EWN: A Few Reasons Not To Get Carried Away (NYSEARCA:EWN)

Introduction

The iShares MSCI Netherlands ETF (NYSEARCA:EWN), a sub $300m sized ETF that focuses on 52 stocks from the Netherlands, has generated decent enough alpha this year. In a year where its European peers have only witnessed single-digit returns, and global markets as a whole, have generated 12% returns, EWN has steadily outperformed these options by 2.3x and 1.4x respectively.

So far so good, but we don’t believe EWN will prove to be too rewarding going forward. Here’s why we are not too bullish on this ETF

Sub-Par Growth Prospects

The Netherlands is currently one of the slowest-growing regions in the world. Europe, by itself, doesn’t have the most robust GDP outlook with expected growth of 0.8% this year followed by 1.5% next year, but the Dutch economy is expected to lag even Europe, with expected growth of only 0.6% this year followed by 1.3% next year.

Already in Q1, we’ve also seen the economy deliver a performance that was worse than expected, with growth shrinking by 0.1% qoq and 0.7% YoY. Of particular concern is the performance of the manufacturing sector, where growth dropped off by 3.8%. The most recent reading for the forward-looking manufacturing PMI also pointed to some slowing momentum of new orders, particularly in the international markets.

Substantial ASML Exposure May Not Be Too Ideal Given The Valuations

EWN has been quite a rewarding play for long-term investors, and one of the key reasons for this has been its heavy tilt towards the world’s biggest semiconductor equipment maker – ASML, which has also managed to build a monopoly of sorts. This one stock alone accounts for over a quarter of the total portfolio.

In recent periods, government subsidies around the world have played an instrumental part in some of the major semi-players choosing to ramp up their EUV-dependent (Extreme Ultraviolet) infrastructure, and it now poised to account for 45% of group sales by next year

Crucially, ASML is believed to have orders from more than 12 semi-players for its high NA (Numerical Aperture) EUV machines, which are expected to reflect favourably on the gross margin profile of the business because of its high ticket price. Gross margins which came in at 51% last year are expected to transition to the 54-56% levels by next year.

All this is very well, but there’s also a price at which you should be looking to get in, and we don’t believe the ASML stock offers great value now. Essentially, the stock is now priced at over 52x forward P/E, which represents a 35% premium over its long-term average multiple. One would be comfortable paying that premium if one were getting even better earnings growth than what we were getting in the past, but after delivering 40% GAAP earnings growth last year, ASML is now on course to generate long-term earnings growth (3-5 year CAGR) of only 22.87%.

The other thing to perhaps be wary of is the ethos of the new government of the Netherlands, who, unlike the previous regime, don’t seem overly fussed about driving tech policy which could galvanize the likes of ASML even further. For context, in their list of 10 priorities, they chose not to make any mention of tech or digital leadership.

Housing Affordability Concerns

One of the unwelcome but standout characteristics of the Netherlands at this juncture is that it has one of the most unaffordable housing markets in Europe; essentially growth in housing infrastructure hasn’t kept pace with population growth with AFB Research highlighting a shortage of close to 400K homes. The effect of this is that the price of the average Dutch home works out to 10x the modal Dutch salary. The IMF has pointed to the Netherlands market in particular, where some of the sought-after neighbourhoods (where house price to median salary is 16x), continue to witness even more overvaluation.

After a brief lull, note that housing price growth has started trending up again, and given the weak base effect all the way till Nov 2023, don’t expect this situation to reverse any time soon.

Closing Thoughts- Unappealing Valuation and Technical Backdrop

Given a high-tech sector exposure (almost a third of the total portfolio), it isn’t particularly surprising to discover that EWN’s valuations are not cheap. The ETF is now priced at an elevated P/E of 17.6x (it represents a 26% premium over the corresponding multiple of a diversified basket of European stocks, and one could perhaps be open to paying such a high multiple if you were getting long-term earnings growth, which was roughly in line with that multiple, or at least in mid-teens, but that isn’t the case here, with expected long-term earnings growth of less than 11%. Given that EWN’s top holding is expected to generate earnings of over 20%, it implies that most of the other holdings are staring at pretty underwhelming earnings growth.

Graphically, the relative strength charts (using global stocks as a base) also help in identifying suitable entry points for different regions across the world. The relative strength chart below measures how Dutch equities are positioned relative to its global counterparts, and you ideally want to be buying these pockets when the relative strength ratio is trading at a substantial discount to its long-term average; not where it is now, a 6% premium over the long-term average.

Meanwhile, recent developments on EWN’s long-term monthly chart to suggest that going long now wouldn’t be too conducive. The price is now less than 5% away from record highs and has recently revisited a terrain that previously served as resistance towards the end of 2021 (area highlighted in yellow). Crucially, note that last month’s candle was a red-bodied shooting star candle (highlighted in pink) which formed just on the boundary of the upper Bollinger band. This highlights how stretched the current price action looks, and how some holders have chosen to take profits at higher levels. Budding investors would do well to heed these signals and not get too carried away at current levels.