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Tilt Your Int’l Holding Toward Value With This ETF

Scott Kubie

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.

International value stocks look cheap. The iShares MSCI EAFE Value (EFV) is attractive compared with other diversified, developed international indexes and ETFs.

Compelling valuations, relative to the MSCI EAFE Growth ETF (EFG), make up the majority of the case for leaning diversified international portfolios toward value. Hopes for improved economic growth and a yield that rewards patience also support a lean toward value. Whatever your allocation to developed international markets, you should tilt the allocation toward value.

Under The Hood Of EFV

EFV invests in 513 stocks that exhibit value characteristics. The ETF maintains a roughly neutral country allocation compared with the parent portfolio, which removes biases in valuation across countries to a large extent.

EFV’s sector allocations vary from the parent index and EFG. EFV maintains a higher allocation toward financials (32% allocation) and energy (9% allocation). EFV meaningfully underweights consumer staples (2% allocation) and health care (6% allocation). The portfolio has a moderate bias toward utilities and real estate, and a moderate bias against industrials and technology.

How Undervalued Is EFV?

As noted above, low valuations make EFV compelling. Measured relative to EFG (which means EFG is always at 100%), the price-to-book value is at levels not seen since the tail end of the 2008 financial crisis. The price-to-book (P/B) chart shows relative valuations are reversing after an extended decline that started in early 2014.

In addition to comparing to EFG, the chart also shows the fundamentally weighted PowerShares FTSE RAFI Developed Markets ex-US Portfolio (PXF), which offers an alternative to EFV, and iShares MSCI EAFE Small-Cap ETF (SCZ). The chart shows the gap between small-caps and value widening in recent years. Value stocks look attractive relative to both

The price-to-sales (P/S) ratio shows a similar low level relative to recent history and a decline in recent years. The P/S ratio is at its lowest level, relative to EFG, in the last 10 years. Compared to international small-cap stocks (SCZ), it has usually traded at a slight premium.

In recent months, that premium has swung toward a moderate discount. Recently, the valuation gap between PXF, which is normally cheaper, reached a much narrower reading than usual.

Other Considerations

Internationals stocks offer investors very attractive yields. Based on Morningstar’s projections, EFV yields 4.8%, which is more than 1% above the parent index. EFV also yields more than the iShares Select Dividend ETF (DVY) and the iShares Core High Dividend ETF (HDV), which both yield close to 4%. Even if things don’t work out immediately, holding EFV will generate a decent yield.

Momentum is also starting to turn. Over the last three months, EFV has outperformed EFG by around 6.5%, but EFG has outperformed an average of 2% each year for the last 10 years. We see the recent improvements as a reflection of the improving global economy.

After a slowdown last year, economic data suggest global growth is rising. Value stocks tend to respond better when economic growth is higher and broader, and a modest pickup in growth should increase lending and interest rates. EFV’s large financial allocation leaves it well-positioned to benefit from such trends.

Alternatives To EFV

PXF represents the most interesting alternative to EFV. It doesn’t yield quite as much or lean as hard toward value as EFV. Instead, it leans deeper into small-caps and expands the number of securities owned to 1,050.

Because PXF uses a FTSE-Russell Index, it also includes a 4% allocation to South Korea and an 8% allocation to Canada. The sector differences between EFV and PXF also make the two reasonably good complements for those who like to mix cap-weighted and smart-beta ETFs in their allocations.

Conclusion

For many investors, the allocation to developed international stocks has been a drag on the portfolio. But it is too large of a segment to remove it from a properly diversified portfolio.

Whether you are holding your minimal allocation or optimistic about a rebound, tilt your allocation toward value.

At the time of this writing, CLS Investments invests in EFV, EFG, PXF and HDV for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS' Chief Strategist Scott Kubie at 402-896-7406 or at scottk@clsinvest.com. Please click here for a complete list of relevant disclosures and definitions.

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