DVYE: Most Likely Undervalued Despite Implied Uncertainty (NYSEARCA: DVYE)

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iShares Emerging Markets Dividend ETF (NYSEARCA:DVYE) is an exchange-traded fund offering “exposure to a wide range of companies based in emerging market countries,” including Brazil (25%), China (25%) and Taiwan (9%).

Geographic Exposures DVYE

iShares

Assets under management were “only” $679 million as of April 29, 2022, according to iShares. This follows mostly positive inflows over the past year, but with significant outflows of $58 million during the week of March 7, 2022.

DVYE Funds Flow

ETF database

The fund is diversified, with the largest position representing only around 2% of the fund. In terms of sector exposures, DVYE is more strongly biased towards materials (18%), real estate (18%), finance (12%) and utilities (12%).

DVYE sector exposures

iShares

Technology (5%) and consumer discretionary (5%), for example, are small exposures. This makes DVYE’s sector composition quite different from that of major Western funds which tend to have larger allocations to these types of sectors. Morningstar presents the breakdown as follows:

DVYE sector exposures

the morning star

Thus, DVYE is more of a “cyclical” fund, with some degree of sensitive and defensive exposures as well. You would imagine that DVYE performs well in the early and mid-phases of the business cycle in this regard. Loyalty research on this suggests that in the first quarter of 2022, Brazil is likely midway through and China is likely in recession. With these two countries being the two main geographical exposures, one could say that DVYE is somewhat protected against the economic cycle.

Business cycle positioning

Loyalty investments

Still, if most of the world is in the middle or late stages of the current economic cycle, DVYE is likely more susceptible to stagnation overall. Stock markets tend to lead the economy (i.e. you can’t invest after the fact), and indeed DVYE has already sold into the 2020 lows.

DVYE Price Action

TradingView

The US dollar index has also risen by around 8% since the start of the year, and a stronger US dollar tends to penalize risky international assets, in particular assets denominated in foreign currencies (such as holdings underlyings of DVYE), as they become less valuable in USD. terms.

Yet, on a 30-day SEC yield basis, DVYE’s yield is around 9.38% (as of March 31, 2022) and 8.48% on a twelve-month basis (according to iShares themselves). However, the fund has not performed well over time. Since its inception, the total annual return, even taking into account distributions, is 0.11% per year according to iShares, therefore essentially nil or negative in real terms (after adjusting for inflation). On the other hand, DVYE has sold out significantly recently, so it’s worth revisiting the valuation.

Morningstar estimates a modest average annual earnings growth rate of 8.81% over the next three to five years for DVYE’s portfolio. I can use this to estimate earnings on a basis that we can derive from the most recent fund benchmark information sheet. As of April 29, 2022, the trailing and forward price-to-earnings ratios were 3.65x and 3.87x, respectively, with a price-to-book ratio of just 0.7x. The forecast return on equity was therefore 18%, which is good, and the indicative dividend yield was estimated at 12.92%. It still looks like the market is pricing the entire “equity risk premium” into the dividend yield, but DVYE’s historically weak price performance is interesting and would suggest a near sell-off, so it’s worth assessing whether the actual price of DVYE shares is due for an “upside correction”.

Before starting an assessment with the data above, we need to have an idea of ​​the fair cost of equity for the fund. I use World Government Bonds for data on government bond yields and Professor Damodaran for data on equity and country risk premia.

DVYE Cost of equity

Author’s calculations

The country-weighted cost of equity by my calculations is 13.63%, which includes a relatively high weighted risk-free rate of 6.63% (much higher than the returns offered in the Western developed world, such as the United States States, which are close to zero).

Even with an implied one-year forward earnings decline (based on projections by index provider S&P Dow Jones Indices), if we continue with a three- to five-year average earnings growth rate of around 8, 48% as a target (my calculations’ five-year average is a more modest 4.3%, including the anticipated one-year decline), DVYE is most likely undervalued.

DVYE valuation

Author’s calculations

Given the level of uncertainty about emerging market stocks and their earnings, I will instead assume zero earnings growth after the first year of negative earnings growth. And 0% “in perpetuity” in this case. Holding our cost of equity constant at 13.63%, our valuation still points to a potential upside of 89.6%. The implicit cost of equity is therefore higher, in this case 25.84%, which is exceptionally high. It appears that risk sentiment is very negative on emerging market equities, even though dividend payouts are high, and this is likely due to a combination of political uncertainty and large currency differentials in 2022 with the rise in US dollar boom.

Nonetheless, assuming zero earnings growth, the implied yields are still very high and therefore it seems nearly impossible to lose money owning DVYE at current prices. The dividend yield is high, and it’s safe to say that the US dollar is close to fair value on a fundamental basis now, although the recent surge higher was more likely to be driven by an unwinding of carry trades. change on the back of a much stronger international situation. yield differential (in favor of the USD). The Economist’s Big Mac Index thinks the USD is likely slightly undervalued in January 2022, but otherwise close to fair value (against the EUR, the largest component of the dollar index American).

Fair value PPP USD

Economist.com

On the other hand, The Economist believes that the Japanese yen, another major component of the US dollar index (although only 13.6% against the euro’s weight of 57.6%) is undervalued. 30.4% against the US dollar. When the currency markets stabilize, we may see a much stronger Japanese Yen, which could help push the Dollar lower on a broader basis, even if the Euro remains mostly firm. A more stable and/or weaker USD should be bullish for risky assets, including emerging market stocks.

I should also note that The Economist’s crude model also suggests that the Brazilian real is overvalued by 22.9% and the Chinese yuan is overvalued by 4.8% (both against the dollar). It is therefore possible that the normalization of the foreign exchange market will be economically neutral for DVYE shareholders. Still, a weaker dollar should generally support risky assets, even if DVYE’s larger currency exposures are not supportive. A stronger US dollar supports the unwinding of carry trades and creates negative risk sentiment, so the reverse will generally be favorable.

Furthermore, while Brazil’s current account is still negative (and therefore the risk of some depreciation is present), China’s current account is positive, and so arguably the Chinese yuan still deserves to be stronger. And if China’s next phase is to start a new economic cycle, emerging markets such as those in which DVYE invests could perform well on a cyclical rebound.

Given the number of geographic exposures and variables to consider, DVYE looks risky and difficult to predict. And risk sentiment is not strong even though inflows have been positive over the past year; DVYE is not a very popular fund, and the valuation would imply very high equity risk premiums. I think given the level of uncertainty investors are placing on DVYE, the ETF presents a very viable macro value investing opportunity.

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