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One reason it is difficult to compare different stock markets directly is because they vary hugely in terms of the assortment of industries that each represents.

The Associated Press

Analysts at Morgan Stanley say Japanese stocks are cheap. In contrast, money managers at Tatton Investment Management declare that European stocks are a bargain. Still other experts tout the case for Canadian equities or shares of companies in emerging markets.

No wonder so many investors are confused about how to position their portfolios. Can one region’s stock market actually be a better investing proposition than another’s?

At first glance, the notion seems reasonable. Different markets vary in how much they pay out in dividends and in how richly valued they are in terms of their underlying earnings.

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Right now, for instance, the S&P 500 index of large U.S. stocks offers a dividend yield of 2 per cent. In contrast, the MSCI Emerging Markets Index pays out a much more lush 3 per cent. The S&P is valued at more than 19 times earnings, while stocks in emerging markets change hands for a mere 13.2 times earnings.

The conclusion appears obvious: Given their higher dividends and lower valuations, emerging markets shares must be a more enticing proposition than their U.S. counterparts, right?

Perhaps so. But before betting your portfolio on that conviction, you may want to consider what history has to say.

Back in 2004, the S&P 500 was also more expensive than emerging markets stocks or, for that matter, European stocks. But over the next 15 years, the S&P would go on to produce greater returns than either of those apparent bargains.

This doesn’t mean investors should ignore starting valuations. But it does suggest that simple comparisons of price-to-earnings ratios (P/E) tell only part of the story.

One reason it is difficult to compare different stock markets directly is because they vary hugely in terms of the assortment of industries that each represents. Investors who don’t account for these industry tilts can wind up with false impressions of what is cheap and what is expensive.

The accompanying chart demonstrates how some major indexes compare in terms of their sectoral composition. As you can see, the S&P/TSX Composite, the most widely used Canadian benchmark, leans heavily toward banks, oil producers and miners.

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Where do technology stocks factor in this picture? So far as the Canadian index is concerned, they’re barely worth a mention. Consumer stocks and health-care shares also get scant attention.

The S&P 500 offers a striking contrast. Technology stocks make up nearly a quarter of the U.S. index. Health-care stocks pack a bigger wallop than financial stocks. Consumer stocks tower over energy stocks. When you put all these differences together, the U.S. index delivers a radically different slice of the global economy than its Canadian counterpart.

Japan’s Nikkei 225 index is even more of an outlier. Banks, oil producers and utilities are nearly invisible in the Tokyo index. Consumer goods, tech, heavy industry and health-care shares reign supreme. In terms of sectoral composition, the Nikkei looks like the polar opposite of the Canadian benchmark.

This proves that national markets can vary greatly. But does it mean that one is cheaper than another? Generally, no – at least not if you are looking for a place where you can consistently find a better deal on a given type of company. Look around the world and you find that similar sectors tend to be valued at similar levels no matter where they are located.

Tech stocks, for instance, are just about always expensive in terms of P/E, because investors usually buy these companies for their future growth potential. In contrast, most banks and other financial-service companies trade for much lower valuations, and deliver bigger dividends, because many of them are mature companies with limited room for expansion.

The differences in sectoral valuations tend to make bank-heavy, tech-light benchmarks such as the S&P/TSX Composite appear cheaper in international comparisons. But they aren’t – at least not if you adjust for their industry tilts.

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You can see this by comparing the valuations of similar companies in different indexes. This week, Royal Bank of Canada, Canada’s biggest bank, was selling for 11.9 times earnings. JPMorgan Chase & Co., the largest U.S. bank, was changing hands for 11.7 times earnings, while HSBC Holdings PLC, the largest European bank, was going for 11 times earnings.

These numbers suggest that Canadian investors who are fond of bank stocks aren’t getting an obvious bargain by sticking close to home or by venturing abroad. The market puts similar valuations on similar businesses, no matter where they are found. This is true at both ends of the spectrum. Canada’s big tech stocks, such as Shopify Inc. or Constellation Software Inc., are richly valued – but no more so than tech companies in other markets.

One lesson that emerges from all this is to take comparisons of different markets with a large grain of salt.

To be sure, extreme valuations should be treated with caution. Investors could have done well by avoiding the S&P 500 during the dot-com era of the 1990s or Japanese stocks during the real estate boom of the late 1980s. But at a time like now, when most markets are trading between 13 and 19 times earnings, differences in sectoral composition explain a substantial part of the apparent gap in valuations.

Another lesson is to make sure that you are getting true diversification when you venture outside of Canada. Buying foreign banks or foreign oil producers merely amplifies the existing biases of the Canadian market. What most Canadian investors need is exposure to leading tech, consumer goods and health-care companies – the sectors that don’t get much love in the S&P/TSX Composite.

One way to get that exposure is by putting part of your portfolio into a U.S. or Japanese index fund. A slightly more complicated way is to buy individual stocks in the desired sectors, or to look for exchange-traded funds that focus on particular sectors. (iShares, the ETF arm of BlackRock Inc., offers a range of sectoral ETFs that serve up global assortments of companies in specific industries.)

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However you decide to diversify, you should remember that the case for diversification doesn’t rest on the notion that some markets are cheaper than others. Rather, it’s based on the observation that it is difficult to know which industry, or which region, will do best over the coming years. Holding a wide assortment of sectors across different countries gives you the best chance at performing well.

What's under the hood

Stock indexes can represent very different mixes of industries. Canada’s S&P/TSX Composite leans toward financial-services, energy and materials. The S&P 500 tilts in the direction of tech and health care.

SectorS&P/TSX CompositeS&P 500Nikkei 225MSCI EuropeMSCI Emerging Markets
Information technology5.222.116.95.814.4
Financials32.612.72.416.926.4
Health care1.413.711.813.82.7
Industrials10.89.219.413.55.3
Consumer discretionary4.410.221.39.513.9
Consumer staples4.27.71015.66.9
Communication services5.710.49.14.711.6
Energy16.34.50.47.17.4
Materials11.22.76.47.27.4
Utilities4.83.60.24.52.9
Real estate3.73.32.31.42.9

Source: Bloomberg

As of Oct. 3, 2019

The valuation gap

Stock indexes trade for widely varying prices

VALUATIONprice-to-earningsdividend yield
S&P/TSX Composite16.63.2
S&P 50019.12
Nikkei 22515.32.1
MSCI Europe18.13.9
MSCI Emerging Markets13.23

Source: Bloomberg

As of Oct. 3, 2019

A murky crystal ball

Starting valuations in 2004 were a poor predictor of future performance

INDEXP/E RATIO ON SEPT. 30, 2004SUBSEQUENT 15 YEAR PERFORMANCE
S&P/TSX Composite16.3188.4%
S&P 50017.8277.8%
Nikkei 22520.6180.3%
MSCI Europe16141.0%
MSCI Emerging Markets10.9240.7%

Source: Bloomberg

Total returns in Canadian dollars as of Oct. 3, 2019

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