Vanguard FTSE Europe ETF: Time To Start Looking Beyond The Gloom (NYSEARCA:VGK)


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introduce

There was a tendency to lump the whole continent of Europe and predict the worst-case scenarios of the war in Ukraine, rising fuel costs and a falling euro after the ECB’s monetary policy review. With so much negativity priced in that Vanguard FTSE Europe ETF (NYSEARCA: VGK) is now available for less than $51 after suffering a nearly 27% drop in one year, as shown in the chart below.

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VGK data from YCharts

However, Europe is made up of many countries and regions that are differently affected by supply chains and high commodity prices, and this work attempts to think outside the box to identify opportunities while highlighting the risks.

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I’ll start with an overview of country engagement.

Diversification at country level

As shown in the table below, in addition to the UK, France and Germany, VGK holds shares in companies based in many other countries such as Austria, Belgium, Denmark, Finland, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain and Sweden. Interestingly, 15.2% of his wealth is devoted to Switzerland, including pharmaceutical companies and financial institutions.

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Diversification at country level (vanguard)

This diverse country level exposure represents diversification in itself and includes a number of value opportunities that remain under the radar as many of the holdings are currently trading cheaply. This is in contrast to the US, where opportunities are limited as valuations are still above historical averages despite recent stock market declines.

Additionally, despite the fact that most countries around the world are suffering, VGK in blue underperforms the S&P 500 (in orange) and the Vanguard FTSE All-World ex-US ETF (VEU) in purple. From a pure valuation point of view, Europe is therefore far from a super bubble.

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performance comparison (Alpha wanted)

This undervaluation is not normal given that, despite an unprecedented energy crisis that could result in natural gas rationing for its industries, Europe has some of the world’s most competitive multinationals that can shift their production to other countries where they operate.

In addition, VGK aims to track the performance of the FTSE Developed Europe All Cap Index. Well, these are developed markets, not underdeveloped or developing countries whose economies need to be bailed out at the first sign of a deterioration in the balance of payments or acute currency devaluations. To this end, many European countries have developed resilience in their economic models through sophisticated welfare systems financed with taxpayers’ money.

As a result, rising energy prices may be constrained by higher taxes on oil companies to fund growing national trade deficits. In that regard, the Vanguard ETF has just 5.76% of exposure to energy companies. Abrupt interest rate hikes by the ECB (European Central Bank) or the Bank of England can also lead to economic slowdowns, but this does not mean that there will be a crisis of apocalyptic proportions that would suddenly blow up VGK’s holdings in existence.

The stocks – strengths and weaknesses

As investors will note, the top 10 holdings out of the 1,369 are not from Germany or Italy, whose economies have a higher dose of industrials that are likely to be hardest hit by rising energy costs. Normally, when we think of Germany, we automatically associate the country with car manufacturers.

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The stocks (vanguard)

Well, VGK doesn’t count any of these big German automakers among its top 20 holdings, but on the other hand, it does hold shares in SAP SE (SAP) as shown above. After short-term headwinds from exposure to Russia, this German enterprise software and cloud game should benefit from more sales as American competitors’ products become more expensive in Europe and other parts of the world due to a strong dollar. Similarly, VGK includes other companies that should benefit from unexpected currency gains, although a lower Euro or GBP is bad for inflation.

The ETF also includes giant Allianz (OTCPK:ALIZF) as well as other insurance companies such as Zurich Insurance (OTCQX:ZURVY), which are seen as beneficiaries of the ECB’s rate-hiking policy. Because in addition to the investment, insurance companies also keep the money of the policyholders with banks and when interest rates rise, the value of their assets also increases. In fact, the fund invests about 15% of its assets in financials, including banks like HSBC plc (OTCPK:HBCYF).

One sector that’s seen as defensive in tough times is healthcare, which accounts for about 15% of VGK’s assets, including big names like Switzerland-based Roche AG (NASDAQ:ROCHE) and Novartis (NVS). The healthcare sector has held up well, as evidenced by the one-month stock performance of these two companies.

