iShares MSCI Philippines ETF: Philippines Stocks Are Fairly Valued (NYSEARCA:EPHE)

iShares MSCI Philippines ETF (NYSEARCA:EPHE) is an exchange-traded fund that provides investors with exposure to Philippines stocks. The fund was launched on September 28, 2010. Current net assets under management are $139.8 million (as of January 25, 2023), with an expense ratio of 0.58%. The fund’s benchmark index, which it seeks to track, is the MSCI Philippines IMI 25/50 Index. However, while this is a capped index, the EPHE portfolio essentially maps to the uncapped version of the index, as the largest constituent is worth roughly 12-13% of the portfolio construction (underneath the 25% limit).

Based on the MSCI Philippines index, as a proxy for EPHE’s portfolio going forward, the fund’s trailing and forward price/earnings ratios were 15.82x and 12.61x, respectively, as of December 30, 2022. The price/book ratio was 1.55x, with a dividend distribution rate of almost exactly one third of earnings. Using these numbers, plus a consensus three- to five-year average earnings growth figure from Morningstar of 15.70%, results in an approximate IRR going forward of 12.5% per annum.

Bear in mind that I assume no buybacks (which is probably fine, given these are unpredictable and would only improve the IRR in any case; we are probably being conservative to ignore buybacks) and this is after the ETF’s expense ratio. I have also kept the price/earnings multiple constant, and under-cut the consensus earnings growth figure by keeping to a lower midpoint for the next three to five years of about 14% per annum. This enables me to ensure that the underlying portfolio return on equity is roughly constant (and eases slightly to under 12% in our terminal year).

I have thought about the earnings multiple; note that the local 10-year yield is circa 5.97% at the time of writing. Further, Professor Damodaran recommends a country risk premium of about 3.3% for the Philippines, owing to its less-developed economic and equity market status. The high risk-free rate and country risk premium lend to a high overall cost of equity of 9.26%. Based on my IRR estimate of 12.5%, while this is good, it would actually suggest over-valuation (to some small extent), as the implied underlying equity risk premium is only 3.29%. That is less than a healthier (unadjusted ERP) bound of 4.2-5.5% (albeit 5.5% being on the high side). Having said that, given the high country risk premium I have factored in, EPHE is probably trading at close to fair value, and simply offers a decent headline IRR over the next five years.

The earnings multiple could certainly move, but while the local 10-year yield is high, this could also certainly fall over the next five years as local inflationary pressures are likely to return to trend (eventually). With a lower 10-year, and hopefully less risk aversion, both local risk-free rates and equity risk premiums are likely to compress. I would not want to assume an earnings multiple expansion; that might be possible on a shorter-term basis, but would be safer to assume against. A flat forward earnings multiple is a fine assumption, in my opinion.

The Philippines is ultimately still going to be considered a riskier equity market to invest in. That makes it more likely to out-perform in times of falling risk aversion. However, you will have noticed from EPHE’s relatively small net assets under management that EPHE is not widely coveted. Net fund flows have been modestly positive over the past twelve months (about $16.14 million).

Coupled with the fund’s naturally positive relationship with investment risk-taking activity, EPHE’s sector exposures are over-weight cyclical and sensitive sectors (see below).

That means that EPHE is probably well positioned to bounce into the next global business cycle. Currently Asian countries are mixed and not in complete synchrony; Fidelity offers the chart below for business cycle positioning as of Q1 2023. China is on the rebound, potentially, while South Korea for example is still “pre-recession”. Japan is too. Recession is not necessarily ever guaranteed, however we are talking about a contraction in activity.

Having said that, markets lead by circa 6-18 months (about 12 months or so on average), so this could be a decent time to accumulate positions in EPHE. I do however think that, given the fairly modest underlying return on equity in the fund (less than 13% on a forward basis), and given that an argument could be made for an even higher IRR being required to justify investment, EPHE could both perform well but also not represent a significant opportunity for investment. On this basis, I would take a neutral stance, as on a risk-adjusted basis I think there are better markets to invest in.