In this note, we introduce the Cornerstone Capital Global Markets Regional Equity Strategy Model. As discussed in detail below, the model employs a quantitative multi-factor methodology to generate regional recommendations based on proprietary measures of valuation and earnings. The Cornerstone Capital model also takes into account corporate governance metrics by region. We will be updating the regional model on a monthly basis.
We will subsequently introduce the Cornerstone Capital Global Markets Sector Equity Strategy Model. In this model, we will rank the 10 GICS in the MSCI All Country World Index (ACWI). The two models will be consistent: a region (e.g., Japan) that has a heavy weighting of a sector with strong earnings momentum (e.g., Consumer Discretionary) will likely be overweight, while a region (e.g., Latin America) with a heavy weighting of a sector with weak earnings momentum (e.g., Materials) will likely be underweight.
Latin America: Relatively Unattractive
The MSCI Emerging Markets Latin America Index is comprised of companies from five countries, with Brazil having by far the largest weighting in terms of market cap (57%). Latin America is one of the seven regions / major economies in the Cornerstone Capital Global Markets Regional Equity Strategy Model.
The model currently ranks Latin America relatively unfavorably, coming in last among the regions / major economies we rank. In fact, Latin America looks unattractive from all three perspectives: valuation, earnings and corporate governance.
Valuation: Still Not Cheap
Even though the MSCI EM Latin America Index has declined 12% over the last twelve months (in dollar terms), valuation metrics suggest the region is still not cheap. So, for example, the region’s P/E ratio on 12-month forward EPS is 17x, which is twice the estimated P/E of the “Central and Eastern Europe, Middle East and Africa” (CEEMEA) region. And relative to its historical average P/E valuation levels, Latin America currently trades at a 20% premium.
Earnings Outlook: Unfavorable
In terms of earnings, the Cornerstone Capital Global Markets Regional Equity Strategy Model takes into account a number of factors, including:
Earnings momentum: Latin America ranks poorly on this metric. Relative to the MSCI All Country World Index, the earnings momentum of the region has been negative, at the same time that other regions/major economies have experienced either positive (Japan) or neutral (Emerging Asia) earnings momentum.
Earnings revisions: The trend in earnings revisions in Latin America has been negative, meaning that downward earnings revisions have outnumbered upward revisions.
Margins: Although margins are relatively high in the Latin America region, this is the only positive factor in terms of earnings and is not, by itself, enough to offset the negatives of poor earnings momentum and negative earnings revisions.
Share buybacks: Given that corporate earnings are reported on a per share basis, we take into account the amount of net share buybacks that have occurred over the past 12 months in each region. On this metric, Latin America ranks poorly given that, like other emerging markets, corporate share issuance has significantly exceeded share buybacks.
Corporate Governance: Poor
Latin America also ranks poorly in terms of corporate governance.
- The joint World Bank and International Finance Corporation “Doing Business 2014” report ranks the major economies reasonably well relative to 189 countries globally in terms of “ease of doing business:” Brazil (116), Mexico (53), Chile (34), Colombia (43), Peru (42).
- However, in terms of perceptions of corruption, the economies rank much more poorly (out of 177 countries) by Transparency International’s “Corruption Perceptions Index 2013:” Brazil (72), Mexico (106), Chile (22), Colombia (94), Peru (83).
Combining the scores for “ease of doing business” and “perceptions of corruption,” Latin America ranks last of the seven regions/major economies.
Latin America: Underweight
In summary, Latin America ranks as relatively unattractive in the Cornerstone Capital Global Markets Regional Equity Strategy Model. In fact, of all seven regions/major economies we track, Latin America is unique in ranking unfavorably in terms of all three metrics: valuation, earnings and corporate governance.
The Underpinnings of the Cornerstone Capital Global Markets Regional Equity Strategy Model
The Cornerstone Capital Global Markets Regional Equity Strategy Model employs a quantitative multi-factor methodology to generate regional recommendations based on proprietary measures of valuation and earnings. The Cornerstone Capital model also takes into account corporate governance metrics by region.
This is a dynamic model, with factors and factor weightings reviewed on a monthly basis for relevance. The key measures of valuation and earnings are also updated monthly; they can be updated more frequently (e.g., weekly) although a risk here is short-term “noise” in the data that does not persist for a longer period of time. (The corporate governance metrics currently employed are updated annually.) A variation of this model has been in use for a number of years, and has added value in the investment decision process.
