The dominance of US tech giants has propelled valuations, lifting the US market to a succession of new all-time highs. With the valuation gap between the US and other regions widening, GAM Investments’ Charles Hepworth discusses why investors should take a global approach in their search for quality growth, highlighting diversification opportunities in European equities.
14 March 2024
There is no denying that the valuation dispersion of US and Europe is running at a high level. On first inspection, clearly the natural state of each region’s economic growth can help to explain some of this difference. Investors might be happier to potentially overpay for growth, thereby reinforcing a more expensive multiple in the US. This became at first pronounced following the 2007-08 Global Financial Crisis when the tech-heavy US equity market was better positioned to benefit from the low-to-zero interest rate environment that subsequently ensued.
FAANGs for the memory. But chip innovator Nvidia is the new tech poster child
The FAANGs of the pre-pandemic years – Facebook, Amazon, Apple, Netflix and Google – have now morphed into a new moniker, the “Magnificent Seven”. The appeal of the same tech-related US names has been turbocharged over the last year as Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla have distorted the market price/earnings ratio (PE), a result of their explosive growth. In particular, chip innovator Nvidia is the current poster child for all things artificial intelligence (AI), and is valued at an estimated forward PE of 35x. If that sounds fanciful, consider this: in early March, Nvidia revealed another set of blockbuster results, its third straight quarter of triple-digit growth in revenues and earnings. Nvidia developed the technology to squeeze 80 billion transistors onto its hugely successful H-100 and H-200 chips, something no rival has ever managed, and with the power of AI maximised by the sheer amount of processing power, this is the chip everyone has wanted. But the good news just keeps coming. Nvidia has just announced a successor GHC 100 chip, which is going to be even more impressive, setting Nvidia even further ahead of the competition. As a guide, one of these chips was recently listed on CDW, a kind of eBay marketplace for corporate IT, for USD 97,000. Given how these margins reflect Nvidia’s real stranglehold in AI infrastructure and the demand growth in accelerated computing and generative AI, you can well understand when Nvidia, which had a market cap of around USD 200 billion in 2022, soared to a valuation of USD 2 trillion in early March.
How the US stockmarket rode with the Magnificent Seven in 2023
The Magnificent Seven drove much of US equities’ outperformance during the second half of last year, thanks largely to AI-related exuberance. And AI exposure is by no means limited to Nvidia, with companies like Amazon, Microsoft and Meta expanding boundaries in terms of how IT can transform even seemingly established industries and sectors. For example, Facebook-owner Meta has successfully tested the use of large language models to support the algorithms that suggest videos to social media platform users. And recent share price performance has been strong, reflecting investors’ optimism that Meta can harness generative AI to boost engagement across its entire ecosystem, which spans Facebook, Instagram, Threads and WhatsApp, with encouraging prospects for advertising revenues.
Tech-lite Europe has underperformed
Even as the performance of the US market has become more broad-based over recent months, the Magnificent Seven group of stocks – which makes up nearly 30% of the benchmark S&P 500 Index – trades on an aggregate forward PE of 25x. By comparison, it is difficult to find a similar cohort in the European equity space that trades at anything close to that PE multiple. Hence, you could argue it is the particular dominance, and investor euphoria over the transformative potential of AI, of these technology behemoths that leads to the apparent valuation gap.
Expensive US tech bros vs cheaper Euro pharma frères
If you constructed a similar growth proxy in the European space with similarly high net profit margins, market cap dominance and high compounding growth rates using the likes of companies such as GSK, Roche, Nestlé, Novartis, L’Oréal, LVMH, AstraZeneca and Sanofi (note the preponderance of pharmaceuticals, as opposed to pure tech plays) then the valuation argument is much clearer. These European stocks trade on aggregate at just 16.6x forward PE – significantly cheaper than the tech-heavy US cohort. Some argue that US equities justify higher PE multiples on the basis that they are of superior quality, have faster structural growth, higher predictability of earnings and greater shareholder friendliness, plus they have better capital allocation and are less influenced by government policies to boot. It would seem odd, to me at least, that these same arguments do not ring true to the above-mentioned European equities.
The case for Europe as a diversifier of US exposure
Perhaps it is just a case of “he who shouts the loudest” where the US valuation distortion over European equities sits. The US is a wide and large weighting to global portfolios, whereas European allocations have all too often been more of an allocation afterthought. But just as the US stockmarket in the 1970s enjoyed growth in the then “Nifty Fifty” with investors seemingly happy to overpay on the expectation of continual high earnings growth, the subsequent bust in these names was far from auspicious. I am by no means advocating a collapse in the current Magnificent Seven performance – on the contrary, on a thematic level, I see these companies as part of a secular trend at the forefront of innovation that are delivering high return on equity. However, while there has been a consensus among many allocators for a while now to be overweight US equities, at some stage this ‘crowded trade’ is likely to be prone to disappointment. So while I recognise that parts of the US equity market can justify seemingly frothy valuations, I believe that a re-rating in other regions that – for whatever reason – have been unloved, is long overdue. Europe is a prime example, and with the US stockmarket increasingly dominated by a relatively small number of tech-focused megacaps, the case for diversifying at least some US equities exposure is ringing ever-louder.
Rather than fixating on trendy labels like the Magnificent Seven, sometimes it pays to go with quality growth, wherever investors happen to find it. Over the long term, I believe the ride will be a lot smoother.
Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.