Investment Outlook: Fourth Quarter 2021 - Football or Football
Just because it sounds the same doesn't mean it is.
A common, long-discussed theme is that European stocks are cheaper than US stocks. This high level and likely-misguided analysis has led many stock pickers and television personalities to recommend buying European equities. Time will tell if the European or American stock market outperforms over the next few years, but investors should invest in Europe for the right reasons.
It is a fact that the price-to-earnings ratio of European equities is significantly lower than that of American equities. The Financial Times Stock Exchange 100 index (FTSE 100) or the STOXX Europe 600 Index both are considered to be comparable to the S&P 500 and both exchanges are trading a significantly lower P/E ratio than the S&P 500, but that is only part of the story.
The first layer of the onion to pull back is the types of companies that dominate each market. The United States is dominated by companies in the technology sector, with consumer discretionary and healthcare a distant second and third. These three sectors account for more than 50% of the total market capitalization of the S&P 500. On the other hand, the three largest sectors of the FTSE 100 are consumer staples, financials, and materials. These sectors make up about 50% of the total market capitalization of the FTSE 100. The materials sector has the smallest weighting of all the sectors of the S&P 500. Based on this, it is clear that the composition of these markets is very different.
The largest sectors of the United States economy – technology, consumer discretionary, and healthcare have historically grown faster and traded at higher price-to-earnings multiples than the slower growth sectors that dominate Europe. It is this difference that causes Europe to look so much cheaper. At a sector level, the performance and the valuations are not all that different between American and European companies. It is the exposure to different types of businesses that is the main driver of the apparent valuation difference.
Much of the revenue generated by the largest companies in any given region of the world is geographically diverse. A company based in Germany may derive most of its revenue from the United States, in the same way a US-based company may derive most of its revenue from Europe. The global nature of commerce makes the country of domicile less important than it used to be. An industrial company based in Europe will likely trade at a similar price-to-earnings multiple as a US-based industrial company, and the same is true for all sectors.
The main difference between the equity markets of the United States and those of Europe is not that the companies are cheaper in Europe. The difference is that the two regions have very different types of companies. If an investor wants to buy a basket of European stocks because they are looking for a portfolio heavily weighted in banks and commodities, that makes sense. However, an investor buying a basket of European stocks because they think they are finding comparable sector exposure to the United State at a cheaper valuation is misguided.