The Key Fundamental Variables: Earnings and Valuation
We start with the assumption that only two things ultimately determine the fair value of equities: earnings and valuation. In the short term, other factors may play a role – e.g., sentiment (“fear” or “greed”), politics (including geopolitical issues), macroeconomic variables (e.g., Central Bank tightening or easing) etc. – but, in the long run, we believe it all comes down to earnings and the valuation of those earnings. A number of factors drive valuation multiples at any point in time, including perceptions of corporate governance.
The Weighting of Regions versus Sectors
The Cornerstone Capital global markets equity strategy model is comprised of a regional element and a sector element. The sectors are the 10 GICS in the MSCI All Country World Index (ACWI). In terms of regions, we focus on seven regions / major economies that account for 92% of the market cap of the MSCI ACWI. We choose to exclude Canada and Australia (each of which accounts for about 3% of world market cap) in order to focus on the developed and emerging regions that are tracked by most investors.
The primary difference between the regional and sector models is the weights assigned to the valuation and earnings factors. The sector model gives a heavier weighting to earnings while, in the regional model, valuation and earnings have roughly similar weights. The reason for this is that, in our experience, investors look for sectors that primarily offer relatively strong earnings momentum, and for regions that offer a combination of attractive valuations and earnings momentum.
So, for example, an investor may choose to overweight Japan and be underweight Latin America primarily because of the relative valuations of the two markets. To be sure, however, a region (e.g., Japan) that has a heavy weighting of a sector with strong earnings momentum (e.g., Consumer Discretionary) will likely be overweight, while a region (e.g., Latin America) with a heavy weighting of a sector with weak earnings momentum (e.g., Materials) will likely be underweight.
Region Valuation Factors
In terms of the valuation of a region, several factors are measured in order to come up with numerical values, which we label “positive,” “neutral,” or “negative” in summary tables.
These factors include:
(i) P/E relative to other regions;
(ii) P/E relative to the historical average for the sector;
(iii) P/E on a “normalized” basis i.e., excluding cyclical peaks and troughs;
(iv) The potential for P/E expansion or contraction.
The first three factors are self-explanatory, while the fourth factor is based on a number of momentum indicators.
Region Earnings Factors
Turning to the earnings of a region, the model aggregates a number of measures under four broad headings:
- Earnings momentum: Relative to the MSCI All Country World Index, we calculate if the earnings momentum of a region has been accelerating, stable or decelerating. We then look at the earnings momentum of one region relative to another. We also take into account a predictor of earnings momentum by region. The resulting numerical values are labeled in Table 1 as “positive” (accelerating momentum), “neutral” (stable momentum) or “negative” (decelerating momentum).
- Earnings revisions: For each of the companies in a region, we look at the recent trend in earnings revisions by calculating the difference between the number of upward and downward estimate revisions. We also include a predictor of likely earnings revisions trends by region. The data are aggregated, and the resulting numerical values are summarized. A high ratio of upward-to-downward revisions is considered “positive” for a region; conversely a high ratio of downward-to-upward revisions is considered “negative.”
- Margins: We look at the margins of each of the companies in a region – both actual and estimated – and aggregate the data. We assume that relatively high margins are “positive” in that they should sustain earnings growth, while low margins are a “negative.”
- Share buybacks: Given that corporate earnings are reported on a per share basis, we take into account the amount of net share buybacks that have occurred over the past twelve months in each region. Once again, we aggregate data from the company level. A large amount of net share buybacks is “positive” for earnings per share growth in a region, while the opposite (i.e., share issuance) is “negative.”
Region Corporate Governance Metrics
We derive corporate governance metrics for the regions by combining the scores of two widely-cited surveys:
- The joint World Bank and International Finance Corporation “Doing Business 2014” report ranks 189 countries globally in terms of “ease of doing business.”
- Transparency International’s “Corruption Perceptions Index 2013” ranks 177 countries in terms of perceptions of corruption.
Ranking Regions by Weighting Valuation, Earnings and Corporate Governance Scores
The values derived from the various measures of valuation, earnings and corporate governance are weighted, and the regions are then ranked on the basis of their total “score.” Regions that are at the very top or very bottom of the distribution are typically ranked “overweight” or “underweight” respectively, while regions that fall in the middle are typically ranked “neutral.”
Given the quantitative underpinnings of the model, we can look at the dispersion of the “scores” in order to decide on the relative weightings. In other words, a region’s score might be so high relative to the others in a given month that it is the sole overweight while, in another month, the scores of a number of regions are closely clustered and they are all assigned the same weighting (e.g., “neutral”).