US equities have underperformed in recent years, with Continental Europe and emerging markets generating superior returns. Following a troubled summer and a wobble in eurozone economic growth figures, however, could it now be time for investors to buy US equities? Below, Greg Kerr, manager of the New Star US Opportunities Fund, gives his view on the prospects for the US market.
US equities have been out of favour among investors for years but the summer shake-out could merit a rethink. Negative sentiment deterred foreign investors from buying US equities during the first five months of 2007 while US investors switched their domestic funds to emerging markets and developed markets in Europe, Australasia and the Far East.
Amid volatile trading conditions this summer, shares on both sides of the Atlantic hit peaks in mid-July before suffering a correction amid growing evidence of financial contagion from the US sub-prime lending crisis. In response, investors should ask whether they should reassess their global exposures.
Continental European equities have risen strongly since 2003, experiencing only modest and short-lived corrections along the way. The summer sell-off, however, coincided with the publication of weaker than expected eurozone economic growth figures, leading to suggestions that Continental Europe’s outperformance may be over.
By contrast, US equities have been relatively subdued but this leaves them potentially looking undervalued compared to those in other markets. At 31 August, the S&P 500 Index was trading on 15.3 times 2007 earnings and less than 14 times 2008 earnings. The US market’s post-war average earnings multiple is about 16 and it usually trades at higher multiples when inflation and bond yields are low. US productivity continues to improve and inflation remains relatively well-behaved.
In avoiding the US, international investors appear to be overlooking US Inc’s corporate performance. The US has some of the world’s best managed companies and they have lots of cash on their balance sheets. Companies in the S&P 500 Industrials Index alone have about $600 billion in cash balances. This represents about 6% of the average market capitalisation and is a useful arsenal for corporate activity. Over the past 18 months, earnings have risen faster than share prices. This means the market has been de-rated and large companies appear particularly attractive.
Followers of financial analysis will be familiar with the method of discounting a company’s future cashflow stream back to the present day to indicate its “present value”. A similar calculation can be done for the market as a whole and the discount rate necessary for the market to be fairly valued can be reverse engineered, as shown in the charts below. In Continental Europe, this ‘market implied’ discount rate in June was just below 5%, which was lower than the long-term average of about 5.5% and below the high of about 7% in 2003. The lower the discount rate, the more expensive is the market valuation. The US discount rate has been flat at about 5.5% for the past four years despite the improved corporate environment. Although the US market has risen over this period, the discount rate has not fallen, suggesting that there is value in US equities relative to Continental Europe.
Investors cite dollar weakness as a principal reason for shunning the US. The link between earnings and the weak dollar, however, has supported the stockmarket and many US brokers see this weakness as a bull point. S&P 500 companies derive about 30% of their sales overseas. When the dollar weakens, the value of these sales increases, boosting the profits of multinational companies. Purchasing power parity could also indicate that dollar weakness is now overdone. To European visitors, US goods appear cheap and if the dollar is undervalued the same could be true for US shares.
The long-term case for US equities remains solid. Recent volatility, however, makes a compelling case for holding high-quality stocks. Growth stocks in particular appear well placed to deliver solid long-term returns even if volatility remains in the broader market. Avoiding speculative, small and highly-leveraged stocks also seems prudent and investors should instead focus on large undervalued companies that are attractive investments in their own right.
Stockmarket declines can provide good investment opportunities. Financial companies suffered during the recent correction but valuations began to look attractive as share prices discounted considerable bad news. In mid-August, E*Trade Financial, which enjoyed healthy growth in new investing and trading accounts in the second quarter of the year, offered attractive risk/reward potential. Within the oil and gas sector, Hess Corporation appeared cheaply valued, with a series of exploration successes improving long-term growth prospects while the share price seemed to barely capture the value of proven and probable reserves.
US equities are not without risks, with rising oil prices, rising interest rates and further fall-out from the US sub-prime mortgage crisis being the obvious concerns. Investors can, however, find attractive opportunities by focusing on valuation anomalies rather than slavishly following market sentiment. Clearly, some fund managers have failed to recognise the attractions of the US stockmarket despite its healthy long-term record and this has left equities, particularly some larger stocks, looking distinctly undervalued.
The opinions expressed here represent the views of the fund manager at 1 September 2007 and should not be interpreted as investment advice.
Important information
Past performance is not necessarily a guide to future performance. The value of investments and any income from them may fall as well as rise and investors may not get back the amount originally invested. The value of investments may also increase or decrease as a result of changes in exchange rates between currencies. Any opinions expressed in this document may vary without prior notice and do not constitute investment advice.
This document is for professional advisers and other financial institutions only and should not be provided to or relied upon by private investors. This document should not be distributed to any third parties.
Issued by: New Star Asset Management (Bermuda) Limited.