On the other hand, the consumer discretionary sector, represented here by luxury brand LVMH Moët Hennessy (LVMH), has suffered by 9% in the last month, despite a 13% increase in sales in the second quarter of 2022 on a year-over-year basis. However, on a sequential basis, there was a slight decline, raising concerns among investors that there could be more problems in the second half of the year.

On the cautious side, industrial holdings, which account for 15% of VGK’s total assets, remain likely to suffer the most as they are likely to face an uncertain demand outlook in addition to higher energy and material input costs. This uncertainty appears to have been priced into the Siemens (OTCPK:SIEGY) 40% downtrend since early 2022.

discussion of the outlook

Nevertheless, Europe’s largest manufacturing company has not yet capitulated and recently commissioned one of the largest production plants for green hydrogen in Germany. In a way, this shows Europe’s commitment to green technology while the US is bogged down with its oil companies. As a result, Europe is better prepared for global warming, while many on the other side of the Atlantic are burying their heads in the sand. This implies that there is a risk that the US federal government will not have enough money to save flooded areas or areas devastated by major fires or hurricanes.

Still, the future remains uncertain, not just in the old continent but pretty much everywhere in the world, including the US, where confidence has now given way to doubt as the Fed is now forced to implement the most drastic monetary tightening policy following a rise in CPI ( consumer price index).

Under the circumstances, Europe deserves a fresh look and looking closely at price action, VGK hit a low of $49.97 on the first day of September, coinciding with Russia halting and not resuming natural gas supplies to Germany. It is currently trading at $50.25 and tested the $50.50 level on July 14th. Therefore, $50.25-50.50 seems to represent a resistance level.

Even as the ECB hiked rates by 75 basis points, VGK subsequently rose by around $2 to $53.51, showing investors appreciate the fact that the ECB is willing to do whatever it takes to contain inflation fight. In addition, many corporations that have liquid funds are fighting back with commodity hedges such as Volkswagen (OTCPK:VWAGY), which gained 400 million euros in this way.

So, to stick with the diversification rhetoric, not all holdings are likely to experience the same level of headwinds, particularly those based in France. This country is in a unique situation as it has not relied on Russian oil as much as Germany as it has more nuclear power plants and engineers are working very hard to fix older ones before winter. It is therefore much less vulnerable to the war in Ukraine.

Finally, the justification for the dividend

Therefore, all is not gloomy and there are many “pockets of opportunity”. For those who have been holding cash for a long time and want to diversify into an income-generating ETF, VGK pays one of the highest returns (at 4.38%), as can be seen in the table below.

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dividend notes (www.seekingalpha.com)

Now, one of the reasons for the high yields is that VGK is depreciating. The chart above also shows that quarterly dividend payments are inconsistent. The reason is that, unlike some U.S. counterparts, European companies have no intention of becoming Dividend Aristocrats. Instead, they cut the dividend when business isn’t doing well and increase yields when conditions improve. That’s why a big dividend doesn’t mean their business is under water, and they’re desperate to set a value trap. Thus, the higher dividend payment in July shows that the underlying fund is doing well.

As an alternative to VGK and for those (like me) whose brokers give them access to funds listed in Europe, there is the Lyxor CAC 40 (DR) UCITS ETF for French equities, the Xtrackers XDAX INCOME ETF for Germany and the Lyxor Core UK EQ ALL CAP DR ETFs that provide exposure to many of the stocks mentioned above. They also pay good dividends. However, the Vanguard ETF remains cheaper with an expense ratio of just 0.08%, and you get all the stocks in the same basket.

After all, the conflict in Ukraine and high commodity prices all have the hallmarks of a “predictable recession,” where investors and ordinary people alike know in advance of many of the pains to come. Whilst there could be further downside for VGK in the event of a ‘winter recession’ in Germany or further trouble in the UK if the value of the pound weakens, I therefore do not foresee a market crash of apocalyptic proportions as is the case during a normal recession.



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