Richard Drury As the P/E ratio of the S&P 500 ( SP500 ) continues its climb towards 30, nervous investors often suggest that investing in ETFs that hold stocks from countries besides the United States might be a good way to protect their assets. That's largely because the ETFs that invest in those markets have far lower P/E ratios right now. For example, The Vanguard Total International Stock Market ETF ( NASDAQ: VXUS ) and its various mutual fund share classes with its $429 billion AUM is by far the largest of any fund that invests in stocks based in countries outside of the US.
Vanguard tells us that as of 5/31/24, the latest date for which it releases data, VXUS's P/E ratio was only 15.4. Vanguard's S&P 500 ETF ( VOO ) at the same time had a P/E ratio of 26.
1. Since then, the P/E of the S&P 500 has risen even further and currently stands at 27.69 .
Proponents of investing outside of the U.S. argue that allocating a significant amount of your stock investment to stocks from outside of the U.
S. is advisable as it protects you against risks specific to the United States, such as its ballooning national debt and thus gives you far more diversification. VXUS holds 8,587 stocks compared to the S&P 500's 504 stocks and far more than even the much broader Vanguard Total Stock Market ( VTI ), a U.
S. only ETF which holds shares of 3,704 stocks. Investing in International Stocks is Orthodox Portfolio Strategy Practice Most financial advisors' standard portfolios and those of the increasingly popular robo-advisors include a significant allocation to ex-US funds and ETFs.
So do the Target Date funds popular in retirement accounts. For example, the Vanguard Target Retirement 2045 Fund ( VTIVX ), which is suitable for investors born around 1980 allocates a full 33.6% of its holdings to the Vanguard Total International Stock Market Fund, which is a mutual fund share class of VXUS.
Betterment's robo-advisor's Core Portfolio also puts investors into ETFs that provide a similar allocation, with a mix of Developed ex-US and Emerging country stocks totaling 34.4% of the whole portfolio. Clearly, the idea that you should diversify one third or more of your holdings into stocks from outside of the U.
S. has become orthodox investing advice. But in the rest of this article, I'm going to argue that this is a mistaken strategy and that investors will do better to invest in the S&P 500 than they would in the Total International Stock Market, even at the S&P 500's current high valuation.
To illustrate this argument, I will compare various metrics pertaining to the Vanguard Total International Stock Market ETF, VXUS, with the matching ones from the S&P 500. International Stocks Outperformed in the "Lost Decade" But Have Had Their Own Lost Decade and a Half Ever Since VXUS's parent mutual fund was founded in 2010. The ETF share class launched the next year.
This timing probably reflects some performance chasing on Vanguard's part, because the decade after the collapse of the Dot-Com boom in the U.S. from 2000 to 2010 had been one where international stocks outperformed U.
S. stocks due to a combination of factors including currency values and investor enthusiasm for stocks from the so-called "Emerging Nations" which at the time were dominated by surging industrial powerhouses like South Korea and China. Unfortunately for those who follow orthodox investing strategies, that outperformance ceased as the U.
S. stock market began to recover in 2013. Since then, the underperformance of international funds has had a significant impact on their portfolios, and not a good one.
Below, you can see how poorly over the past 10 years, investors have been rewarded for their investment in VXUS compared to one made in a fund or ETF that tracked the S&P 500. VXUS 10 Year Total Return Compared to the S&P 500's Total Return Seeking Alpha Over this past 10 years, even if an investor had reinvested all their dividends in VXUS, their total return was only a 52.95% gain.
During the same period, the S&P 500 with its dividends reinvested has delivered a total return of 239.42% - almost 5 times as much as VXUS. The divergence has been consistently growing throughout this period.
Even the 2020 U.S. COVID shutdown did not dent this outperformance.
And the chart above shows you returns with dividends reinvested. The past 10-year price performance without reinvested dividends was far, far worse. VXUS vs.
S&P 500 10 Yr Price Return Seeking Alpha Why Does VXUS Underperform So Badly? It's the Holdings, Stupid! Though the top 40 holdings of VXUS make up an impressive list of large cap companies whose names are familiar to investors and most consumers, these stocks make up only a 10% proportion of its entire holdings. That's because of how many other stocks are also held by VXUS VXUS Top 10 Holdings with Weights Seeking Alpha But if you look deeper into VXUS's many holdings you see fewer and fewer stocks that you might have heard of as either an investor or a consumer. And when you do see familiar names, the holding is so tiny that if the company's stock were to double, it would make almost no difference in VXUS's share price.
