I’m subscribed to the Briefings newsletter by Goldman Sachs and just about every week I find some incredible value from the research they release.
Two Friday’s ago they released “European stocks may give US equities a run for their money” and last Friday they released "How much could AI boost US stocks?”
I found these two articles complement each other in unique ways. I think largely the latter explains the former.
The US historically has been an incredible place to allocate capital, but every now and again Europe and other international markets have outperformed. For the last 20 some odd years however the winner has been largely the US, with some short lived outperformance internationally.
It has been a centerpiece of research firms, like Goldman Sachs, for years to state that international stocks have cheaper valuations than US counterparts. And they state that international markets should have an overweight in portfolios because of that. But I feel like they are comparing apples to apples, when it’s really apples to oranges.
But let’s dive deeper than relative valuation.
In the article on European stocks Sharon Bell lays out why she believes this discount exists. She says that the Euro area was hit harder than the US by the Great Financial Crisis, the American technology sector benefited greatly from 0% rates in the aftermath of the GFC, and that Europeans generally don’t invest in the stock market as much (so the investor base is smaller - which means less demand).
Then she goes onto state why she believes the valuation gap should narrow.
Currently the gap is around 20-30% depending on how to weight the individual markets. That is rather substantial and I agree with Sharon on how that got there.
She believes that higher US interest rates, improving regulations, broader global representation, falling US profit margins, and European stock buybacks.
My first question is why didn’t she mention earnings growth expectations for European companies? After all around 70% of long term returns come from companies being able to growth their earnings. I could make the same case for Europe as for Japan.
Japanese companies have been under pressure by the Japanese exchanges to increase their stock prices. About 50% of Japanese companies have a lower valuation than there actual book value - or net worth.
The reason you see valuations like that is because investors have lost all faith in the ability of the business to grow. Why, even at a discount, would you buy something that could very well one day die?
Investor sentiment very much plays into investing. Even if all of Sharon’s points were to come true, if the outlook for US earnings growth was still higher and more predictable, why should we expect anything to change from a global perspective?
In the other article, released last Friday, Goldman analyst forecasted that AI adoption could push the S&P 500 to $4,600+ by the end of June, that’s less than two weeks away. And as of Friday June 16th the S&P 500 trades for ~$4,437.
This is very much a reason why the US is more attractive in the eyes of investors.
AI has the possibility, per Goldman Sachs, to boost productivity in the US by around 1.5% annually, which is significant. But increased productivity hasn’t always boosted the S&P 500’s price.
Goldman economists note the U.S. equity market appeared to price the impact of electricity in the 1900s after the productivity boom was realized, but following the widespread adoption by businesses of the PC along with early-stage use of the Internet, the S&P 500 index priced the innovations’ impact as the productivity boom was realized, returning 26% annually between 1994 and 1999, near the peak in productivity growth.
Europe, despite claims by Sharon, is already starting to put strict regulations on AI, as they have done with technology and internet companies. She claimed that the US benefited greatly from having a booming internet expansion following the onset of 0% interest rates, yet the regulatory framework in Europe set a moat around the US in terms of technology productivity and profitability globally.
On the other hand if Sharon is correct about margin destruction, that could kill some of the investor sentiment around US business growth potential (and thus narrowing the valuation gap).
The discount is hard to ignore, and there certainly are opportunities, but I just remain cautious. I always ask these questions. Why is there a discount/premium? Are the claims on the discount/premium accurate and sustainable? Is the premium backed by sustainable earnings growth? Is that a reasonable case?
Our investment strategy is quality growth at a reasonable price, and that can mean many things. That can mean we buy companies that are growing really fast with sustainable features that are trading at premiums to their peers. It can also mean that we are buying discounts that we feels aren’t accurately being assessed. And that very much applies to our approach to international to domestic allocations.