In our previous article, Dissecting the Emerging Market Rally, we analyzed the drivers of one of the year’s most unexpected bull markets. We proposed that relative to its emerging market counterparts, China still has room to grow, and that within China, internet and E-Commerce companies may represent the strongest growth opportunity. This week we sat down with Michael Krause, the founder of the ETF Research Center, to give us some perspective on how the fundamentals of emerging markets and China internet sector compare to other global markets right now. Michael has over two decades of experience as an analyst evaluating ETFs from a fundamental perspective. His firm, the ETF Research Center, provides unparalleled tools that enable analysis of exchange traded funds (ETFs).

Brendan: Could you provide background on yourself and the ETF Research Center?

Michael: Over ten years ago I started a firm to conduct research on what was then still a very small universe of exchange-traded funds (ETFs). Our idea was that, of all an ETF’s benefits, including low costs, intraday trading and tax efficiency, one of the most important—and overlooked—was its transparency. It’s that transparency—the ability to know exactly what securities are in each fund—that enables a completely different type of analysis. We’re able to apply the traditional tools of security analysis to each underlying stock (or bond) in an ETF, and then aggregate those figures up to the fund level so that investors can view and value them in a familiar yet very disciplined way.

Brendan: According to Bloomberg, year to date investors have allocated $18.7 billion to U.S. listed emerging markets ETFs¹ and the MSCI Emerging Markets Index is up 17% for the year². What is your view on emerging markets (EM) today?

Michael: Commodity-dependent countries in emerging markets were deeply undervalued; but their rallies this year have largely remedied that, putting them on par with the broader EM universe, which we see as modestly undervalued. Going forward then—and this highlights why it’s so important to focus on fundamentals as opposed to just past performance—further appreciation is likely to be driven less by valuation disparities and more by earnings growth.

So where do we find the best earnings growth? For commodity-dependent areas that of course depends on the future direction of commodity prices. But for what they’re worth, consensus estimates for companies in the MSCI Brazil Index³ forecast a 5.9%* decline in earnings next year, while for the broader MSCI Emerging Markets Index that figure is a gain of 16%*, supported by growth in China and India, particularly Tech-related areas.

Brendan: The ETF Research Center conducts in-depth ETF analysis and provides a wealth of fundamental ratios and analytics. Can you give us an overview of the numbers you have calculated for the KraneShares CSI China Internet ETF (KWEB) and U.S. technology indexes?

Michael: While KWEB’s forward price-to-earnings (P/E)⁴ may look high at 38x, P/E doesn’t always tell the full story. KWEB’s long term earnings per share (EPS)⁵ growth rate estimate is 36%*.

Like all the metrics we calculate, we look at the consensus estimates from analysts covering the stocks held by exchange traded funds. These analysts provide estimates on what they believe a company’s earnings per share (EPS), revenue, dividends and other financial metrics will be. Long-term EPS growth is simply the aggregate of Wall Street analysts’ estimates for each of KWEB’s holdings.

I should caution investors to take these figures with a grain of salt, because the Wall Street analysts who contribute their estimates to the consensus are a notoriously optimistic bunch. Still, we have no reason to believe that their bias is greater in one area than another, and so the relative differences between companies (and funds or entire indices) are still important.

Not surprisingly, in the U.S. internet sector the long term growth forecasts are not as high as in the China internet sector. For example, we calculate the long term earnings growth for firms in the Down Jones Internet Index, which tracks the performance of U.S. internet firms such as Amazon.com and Facebook, to be about 16%, which is less than half of that for the Chinese firms in KWEB.

Brendan: You also calculate KWEB’s price / earning to growth (PEG) ratio⁷. What does this calculation tell us?

Michael: In general, the P/E ratio tends to be higher for companies with a higher growth rate. Thus using just the P/E ratio would make high-growth companies appear overvalued relative to others. P/E is simply a snapshot in time that does not factor in how fast the company is growing. But by looking at price-to-growth, or “PEG” ratios, we can help determine the relative trade-off between the price of a stock, the earning per share (EPS), and the company’s growth rate. Think of it as a “growth-adjusted” P/E ratio that helps facilitate valuation comparisons between companies growing at different rates.