For example, the 25th largest holding in VXUS, Vanguard tells us was, as of 5/31/2024, is Sanofi ( SNY ). But Sanofi makes up only one third of one percent of the total value of VXUS. And Sanofi is only 25 stocks deep into the ETF.
Scrolling down further through VXUS's holdings to the 51st stock listed, we begin to see a pattern developing, which explains a great deal of why VXUS appears to be undervalued. VXUS's Holdings Tilt Heavily towards Financials That's because only 51 stocks down the list of holdings ranked by weight, we start seeing a lot of financials, banks and insurance companies. A look at the breakdown Vanguard gives us of its sector distribution confirms that this preponderance of Financial sector stocks holds true throughout the ETF.
One out of 5 stocks held in VXUS comes from the Financials sector - 20.31%. And right there, this should send up some red flags about just how meaningful that 15.
4 P/E ratio of VXUS might be. That's because Banks aren't valued the way that other stocks are, and typically have lower P/E ratios even when healthy. For example, look at the recent P/E ratio history of Bank of America ( BAC ) and some peers.
Bank of America Recent P/E Ratio and Those of Competitors Y-Charts Clearly, even in boom times, banks tend towards P/E ratios that are well under the historical 15 characteristic of the S&P 500 before the boom of the last decade. The U.S.
banks you see in the table above are all in the S&P 500, but as a sector, Banks and other Financials, make up a much lower percentage of the value of the whole S&P 500. Currently, the Financial sector makes up only 12.25% of the total value of the S&P 500, far less than the 20.
31% that sector makes up of VXUS. A Closer Look at VXUS's Other Sector Weightings is Revealing VXUS is weighted more heavily towards large holdings of slower growing sectors than is the S&P 500. It holds slightly more than twice as many companies falling into the cyclical Industrials sector than does the S&P 500.
Meanwhile, it has only 38% as much investment in the Information Technology sector as does the S&P 500 and only about a third as much investment in the Communications/Telecommunications sector. Also, significant is that VXUS has over three times as much weight sitting in the Basic Materials sector than is found in the S&P 500. Sector Weightings Compared VXUS and S&P 500 VXUS as of 5/31 S&P 500 (As of 7/10) Sector Weight Sector Weight Financials 20.
31% Information Technology 33.44% Industrials 15.99% Financials 12.
25% Consumer Discretionary 13.06% Health Care 11.39% Technology 12.
87% Consumer Discretionary 10.10% Health Care 8.85% Communication Services 9.
38% Basic Materials 6.80% Industrials 7.88% Consumer Staples 6.
42% Consumer Staples 5.65% Energy 5.77% Energy 3.
46% Telecommunications 3.62% Utilities 2.23% Utilities 3.
41% Real Estate 2.10% Real Estate 2.91% Materials 2.
06% Unassigned 0.05% Click to enlarge Data from Vanguard and SSGA.com table by the Author The Differences Go Beyond Sector When We Look at What Actual Companies Fill those Sectors Many of the thousands of stocks that make up VXUS are stocks of companies that sell products and services only within their region: regional banks and insurance companies, regional food and beverage companies, regional restaurant and hotel chains, regional service companies and the like.
These are companies with limited markets and hence limited earnings growth prospects. For example, here are the 10 stocks that fall at the midpoint of all 8,587 holdings in VXUS when those stocks are ranked by their weight in the ETF. The companies are holdings number 4293-4303.
Stock Weight in VXUS Subsector Nippon Pillar Packing Co Ltd <0.01% Chemicals Yamazen Corp <0.01% Trading Companies & Distributors Johnson Electric Holdings Ltd <0.
01% Automobile Components Trident Ltd/India <0.01% Textiles, Apparel & Luxury Goods KNR Constructions Ltd <0.01% Construction & Engineering Zhejiang Zheneng Electric Power Co Ltd <0.
01% Independent Power and Renewable Electricity Producers LOTTE Fine Chemical Co Ltd <0.01% Chemicals Kontrolmatik Enerji Ve Muhendislik AS <0.01% Construction & Engineering Vossloh AG <0.
01% Machinery Sporton International Inc <0.01% Professional Services Click to enlarge These are not companies that are likely to spread their business world-wide anytime soon. And remember, these were the median companies, ranked by weight, in VXUS.
There are another 4,284 companies that are held in decreasingly smaller amounts in VXUS that are likely even more obscure. Unimpressive ETF Metrics Reflect the Unimpressive Companies in VXUS VXUS's broad investment in thousands of small, largely regional companies scattered around the world's most of which have limited growth prospects, and quite a few of which possibly have limited survival prospects, results in the ETF having overall metrics that do not impress. Below, you can see a comparison of the Fundamentals of VXUS and of the Vanguard S&P 500 ETF (VOO).
