Most Undervalued Asset Classes, Equity Industries, Segments

Author’s note: This article was released to CEF/ETF Income Laboratory members on April 15th, 2022.

The J.P. Morgan Guide to the Markets is exactly what it says on the tin: a comprehensive, in-depth guide to global investment markets. It includes a treasure trove of quantitative information regarding U.S. and international equities, bonds, and other investment securities, as well as broader macroeconomic conditions. The guide includes detailed information concerning equity valuations, including comparisons across industries, regions, segments, etc. I thought an article looking through the most undervalued of these, including relevant ETFs, would be of interest to readers.

The Global X Russell 2000 Covered Call ETF (RYLD), which invests in U.S. small-cap equities, deserves special mention. The fund focuses on small-cap equities, which are currently undervalued, yields 12.6%, and has significantly outperformed YTD as small-cap equity valuations normalized. The fund is a fantastic investment opportunity, but riskier than average. I last covered RYLD here.

Most Undervalued U.S. Equity Market Segments – Small and Cheap

U.S. growth stocks always trade with comparatively high valuations, as investors are willing to pay premium prices for strong growth. Growth stock valuations are, on average, 45% higher than value stock valuations. Said figure has risen to 75% as of 1Q2022, significantly above the historical average. Growth stocks were last this expensive during the dot-com bubble.

Comparatively low value stock valuations are in large part driven by small-cap value stock valuations. Large-cap and mid-cap value are looking reasonably valued, only small-caps are cheap.

Considering the above, focusing on U.S. small-cap value stocks to profit from valuations normalizing seems like a reasonable idea.

The Vanguard Small-Cap Value ETF (VBR) is a cheap index fund providing broad-based exposure to these undervalued securities. It is a simple, straightforward play on U.S. small-cap value stocks, and should outperform as valuations normalize. I last covered VBR here.

The Avantis U.S. Small Cap Value Fund (AVUV) is an actively managed fund in the same space. AVUV is a more aggressive play on the same securities, with a stronger performance track-record, but also somewhat riskier. I last covered AVUV here.

I’m not aware of any small-cap value dividend equities out there, but the Global X Russell 2000 Covered Call ETF is close. RYLD focuses on U.S. small-cap equities, sells covered calls on its holdings, and yields 12.6%. Although the fund is not a straightforward play on small-cap value U.S. equities, it should outperform if segment valuations normalize. I last covered RYLD here.

All three funds have outperformed YTD, as improved economic fundamentals, rising interest rates, and bearish tech industry sentiments have caused investors to sell overvalued tech growth stocks, to buy undervalued old-economy value stocks. VBR has underperformed for the past decade, during which tech has significantly outperformed, but outperformed in the 2000s, in the aftermath of the dot-com bubble. AVUV has slightly outperformed since inception, incredibly strong performance considering prevailing market conditions, due to significant alpha / savvy investment decisions. RYLD has underperformed since inception, as the fund’s covered call strategy significantly reduces potential capital gains, and capital gains have been exceedingly high for most of the fund’s history.

A quick table of the fund’s yield and performance.

In my opinion, all three funds are appropriate plays on U.S. small-cap value stocks. VBR is the simplest. AVUV is riskiest, but the one with the strongest potential returns. RYLD has the highest yield, by far, but is a more complicated, less straightforward play on small-cap equities.

Most Undervalued U.S. Equity Industry – Energy

U.S. equity industry segments are all overvalued relative to their historical averages, with one exception: energy. U.S. energy stocks are currently 20% undervalued on both an earnings and yield basis. As a comparison, the S&P 500 is currently 25% overvalued on both measures. Energy is moderately cheap, the broader market is moderately expensive, so the valuation gap between these two is quite large, all things considered.

Considering the above, and with oil prices being relatively elevated, the energy industry seems like a strong bet moving forward.

There are several simple, diversified energy ETFs out there, including the Energy Select Sector SPDR ETF (XLE) and the Vanguard Energy ETF (VDE). These provide broad-based exposure to said industry and are straightforward plays on the same.

For income investors and retirees, the Global X MLP & Energy Infrastructure ETF (MLPX) is a particularly strong bet. MLPX invests in midstream energy corporations, which focus on the transportation and distribution of energy products. Midstream energy companies tend to have safer, more resilient revenue streams, and stronger yields, with MLPX itself yielding 4.6%. Midstream energy companies are also less exposed to energy prices. Losses are comparatively low when prices decrease, gains are comparatively low when prices increase. I last covered MLPX here.

Both MLPX and XLE have significantly outperformed for the past twelve months or so, due to improved economic fundamentals, rising oil prices, and increasingly bullish investor sentiment. Long-term results are broadly negative, with both funds significantly underperforming relative to the S&P 500, as oil prices have been quite low for the past decade or so.

A quick table of the fund’s yield and performance.

Most Undervalued Equity Region – International

U.S. equities consistently trade at higher valuations than comparable international equities, as investors are willing to pay premium prices for the stability, resilience, and strength of the U.S. economy and corporate sector. International stocks are generally about 14% cheaper than U.S. equities, but the gap has widened to 32%. It is a significant gap, widest in decades. International equities also yield moderately higher than comparable U.S. equities, currently about 1.7%, versus a historical average of 1.1%.

Importantly, economic fundamentals and expected growth rates in most international markets are quite strong, so such a massive valuation gap seems unwarranted.

As with the other market segments, there are several simple, diversified international equity index ETFs out there. These include the Vanguard Total International Stock ETF (VXUS), and the iShares Core MSCI Total International Stock ETF (IXUS). Both provide broad-based exposure to international equity markets and are strong plays on the same.

For income investors and retirees, there is the Vanguard International High Dividend Yield ETF (VYMI). VYMI invests in international equities with above-average dividend yield and offers investors a diversified portfolio of international stocks with a 4.2% yield. I last covered VYMI here.

VXUS and IXUS have slightly outperformed YTD, as valuation gaps have mostly refused to budge. VYMI, on the other hand, has significantly outperformed, due to the fund’s greater focus on cheap, high-yield stocks, which have fared relatively well these past few months. All three funds have significantly underperformed for the past decade, as international stocks have lagged behind U.S. equities for the same.

A quick table of the fund’s yield and performance.

Most Undervalued Fixed Income Asset Class – Emerging Market Debt

Finally, the most undervalued fixed income asset class are dollar-denominated emerging market bonds. These carry yields which are about 0.6% higher than their historical average, even as interest rates and yields have fallen across the board.

Bonds have low potential capital gains, so investors should not expect these undervalued bonds to significantly outperform even if yields were to narrow, but there is still the potential for above-average yields, capital gains, and returns.

The VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) is a simple, diversified dollar-denominated emerging market bond index ETF. HYEM provides broad-based exposure to said industry and is a straightforward play on the same. HYEM yields 6.1%, higher than most relevant bond sub-asset classes. HYEM has underperformed in the recent past, as the fund’s Chinese holdings suffered significant losses following negative developments in the country’s construction industry. The fund’s Russian holdings were also effectively wiped out in the aftermath of the Ukraine war, although these were not a significant percentage of the fund. I last covered HYEM here.

A quick table of the fund’s yield and performance.

Conclusion

Undervalued equity market segments and asset classes offer investors the potential for strong, market-beating returns. The asset classes and funds presented here are all undervalued and could outperform in the coming months and years. Hopefully this article was an interesting, useful, informative starting point for investors interested in undervalued asset classes and funds.