Based on current share prices, the stocks in KWEB are trading at about 38x forward EPS estimates, while those in the Dow Jones Internet Composite Index⁶ are just somewhat cheaper at 28x. Dividing each P/E ratio by the long-term growth forecast results in a PEG ratio of just over 1.0x for KWEB, but about 1.8x for the Dow Jones Internet Composite Index. So, when you factor in growth rates, stocks in KWEB start to look cheaper.

Brendan: I like to use the ETF Research Center's Historical Valuation Trends tool when researching valuations. Do you mind providing an overview of the tool and what it can tell us about KWEB's valuation?

Michael: It probably sounds strange to characterize a basket of Chinese internet stocks held by KWEB as bargains, but at least in relation to their own trading histories they appear quite cheap. The tool you mentioned shows the historical valuations for KWEB back to the fund’s inception in August 2013. Whether you’re looking at P/E, Price-to-Sales⁸ or Price-to-Book Value⁹, companies in KWEB are trading at or near the bottom of their valuation range of the last three years.

Brendan: What insights can price-to-book value give emerging market investors that P/E cannot?

Michael: We like to look at price-to-book value not just in emerging markets but across all ETFs we cover for two main reasons. First, though still imperfect, book value—that is, Owners’ Equity—can’t be as easily manipulated as the EPS figures on which the P/E ratio is based. Second and more importantly is that book value reflects a firm’s historical results including both the good and the bad, whereas a P/E is a snapshot at a single point in time. This can be particularly misleading for cyclical areas. When earnings are at their peak the P/E ratio will go down, making shares look cheapest right before a downturn. And when things get really bad and firms record a loss, the P/E ratio becomes altogether meaningless.

Brendan: ETF Research Center has a wealth of great information to help investors make informed decisions. Your approach of looking at Wall Street analysts and fundamental analysis is unique amongst research providers. I really enjoy the fundamental information you provide. How can investors explore this tool on their own?

Michael: Investors can go to www.etfresearchcenter.com and sign up for a free trial subscription. Once logged in, they can use our search tools to find ETFs that meet investment criteria that they set, and then research those ETFs in depth to help pick the best ones for their portfolio.

Brendan: Many thanks again Michael!

KWEB inception date: 7/31/13. The ETF is benchmarked against the CSI China Overseas Internet Index.
 The views provided by Mr. Krause represent his views and analysis; neither KraneShares nor SEI Investments Distribution Co. is responsible for the accuracy of his statements.

Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

*Data from the ETF Research center as of 9/30/2016. Not a forecast of the fund’s future performance.

Michael Krause and the ETF Research Center have no business relationship with Krane Funds Advisors, LLC and were not compensated for this interview / analysis.

1. Data from Bloomberg as of 9/30/2016
2. Data from Bloomberg as of 9/30/2016. The MSCI Emerging Markets Index captures large and mid cap representation across 23 Emerging Markets (EM) countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
3. MSCI Brazil Index: The MSCI Brazil Index is designed to measure the performance of the large and mid cap segments of the Brazilian market. With 60 constituents, the index covers about 85% of the Brazilian equity universe.
4. Price-to-earnings (P/E): A valuation method used to compare a company's current share price to its per-share earnings
5. Earnings per share (EPS): is the portion of a company’s profit that is allocated to each outstanding share of common stock, serving as an indicator of the company’s profitability. It is often considered to be one of the most important variables in determining a stock’s value, and it comprises the “E” part of the P/E (price-earnings) valuation ratio. EPS is calculated as: EPS = net income / average outstanding common shares. Estimates provided do not represent a forecast of the fund's future performance.
6. Dow Jones Internet Composite Index: To represent the largest and most actively traded stocks of U.S. companies in the Internet industry. The index has several features: 1. to be eligible for the index, a company must generate at least 50% of its revenues from the Internet; 2.the index is designed to provide representation of both the Internet commerce and Internet services sectors; 3.stocks are selected to the index based on float-adjusted market capitalization and liquidity; and 4.the Dow Jones U.S. Internet Composite Index was first calculated on February 18, 1999.
7. Price / Earnings to growth (PEG) ratio: The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. Estimates provided do not represent a forecast of the fund’s future performance.
8. Price-to-Sales: A valuation ratio that compares a company's stock price to its revenues.
9. Price-to-Book Value: A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share