While US equities may look expensive using some traditional yardsticks, there is reason to expect their marked outperformance of the past three decades may continue, argues Giles Parkinson.
6 minute read
1985 witnessed a number of important events. Among the more memorable: Mikhael Gorbachev became leader of the Soviet Union; the US Food and Drug Administration approved the first ever blood test for the HIV virus and scientists of the British Antarctic Survey discovered a hole in the ozone layer.
Within the field of business and technology, Microsoft launched the first version of its Windows operating software, the Internet’s Domain Name System was created, while Vodafone established the UK’s first mobile phone network.
Perhaps less memorably, on October 31, the FTSE 100 closed at 1377.2, 2.9 points higher than the Dow Jones Industrials Average. That marked the last time the UK’s flagship stock index stood above its US peer.
Having been launched at the end of 1983 with a value of 1,000 – which at the time represented a 20 per cent discount to the Dow – in its early days the UK benchmark steadily outperformed. Its relative zenith came on May 15, 1985, when the FTSE closed at 1342.4, a 5.4 per cent premium to the Dow. Few then could have imagined the extent to which the US stock market would outperform the UK equity market – and for that matter most others in the developed world – over the next three decades.
As of 24 September, 2017, the Dow stood at 22,296, while the FTSE trailed at a lowly 7,301. That means that since the end of October 1985, the Dow has risen 1523 per cent while the FTSE has gained barely more than a quarter of that amount, having risen a comparatively miserly 444 per cent. From an investor’s perspective, this begs three questions: to what extent has the US market actually outperformed; what are the reasons for this outperformance; and are these factors likely to persist or even intensify?
Don’t forget the dividends
In order to answer the first of these questions, it is important to recognise that using the two indices’ level provides us with no more than a very crude yardstick of the degree to which the US market has outperformed. Crucially, the figures do not include the impact of dividend payments.
In the UK, and elsewhere in Europe for that matter, there is a cultural preference for dividends to share buybacks. By contrast in the US, there has been more of an acceptance, even preference, for the latter since the Securities and Exchange Commission in 1982 introduced ‘Rule 10b-18’ to protect companies’ executives from possible legal action if they chose to buy back their own company’s stock. Distributing capital as a dividend reduces the value of an index as the money is paid out, much as visiting an ATM lowers your bank balance. Share buybacks don’t have the same effect.
When one takes into account the fact UK companies have tended to pay higher dividends than their US peers, we see the US market has outperformed by a much smaller margin on a ‘total return’ basis – the Dow has delivered a total return of around 4200 per cent and the FTSE 100 around 1600 per cent. That still means the Dow, at 12.25 per cent, has delivered 3.25 percentage points more annually than the 9.0 per cent generated by the footsie.1
Of course, by comparing a capitalisation-weighted index such as the FTSE 100 with a price-weighted index such as the Dow we are arguably not comparing like with like. However, the S&P 500, which like the FTSE 100 is a price-weighted index, has still comfortably outperformed, albeit by a smaller margin; generating a 10.9 per cent annual return over the same period. That still leaves an annual gap of 1.9 percentage points.
With the FTSE 100 priced in sterling and the S&P 500 in US dollars, does the performance differential shrink when we compare the two markets’ performance in a common currency? Unfortunately for UK investors, the answer is no. Although the exchange rate fluctuated over the intervening period, at $1.30 the pound is currently worth just fractionally more than the $1.25 it bought in May 1985. It turns out exchange rate fluctuations have had negligible impact.
However you cut it, the US won. Over a thirty-two year span, the UK market was outpaced by 1.9 per cent per annum in common currencies.
The growth effect
Turning to the second of our questions, can the US market’s outperformance be explained by a difference in US and UK economic growth? After all, even though most companies included in the FTSE-100 and S&P500 over the years have tended to harvest a large slice of their profits overseas, superior domestic economic growth should be a tailwind.
Unfortunately, the answer once again is no. US economic output more than quadrupled between 1985 and 2016, from $4.35 trillion to $18.57 trillion, a 327 per cent increase (3.9 per cent per year). During the same period, UK output actually grew faster in dollar terms, from $489.3 billion to $2.62 trillion, equivalent to 4.85 per cent per year.2
So it appears something else is at work. Could it be that US stocks have simply become more richly valued? Again, the answer is no. It is true that with US stocks currently trading on a P/E ratio of 19 times earnings, they are more expensive on this metric relative to their UK peers trading on 15 times. But that is no different to the situation in 1985 when the S&P was trading on a P/E ratio of 12 versus the footsie’s 10. An expansion of the P/E multiple has provided a similar boost to both markets.
