Every so often a reader suggests I pen a book about investing. They’re obviously confusing you with someone else I hear you laugh. Why don’t you call it: “How to miss a fortune in US stocks.” Very funny.
Anyway, relax. I wouldn’t dare. An old colleague of mine on the Lex column, Spencer Jakab, has already written the best investment book ever. It’s called Heads I Win, Tails I Win, and you should own a copy.
I only mention it as I was thinking of Spencer on Monday. Whenever the S&P 500 had a meltdown during the financial crisis, he would cup his hand to his mouth and shout “timber!” across the newsroom.
That’s when Robert Armstrong and I knew things were bad. Did Spencer give the same cry this week? Maybe he will email me so I can tell you either way. His market timing is usually spot on.
But the US can wait. I promised a second column on European equities and what to make of the rally thus far. We previously covered the reasons they began to look interesting despite the widespread gloom.
And also why I didn’t buy them last May? Is it now too late? Or are European stocks still attractive? How best to judge the latter, anyway? Versus their own history, other shares, something else?
That’s a lot of questions, so let’s begin. The first analysis I like to do when a market is hot is to see what people are staring at. I don’t mean themes — they’re obvious in this case. Europe’s long underperformance. Trump’s long poker.
No, I’m interested in which so-called “equity factors” moved share prices. Maybe it’s differences in sales growth. Or which stocks have already performed well, or not — momentum in other words.
Size is another factor. As is earnings quality. But having twiddled with my Capital IQ database for a while, the overwhelming culprit — since January 1, when European shares really started flying. is none of these.
Mostly, investors are focusing on value. Indeed, seven of the top 10 subfactors (out of 30 overall) when it comes to producing the widest gap between the best and worst returns, are valuation metrics.
Price to earnings. Price to cash flow. Sales versus equity value plus debt. Price to book. Such are the type of ratios which have driven performance. Investors may have fallen for Europe. But it’s price they love most.
Nor are they in awe of the economic story, it seems — even with Germany proposing some serious fiscal me-time. The long-term growth factor was fourth to last in explaining the dispersion of returns.
Such analysis may seem nerdy. But it helps to support a couple of simple and positive observations. The first counters the idea that the recovery in European stocks is just a re-arming story.
Sure, defence stocks have fired this year. But banks are up by a fifth, while telecoms and insurance, as well as chemical sectors, have all seen double-digit returns. And within each sector, cheap did best.
The second takeaway suggests the rally could last. Valuation tends to be a powerful factor early in any upturn. Having made some money, investors then start looking at the likes of capital efficiency, earnings quality, momentum and so on.
We’re not there yet. But when we are, Europe must deliver. For example, US shares haven’t been undervalued for more than a decade. But they kept justifying their luxurious prices with each knockout quarter.
Being cheap only gets you so far — as my daughter soon learned after discovering Temu. Crap is crap. Are the fundamentals of European companies solid enough once this first re-rating phase is over?
Before we answer this, is this first phase even over? The forward price/earnings ratio of the Stoxx 600 index (that is, using expected rather than historical profits) is now 14.5 times, up from 11 times two years ago.
And the average this millennium is exactly the same. On that basis, European stocks are no longer cheap versus history. You might argue, though, that the outlook is much better today.
Certainly, the breadth of upward revisions to earnings estimates is stronger in Europe than anywhere else in the world now, according to FactSet data (revisions are actually down in the US and emerging markets).
How do continental firms overall stack up on other metrics — in particular versus the US? Yes, returns on equity will rise from 12 to 13 per cent this year; but S&P 500 companies generate 19 per cent for shareholders.
Likewise, ratios of debt to profits (once you adjust for tax, depreciation and amortisation) are falling nicely in Europe. But they are still forecast to be double US levels come December.
Meanwhile American firms spew out twice the cash flow versus their market capitalisation, and their operating margins are 2 percentage points higher — even though Europe’s are forecast to rise by a third this year.
Of course, you could be encouraged by all this. There is upside galore for executives to ponder in their C-suites from Amsterdam to Zurich. Can they produce the goods? Where to begin? And what should we watch out for?
I will be monitoring what are for me the most revealing stats when it comes to US and European companies: their respective payout ratios. The S&P 500 returns 35 per cent of its earnings to shareholders in the form of dividends and buybacks. For the Stoxx 600, it’s almost 60 per cent.
Put simply, US bosses are investing more in the future of their businesses. European ones, on the other hand, are almost saying: “We see no exciting opportunities ahead. Here’s your money back.”
Only when you see this ratio plummet across the continent will we know it’s properly game on. Until then, Europe is just a valuation play.
The author is a former portfolio manager. Email: stuart.kirk@ft.com; X: @stuartkirk__
