EPP: An Undervalued Asia Pacific ETF With Weak Outperformance Potential (NYSEARCA:EPP)

iShares MSCI Pacific ex Japan ETF (NYSEARCA:EPP) is an exchange-traded fund (“ETF”) that provides investors with exposure to companies in Australia, Hong Kong, New Zealand, and Singapore (i.e., targeted access to a specific subset of Asia Pacific stocks, excluding Japan). The fund sounds niche, and it is, and yet it is also popular; net assets under management were $2.26 billion as of February 3, 2023. The expense ratio is 0.47%, which is quite high, but in line with other macro funds from iShares.

The fund is based on its chosen performance benchmark, the MSCI Pacific ex Japan Index. The most recent factsheet for the benchmark, as of January 31, 2023, can serve as a proxy for EPP’s financial position as at the same date. The factsheet reports trailing and forward price/earnings ratios of 17.12x and 14.74x, respectively, with a price/book ratio of 1.79x. The implied forward return on equity is 12.14%, which is on the low-moderate side from an international perspective, with implied earnings growth of 16.15% on a forward one-year basis. Morningstar offers an estimated average three- to five-year earnings growth rate for EPP’s portfolio of 6.13%.

It would appear that, given the high rate of earnings distributions (implied by an index-based trailing dividend yield of over 4%) and a relatively modest portfolio return on equity, the fund’s forward returns are likely to be generated mostly through dividend income across the portfolio. The modest 6% earnings growth forecast over a medium-term time horizon I can, therefore, accept; I assume slightly less than this over a five-year horizon, but with a minimum 2% earnings growth as a floor. If anything, you could argue I am erring on optimism here.

Further, the prevailing forward price/earnings ratio of 14.74x could be challenged. The current EPP geographically-weighted 10-year yield is 3.35% at the time of writing. Let’s assume the average 10-year (a proxy for the risk-free rate) to 3%, given recent inflationary pressures that may eventually abate. Assume a 2% nominal earnings growth rate into perpetuity for the fund. Further, assume a 5.5% equity risk premium (to account at least for country risk premiums that are non-zero per work from Professor Damodaran).

Working these inputs gives us a fair value earnings multiple of 15.38x, but that is of course subject to debate; risk-free rates could be much different, and so could long-term earnings growth prospects. In this case, I would prefer to hold constant the present multiple into the future. The result is ultimately an IRR potential of some 9.5% per annum over the next five years.

The underlying equity risk premium as implied, after subtracting the geographically-weighted risk-free rate and country risk premium, is 5.90%. That is fair; I would probably look for 5.5% or so. EPP looks modestly undervalued. I could see a small bump of 0-5% on a valuation basis alone, and that is including the ongoing expense ratio, etc. On the other hand, perhaps I am being optimistic with earnings, perhaps the fund will retain earnings and invest at a progressively lower return on equity (with a risk there of capital misallocation), and so forth. The IRR potential for EPP is good, but I am not keen on buying into lower-ROE portfolios unless there is a steep valuation gap. There is not a steep gap in this case.

Buying into EPP is perhaps analogous to buying into a “bad company” at a “decent price.” In value investing, you might look to buy into “good companies” (high profit margins, returns on equity, etc.) at “good prices” (as an ideal). In this case, the price isn’t quite good, but decent; more concerning is the relatively modest productivity of the EPP portfolio. The main reason for the sluggish portfolio-wide ROE is the over-exposure to Financials (at 37% of the portfolio as of February 2, 2023).

Generally speaking, the fund is invested in mature sectors and mature companies, hence the high rate of earnings distributions into dividends. If I assume that the distribution rate ticks down to 50% over the next five years, the IRR is basically the same, as with dividends I am assuming one is reinvesting.

I think iShares MSCI Pacific ex Japan ETF is likely to track other funds upward into the next business cycle. That is natural. But I am not counting on outperformance, and I think that EPP is not particularly interesting as an international hedge for U.S. investors. I don’t really understand the strategy enough to consider iShares MSCI Pacific ex Japan ETF exciting. There is no clear outperformance potential here; better opportunities exist elsewhere.