The S&P 500 index is currently trading at 22x next year’s earnings, notably higher than its historical average. It is also trading at a rather large premium when compared to most other indices across the globe. Before concluding, on optics alone, that the US market is just too expensive, we would ask that you consider the following.
One of the reasons that the US market commands a higher valuation is that it has the highest concentration of top-quality businesses compared to any other country in the world. Higher-quality businesses tend to trade at a premium. Investors are generally willing to pay up for quality. Quality offers a level of comfort and certainty around a company, be it financial stability or the predictability of future earnings.
Growth has also been a driving factor behind the higher valuation for American stocks. When growth becomes scarce, investors are willing to pay up for it. Research from Goldman Sachs shows that since the Global Financial Crisis (GFC), global growth, be it economic or corporate, has slowed. The US was not immune to this slowdown, but it still offered relatively higher growth compared to other developed nations. US technology stocks grew substantially post the GFC.
US technology stocks now account for a sizable portion of the S&P 500. Eight out of the 10 largest stocks in the S&P 500 would be considered “tech” in nature. These eight stocks alone account for more than one third of the entire market cap of the index. They also trade at higher valuations compared to most other stocks, both inside as well as outside the US. The combination of their higher weightings in the index as well as their relatively higher valuations has been a contributing factor to the S&P 500 index valuation moving higher. The high level of index concentration and elevated valuations have led many to sound the alarm bells around these tech stocks and, more broadly, the US market.
As bottom-up investors, we prefer to evaluate each company on its own merits. This will help inform our decision as to whether the multiple currently being offered by the market is too high or too low. A “cheap” company on a 5x multiple could still underperform one that is trading at 50x. We would also caution against using a valuation multiple in isolation. Embedded within that number are a host of assumptions that the market is currently implying. These assumptions tend to revolve around “valuation drivers” such as growth, risk and profitability.
Many of these technology companies may appear expensive at first glance, but once you pop the hood and take a closer look at these assumptions, your perception may change. These companies are growing faster, some much faster, than your average company. They are also exceptionally profitable. It is certainly possible that despite possessing strong fundamentals, some may have “gotten ahead of their skis”. That said, if they continue to grow at a faster pace than your average company while churning out swathes of cash for shareholders, we will caution betting against them.
As much of the focus on the US market tends to revolve around technology stocks, one could easily forget about the number of great businesses on offer that are non-tech in nature. Again, we would evaluate each stock individually rather than jumping to conclusions after a cursory glance at a multiple. Some trading at expensive-looking multiples may be just that. You may also find that despite a high multiple, the market is in fact underappreciating the growth and quality inherent in the underlying business.
Of course we haven’t addressed the elephant in the room, the mighty US dollar. Like the US equity market, a growing number of voices have expressed concern that that dollar is just too strong. Some have even gone as far as to predict that the dollar is set to lose its reserve currency status.
As we are bottom-up fundamental analysts, we are not too focused on predicting currency movements. We also acknowledge that no empire lives on forever. The demise of the Roman, Ottaman, Dutch and British empires are well documented. The sun will eventually set on America and the dollar will lose its status, but will this happen anytime soon? We remain sceptical that a BRICS currency will fill the void; and cryptocurrencies still have a long, long way to go.
To be clear, we are not advocating to only target the US as your offshore investment destination of choice. Markets, be it stock or currency, tend to move in cycles. There will be periods where the US underperforms in both. Diversifying across multiple geographies would be a wise approach for most. We do however disagree with the doomsday scenarios currently being scripted about the US.
Taking a long-term bet against the dollar, and the US for that matter, has not been a winning strategy. Would you want to bet against a nation that is home to the largest, most diverse economy and stock market in the world, the most powerful military, is energy independent and is still the immigration destination of choice, just to name a few? China and India may be catching up, possibly leading, in certain areas, but US hegemony look sets to continue, at least for now.
