations above 20-year average valuations.4 But with earnings fundamentals improving, we are watching carefully for opportunities to emerge.
As always, we believe our long-term, bottom-up stock-picking approach — which focuses on companies’ EQV characteristics — can reward investors over the long term. The years 2008 through 2016 were known as a period of unprecedentedly high stock correlations. When stocks move in lockstep with the overall market, it tends to be a better environment for passive investment strategies. But since February 2016, stock correlations have collapsed.3 In our view, this helps make the case for active management, as lower correlations can create conditions that are more beneficial to skilled stock pickers.
The Vanguard FTSE Pacific (NYSE:VPL) closed at $64.88 on Friday, up $0.51 (+0.79%). Year-to-date, VPL has gained 11.63%, versus a 6.61% rise in the benchmark S&P 500 index during the same period.
VPL currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #4 of 75 ETFs in the Asia Pacific Equities Ex-China ETFs category.