It seems the outperformance of the US stock market is primarily down to one factor: US companies have simply been able to grow cash-flow and earnings faster than their peers elsewhere in the developed world. Which begs the question, how have they been able to do this? A number of factors are probably at work and it is difficult to provide definitive answers, much less quantify them. However, we can point to some evidence and suggest that American firms are – simply – better than their overseas counterparts.
The talent advantage
The United States has been able to attract far more than its fair share of skilled workers from other countries. In a research paper entitled Global Talent Flows published in October 2016, the World Bank said the US has historically hosted close to half of all high‐skilled migrants to the OECD and one‐third of high‐skilled migrants worldwide.3 In 2010, the US had 11.4 million skilled migrants, 41 per cent of the OECD total. It appears the country’s high standard of living and dominance of the international rankings of elite universities – among other factors – have created a self-reinforcing virtuous circle.
The significance of this was underlined in a research paper published by the National Foundation for American Policy, a public-policy think tank. In its March 2016 article Immigrants and billion-dollar start-ups, it found that immigrants play a key role in creating new, fast-growing companies, as evidenced by the fact they had started 44 of the 87 privately owned start-up companies that were valued at over $1 billion as of January 1, 2016. It put the collective value of these companies at $168 billion, “close to half the value of the stock markets of Russia or Mexico”.4
Furthermore, there appears little prospect of this trend ending any time soon. The World Bank added: “The volume of skilled migration… coupled with the significant asymmetry in the concentration of leading universities, high‐tech firms and research centers, implies that the global competition for skills will continue to be fierce and will likely remain unequal”.
The US’ ability to attract some of the best migrants, coupled with the strength of its universities, helps explain its dominance in the field of technology. It is surely no coincidence today’s tech giants – Facebook, Google, Apple and Microsoft – were all founded and consequently listed in the US. This isn’t to say Europe and Japan don’t innovate or have anything to offer, but the US is clearly a world leader in these industries of the future.
Financial performance
It isn’t just in technology where American companies are ahead of their international peers. While it may not be true in each and every case, as a general rule an American company tends to have superior financial performance to its foreign peers. We can measure aspects of this greater efficiency in various ways: return on equity (RoE), profit and sales per employee, and profit margins.
In the oil industry, for example, the RoE earned by the US majors Exxon and Chevron has averaged 17.6 per cent over the past decade – a period that has seen oil booms and busts. By contrast, the average ROE of European rivals BP, Royal Dutch Shell, Total and ENI was just 13.8 per cent.
The difference in performance is starker still in the pharmaceuticals sector. As the following two charts demonstrate, US drugmakers (orange) are comfortably more efficient than their European peers (blue), generating higher sales and profits for each employee.
The US is an instinctively capitalist nation. The flexibility of the labour market enables its companies to be much more aggressive in cutting labour and other costs during economic downturns. One can see the impact of this in the advertising industry, which has a highly variable cost structure. The EBIT (underlying profit) margin of US group Omnicom fell 1.4 percentage points between 2007 and 2009 when developed economies went into recession, compared to a 2.3 percentage point fall recorded by the UK’s WPP and France’s Publicis. Small differences compound over time.5
Furthermore, a full-time employee is entitled to 28 days of paid holiday in the UK and thirty six days of annual leave is not uncommon across Europe. In America, around eighteen days is common practice.6 The country also tends to score highly on ‘Ease of Doing Business’, ‘Economic Freedom’, and other comparative assessments of bureaucracy and red tape.
The fact US companies tend to be run more efficiently means they often have more acquisition opportunities available to them. A common thread linking US industrial gases group Praxair’s takeover of Germany's Linde, Kraft Heinz’s attempt to buy Unilever, and PPG’s bid for AkzoNobel, all of which took place in the past year, is that the European companies were less tightly managed.
It is not always the case that US companies are better or more efficient, however. Take the car industry. Few would contest that as a rule Germany and Japan have boasted, until recently at least, better run car manufacturers than the US. However, even here we can point to the seeming success of Elon Musk (an immigrant) and Tesla (headquartered in Silicon Valley) in galvanising the industry’s efforts to adapt electric vehicles.
Back to the Future was 1985’s highest-grossing film in which the film’s main character was sent back 30 years in time to meet his future parents, only to be returned to the present day. While it would have been impossible in 1985 to know the extent to which the US stock market would leave international peers trailing in its wake over the subsequent three decades, it would appear unwise to bet against a repeat.
It is true investors need to pay attention to relative valuations as measured by traditional financial yardsticks such as price/earnings and price/sales ratios in the short-run. However, over longer periods of time the underlying performance of the company is what determines performance. In that regard, the majority of US businesses continue to stack up favourably against their international rivals.
References
Source for all data unless otherwise stated: Bloomberg
1 Thomson Reuters Datastream, Aviva Investors’ estimates
2 World Bank
4 National Foundation for American Policy
5 Company reports
6 Wikipedia
