- Our analysis indicates that half of the discrepancy in valuations between the United States and Europe can be attributed to differences in industry group weightings, while other idiosyncrasies explain most of the rest.
- The majority of industry groups appear to be similarly valued in both regions.
- We believe current price-to-earnings multiples are not a reason to avoid U.S. equities, nor are valuations alone a reason to own European equities. Rather, selectivity is key in both markets.
A narrative often heard regarding today’s global stock markets is that U.S. equity valuations are quite expensive, and that better value can be found in other regions, such as Europe. As active, research-driven investors, we regard broad market valuation levels as relevant for risk awareness, but of limited usefulness for identifying specific investment opportunities. However, given the power of this narrative, we took a closer look at regional discrepancies.
How cheap are European stocks?
On the surface, the European market (MSCI Europe Index) appears 20% cheaper — with a P/E of 15x expected 2017 earnings, versus a P/E of 18x expected 2017 earnings for the U.S. market (S&P 500 Index). We addressed the “Europe-is-cheaper” theory by comparing U.S. and European industry group weightings and also by identifying a few special-case outliers — companies or industry groups that have an outsized influence on the overall difference in regional P/E multiples.
Large differences in industry group composition
We found that half of the discrepancy in the aggregate P/E multiples between the United States and Europe can be attributed to differences in index industry group weightings. European equities appear cheaper, but that is largely because the MSCI Europe Index generally has higher weightings in lower-multiple sectors such as energy and financials, while the S&P 500 Index has larger weightings in the higher-multiple technology sector. Technology, for example, is currently less than 5% of the MSCI Europe Index but nearly a quarter of the S&P 500 Index.
About half of the U.S. and European industry groups have comparable P/Es — that is, P/E ratios that are within two multiple points of one another in a given industry group. Furthermore, some of the European industry groups are more expensive than their U.S. counterparts. We find that the difference in industry group weights drives much of the difference at the aggregate index level. When we normalized for this by applying S&P 500 industry group weights to the MSCI Europe Index, the valuation spread between the two regions is cut in half.
Outliers at the stock level: The Amazon effect
As a prime example, Amazon, a high P/E (>150x 2017 EPS estimates), mega-cap constituent in the consumer discretionary sector, has no equivalent in Europe. It alone accounts for 10% of the difference in the valuation spread between the U.S. and Europe indexes. Additionally, when excluding Amazon from retail, the sector is more similarly valued — at 19.4x in the S&P 500 and 17.5x in MSCI Europe.
When excluding Amazon, the P/E differential is reduced by 0.3x and it alone explains 10% of the P/E gap between the S&P 500 and MSCI Europe.
Outlier at the industry group level: Energy
The energy industry group also has an outsized effect. Within the energy sector, there is a considerable valuation difference between European energy companies — which are typically large, integrated businesses — and the U.S. energy sector, which has a few integrateds, but also many more exploration and production companies, which tend to have low profitability and thus trade at high earnings multiples. U.S. energy stocks trade at a P/E of 28x versus European energy stocks, which trade at 16x. Although energy accounts for just 6% of the S&P 500, controlling for this difference shrinks the valuation gap another 0.6x.
It’s about more than multiples
In all, adjusting for these differences, the valuation spread in aggregate Europe is only 3% cheaper than the S&P 500, which is not material, in our view. Seeking broad exposure to Europe as a whole based on valuation levels may be misguided. Without closer, stock-by-stock analysis, this approach could lead to a “value trap” — a strategy that erroneously favors stocks with low multiples, but which lack a growth catalyst. That’s not to dismiss Europe with a broad brush; Putnam’s fundamental research has uncovered many attractive opportunities among European equities today. These opportunities are fueled in part by the long-awaited improvement in economic conditions across the whole of Europe, combined with select companies where earnings potential seems meaningfully underestimated.
Source: Putnam research. All data as of 10/31/17.
Quantitative Analyst Brian J. Hutter, CFA contributed to this research.
As of 9/30/17, Amazon.com represented 1.58% of Putnam Global Equity Fund assets; 0.93% of Putnam Europe Equity Fund assets; and 0.78% of Putnam International Equity Fund assets.