Just How Cheap is Europe vs. the US, and Should it Be?

As a quick follow up to our recent piece we wanted to dig deeper into the history of the relationship between multiples in Europe and the US, as well as between value and growth.

In the article linked above, we pointed out that – for the longest time (from 1980 to 2010) - the annualized total returns in the US and Europe were almost precisely the same.

In a similar vein Meb Faber has written a lot about the myth that the US a) always trades at a premium to European or other foreign markets (it doesn’t) and b) that it deserves to (it also doesn’t). Indeed, he shows that – using CAPE ratios as a proxy for multiples– over the long term the valuation premium for US equities is precisely zero, or at least it was before the events and developments over the past few years.[1]

I know that we Americans can all say, “hey, our government is more stable, we have stronger accounting regulations, better corporate governance, etc.” and of course we like to think “we have better companies.” But guess what, the Germans say the same thing. So do the Brits. Many Europeans think it is an advantage to have multiple languages and cultures; while many Americans think it is an advantage to all speak the same one. Tomaytos and Tomahtos.

The truth is that no matter where we live, we all are infected with home bias when it comes to how we feel about investing inside our own countries. There are some practical reasons for this, but there are also psychological reasons for us to (incorrectly) apply lower discount rates to our own local markets vs. foreign ones. Indeed, there is strong empirical evidence that we all have “relative optimism” for our home equity market over international markets.[2],[3]

In our view, this has become even more pronounced over the last few years. This may have manifested in a real or perceived difference in the quality and investibility of US companies generally; which in turn may have led to momentum and higher index weights for the obvious “winners” (and people running for the exit doors elsewhere).

To the extent that the tail wags to the dog here is another topic (and an interesting one), but whether it does or doesn't, this dynamic needs ever-expanding exuberance (or perhaps decreasing interest rates) to sustain itself; yet each of these features has boundaries.

Anyway, to see where we are today, let’s look at some pictures to help illuminate all this. This chart below shows the recent multiple evolution for the US and Europe, using the Russell 1000 and Euro Stoxx 600 as proxies, respectively. We can see here that the Russell 1000[4] is trading at a forward P/E of 23.2x, and the Euro Stoxx 600 at 17.1x. We can also see that the US has traded at a premium to Europe over much of this last decade, and that the valuation premium appears to be increasing.

We can also look at the multiples as a ratio to each other to see just how much the US multiple has been expanding (relatively to Europe) since early 2015. Then, it bottomed at just a 5% premium; and today, the US is trading at a 35% premium to Europe.

And if we go back 15 years, we see that the current level was only exceeded in the months leading up to the GFC in 2008.

So we have some decent support for the argument that the US has become more expensive than Europe, both in the context of recent multiple expansion, as well as historically. Yet, if growth opportunities going forward (not backward) are greater for US companies than European ones, we naturally could justify some sort of premium for the US market. But it is hard to square this circle, especially since European multinationals generate half of their profits outside Europe, whereas the US only generates 30% internationally.

Now, it could just be a thing where the US market is awesome and always will be, and Europe sucks and always will; but the home bias thing surely affects us there, and we should also but consider that US multinationals are also exposed to Europe, and European multinationals are even more heavily exposed to the US.

Moreover, before we immediately react and pull out some “see but look US companies have been growing much faster” chart, we need to make we are comparing apples and apples.

A lot of the “Europe isn’t growing as fast” meme is a) based on recent history, and b) based on the earnings growth of the Euro Stoxx 50 (SX5E), which is just the wrong index for this. It is laden with low-multiple, low-growth telcos, utilities, and financials; and is a nonsense proxy for Europe when comparing it to the US and its S&P 500 (SPX) chock full of all those wonderful FAMANGs we discussed in our last post. In our view, comping to the S&P 500 using the Stoxx 50 as a proxy for “Europe” suffers from some confirmation bias, as it serves to validate a pre-existing view about the superiority of US companies.

‍What we instead need to do is compare US growth to European growth, and US value to European value.

But forget all that for a second, and let’s just quickly revisit what we’ve already learned. We know from the charts above that the US multiple premium has expanded over the last few years. Here it is in tabular form:

Now, let’s see how things split out between value and growth. Firstly, apologies for not emphasizing this point earlier, we are – unlike Meb’s CAPE analysis – looking at forward earnings to determine P/E ratios, not historical earnings.

For the indices themselves, the each have growth and value versions which are based on a subset of the components in the index meeting the criteria. An overview of this methodology and these indices is provided in the endnotes.