I used VOO's metrics here, as they were reported on the same date as VXUS's most recent data. VOO tracks the S&P 500 very closely and is an excellent proxy for the S&P 500. VXUS Fundamentals Compared to VOO (S&P 500) Fundamentals FUNDAMENTAL VXUS FUNDAMENTAL VOO Median market cap $36.
8 B Median market cap $228.1 B Earnings growth rate 13.29% Earnings growth rate 15.
69% P/E ratio 15.4x P/E ratio 26.1x P/B ratio 1.
8x P/B ratio 4.5x Return on equity 12.07% Return on equity 24.
61% Click to enlarge Data: advisors.vanguard.com table by the author Notice how much lower the overall earnings growth rate is of the stocks in VXUS compared to those in the S&P 500, 13.
29% vs 15.69%. Notice also the more than double Return on Equity you get when investing in the stocks held in the S&P 500.
Ex-US Investing Brings Other Challenges Lack of Transparency Besides the issues we see with the kinds of companies that dominate ex-us stock investment, there are other issues to consider. An important one is the lack of transparency in the accounting used by companies from all over the world, including the 25.39% of VXUS's stocks that Vanguard tells us are domiciled in Emerging Countries.
How much can you trust the numbers that companies report in China, India, Russia, and various other countries not subject to U.S. accounting rules report? Companies From Countries Without a Tradition of Free Markets China, Russia, and some African and Middle Eastern countries ruled by despots of one kind or another all contribute their stocks to VXUS.
As we have seen with how China has treated some of its most successful companies and entrepreneurs like Alibaba ( BABA ) and Jack Ma, companies from such countries can face expropriation or destructive regulation at any time if they offend or challenge the countries autocratic rulers. Expropriation--where the government nationalizes a major company just because it can--is another threat not to be overlooked. Currency Issues Are Also A Major Risk Inflation is a problem world-wide, but differs in its extent from country to country.
In India, inflation is currently pegged at 4.75%. In Brazil, it is 4.
23%, but Argentina has brought its inflation rate down to "only" 276.40%. Below, you see a chart based on International Monetary Fund (IMF) data of inflation worldwide in 2024.
Global Finance Magazine Graph of Worldwide Inflation Rates gfmag.com The impact of inflation on earnings recorded in national currencies is one factor that makes evaluating earnings from companies whose revenues are not converted into dollars tricky. Then there is the additional factor of what happens when the dollar strengthens or weakens.
When major foreign currencies like the Euro or UK Pound strengthen against the dollar, this temporarily boosts VXUS's earnings, and it has historically seen its share prices rise when the dollar is weak, only to sink when it recovers. Nothing in the economies of the major developed nations suggests to me that they are posed to see their economies expand while the U.S.
shrinks. In fact, they are at the mercy of the same factors that threaten the U.S.
: inflation, political turmoil, and aging populations. US Megacap Stocks Sell Products Throughout the World, Giving the S&P 500 Plenty of International Exposure The stocks that dominate the S&P 500 derive a large percentage of their income from countries outside of the U.S.
Only 42% of Apple's ( AAPL ) revenue comes from the U.S., 47% of Alphabet's (GOOG, GOOGL), and 46.
7% of Tesla's ( TSLA ). This is true for some of the smallest components of the S&P 500, too. Snap-On ( SNA ) one of the smallest companies in the S&P 500 reports that it "serves customers from 130 countries.
" The market caps of the companies that top the S&P 500 dwarf those of almost all the companies in VXUS save for those at the very top that make up, together, only about 10% of the ETF's entire value. This is largely because these are fully international companies Thus, it makes sense that John Bogle , founder of Vanguard, held to the end of his life that an investment in the S&P 500 is, in fact, an investment that is already diversified world-wide. It may even be truer now than it was 14 years ago when he stated it.
It is also, apparently, the belief of Warren Buffett, whose will directs his wife's money to be invested 90% in the S&P 500 and the rest in U.S. Treasuries.
I defer to the wisdom of these two gentlemen. How about you? Analyst’s Disclosure: I/we have a beneficial long position in the shares of VOO, VTI, SNA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions.
I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am not a certified investing professional or registered investment advisor.
I am just an ordinary investor with a lot of curiosity who enjoys researching stocks and sharing what I find with others. Don't buy or sell any security you read about here before doing your own research and considering opposing views. Be particularly cautious about investment advice that only presents the upside potential of an investment you are considering.
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