Are ‘expensive’ American stocks really more risky?

Since the global financial crisis people have warned that the US has become expensive compared with other major markets and therefore risky. We currently hold over 60% of our two global equity portfolios in North America. Although I have just returned from a trip there feeling as confident about the place as ever, the question arises: are we being reckless with investors’ money?

A glimpse into our investment personalities will explain why I find this question funny. We are valuation-focused investors. Our portfolio turnover is probably greater than that of some of our peers because we do not subscribe to a “buy and hold at any price” mantra. We take profits or sell when we think valuations have become stretched.

Over the long term this has helped us deliver strong returns. Hardly reckless! We call it prudent. We do not take big bets. And we do not hold stocks we think are overpriced.

So why do we and many other global managers have so much exposure to the US and how do we respond to concerns that American stocks are expensive?

Current valuations

The S&P 500 is currently valued at 17.3x next year’s earnings, the EURO STOXX 50 at 11.3x, the FTSE 100 at 9.9x and Japan’s TOPIX index at 14.6x. But the 10-year average for the S&P is just under 17x[1]. So it is not historically expensive, but it is relatively speaking. 

It is this differential that makes some investors nervous. A common argument over the past decade or so has been that it makes the US more vulnerable when a market correction strikes – the higher the valuation, the greater the fall. Critics have argued for a long time that in a period of multiple contractions the US would underperform.

The past year has seen such a period, so how did that argument pan out? Year to date in local currency terms the S&P 500 and EURO STOXX 50 are both down around 12%. But what matters to British savers is the sterling return. In GBP terms the S&P is only down 1.6%. It seems that a long-held hypothesis has failed. If nothing else, this reminds investors that there is no substitute for looking at the value for money on offer when analysing equities.

The US is a giant market. Its workforce is mobile, so it is not as vulnerable to labour shortages. It is a net exporter of energy[2]. And its strong currency means that it is not importing inflation. These are just some of the features that have made it more resilient.

Finding fewer bargains

Of course, markets are always moving. A few weeks ago American stocks looked better value. Since mid-June to my writing in mid-August the S&P is up around 15%.

Other markets have risen, too, but not so much. It is harder to find bargains. Our most recent acquisition is a European stock we have been monitoring for years and which has finally fallen to a valuation we feel is reasonable. But we feel no compulsion to rotate significantly from the US to cheaper stocks elsewhere. Indeed, where possible, we tend to use a period like this to upgrade the quality of the portfolio.

The concern many of us have now is that the activity of central banks will tip the global economy into recession. The US Fed has been particularly aggressive with rate rises. You would imagine that this is where the first domino might fall. For this reason I recently spent ten days visiting major American companies, asking how things are. 

Insights from on the ground

My trip was focused on the American Midwest. Most of the cities I visited were growing and excited about the opportunity of reinvesting in industry. Near Columbus, Ohio, Intel is spending $20bn on two giant cutting-edge semiconductor factories that will create thousands of jobs and attract more to the region. The talk was of how America’s coastal cities are becoming overpopulated and polluted. The Midwest cities do not have these problems. They have low-cost energy – and water, too. Employee mobility helps in these circumstances.

Inflation is a global issue. Management talked of problems in the supply chain pushing up costs, but these pressures are receding. Energy prices appear to be falling as well. That leaves wage inflation, but this was not deemed a major issue. Yes, wages are going up faster than they were, but these are companies – often tech companies – for which wages, as opposed to stock-based compensation, are a relatively small part of overall costs. These companies can pass on a proportion of the costs and easily absorb the rest to help preserve their customer relationships. This is because many of these companies have high profit margins.

As active managers, we can focus on such companies. Across both our portfolios, around half of the 60 or so stocks we hold have a 10-year average operating profit margin in excess of 20%. Six of them have a profit margin of over 50%.

Companies we own that I saw on my trip include Thermo Fisher (23.4% operating margin), Mettler-Toledo (23.3%) and Proctor & Gamble (21%).

Profitable companies help protect your portfolio in times of trouble. Companies with high profit margins that are not capital-intensive can be found around the world, but they are more abundant in the US and especially at the top end of the S&P 500 – which is why aggregate P/E multiples are higher. Take Microsoft, for example. It is on a 26.3x forward P/E valuation, but its 10-year average operating profit margin is 34%.

Not overpaying for stocks becomes more important than ever in the current climate. Similarly, we do not want to hold stocks that are overvalued because their price is vulnerable to a bigger correction. But a stock can be more expensive and still fair value. I am confident that the profit margins and prospects of the high-quality American companies we favour mean these businesses merit their higher prices. Many offer globally diversified exposure to end markets as well. Therefore, I do not believe that having a big exposure to US listed companies necessarily increases risk in a portfolio. Executed smartly the strategy should reduce it.

Alex Illingworth is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund

[1] Source: Factset: https://insight.factset.com/sp-500-forward-p/e-ratio-falls-below-10-year-average-for-the-first-time-since-q2-2020

[2] Source: EIA: https://www.eia.gov/energyexplained/us-energy-facts/imports-and-exports.php

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