So let’s look at the differences between value and growth within each region. In the US, again based on consensus forward earnings expectations, the premium paid for growth stocks over value stocks has increased dramatically over the past five years. Using the Russell 1000 value and growth indices, the growth index is at a forward P/E of about 33x, and the value index close to 18x; and that all works out to growth being at an 84% multiple premium.

And over in Europe, we’ve also seen multiple expansion for growth over value. Believe it or not (or maybe this makes sense) the Europeans actually pay a larger multiple for growth over value than the Americans, and have every year. Moreover, the growth multiple premium in Europe today is a whopping 180%.

‍So, investors are paying a larger premium for growth names in both regions; but it has been Europe – not the US – where this feature has been most pronounced.

Another interesting point, which maybe you caught already, is where the outright US growth multiple is. It’s 33x.

Now look at it in Europe. It’s also 33x.

As it turns out, it isn’t that the people are paying a bigger growth premium for US Growth over European Growth; but instead it is that people are paying a (much) bigger multiple for US Value than for European Value.

Your first reaction to this might be “well, this can’t be – the overall US market is so much more expensive than Europe, and we have these FAMANGs and their ilk.” Well, I think your suspicions are correct, but even similar growth multiples can drive the US benchmark higher than Europe.

These “FAMANGs and their ilk” were already such a large component of the overall index in the first place. Add some fundamental earnings improvement, and a huge amount of multiple expansion (from 16x in 2013 to 19x in 2019 to 33x in 2021) you get a bigger weight in the index, supporting the overall index multiple. Similarly, since these tech names are bigger in proportion to their overall index in the US (the S&P 500) than they are in Europe (the Euro Stoxx 600), this too helps to explain that the US multiple premium isn’t simply the case of people thoroughly discarding European value (which they seem to be) but also a case of the importance of the FAMANGs and tech to the overall returns of the S&P 500 (or Russell 1000) and underperformance of the Euro Stoxx 600.

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‍ENDNOTES‍

Forward P/E Ratio:  Ratio of the current share price to the analyst forecast consensus forward EPS estimate, which is a proportionally-weighted blend of the next 24 months (either eight quarters or four halves, depending on the reporting period).

‍The Russell 1000 Growth Index: The Russell 1000 is a cap-weighted index that represents the top 1,000 companies by market capitalization in the United States.  The Russell 1000 Growth Index (RLG) includes those companies with higher price-to-book ratios and higher forecasted growth values, and is reconstituted annually. As of June 30, 2021, it held 499 securities, the median market cap was $19 billion, and top holdings were Apple, Microsoft, Amazon, Facebook Google, Tesla, Nvidia, Visa, and Home Depot.

‍The Russell 1000 Value Index: The Russell 1000 Value Index (RLV) includes is a subset of the Russell 1000 and includes those companies with lower price-to-book ratios and lower expected growth values, and is reconstituted annually. As of June 30, 2021, it held 842 securities, the median market cap was $14 billion, and top holdings were Berkshire Hathaway, JP Morgan Chase, Johnson & Johnson, UnitedHealth Group, Procter & Gamble, Bank of America, Disney, Exxon Mobil, Comcast, and Verizon.

‍Euro Stoxx Growth Index: The Stoxx Europe Total Market Index (TMI) is a cap-weighted index representing the Western Europe region as a whole, covering approximately 95% of the free float across 17 countries. The Stoxx Europe TMI Growth Index (STGE) is a market-cap weighted subset of Stoxx Europe Total Market Index, and is designed to enable investors to monitor the performance of companies with similar growth characteristics. Style characteristics are sorted on projected P/E, projected earnings growth, trailing P/E ratio, trailing earnings growth, price-to-book, and dividend yield. A high P/E ratio (historical or prospective), high growth (historical or prospective), high P/B ratio, or low dividend yield is associated with the growth. As of July 19, 2021, it held 433 securities, and its top holdings were ASML, Roche, LVMH, SAP, Unilever, Astrazeneca, Linde, Novo Nordisk, Diageo, and L’Oreal.

‍Euro Stoxx Value Index: The Stoxx Europe TMI Value Index (STVE) is a market-cap weighted subset of Stoxx Europe Total Market Index, and is designed to enable investors to monitor the performance of companies with similar value characteristics. Style characteristics are sorted on projected P/E, projected earnings growth, trailing P/E ratio, trailing earnings growth, price-to-book, and dividend yield. A low P/E ratio (historical or prospective), low growth (historical or prospective), low P/B ratio, or high dividend yield is associated with the value style. As of July 19, 2021, it held 604 securities, and its top holdings were Novartis, Sanofi, Siemens, HSBC, Total, Allianz, GlaxoSmithKline, Rio Tinto, British American Tobacco, and BP.