Much has been said about the degree to which US stocks have outperformed their global counterparts. Over the past 10 years owning US stocks has returned 13% compounded per annum (in dollars), versus 5% for the rest of the world.
Given the nearly 8% annual divergence in returns, many would ask if now is the time to invest in Europe, Japan or emerging markets. This is a particularly interesting question for your typical valuation-based investor who believes in mean reversion (as we do) to a lesser or greater degree.
The notion of mean reversion implies that the factors driving the return an investor makes from a stock will revert to its long-run average over time.
Three factors drive stock returns: the dividend yield when you purchase it; the rate at which it grows its earnings (which in turn is driven by its ability to grow its revenues or expand its margins); and the price-to-earnings (p/e) multiple that the market is prepared to pay for the stock (which can expand or contract).
Of these three factors the only one that is fixed is the dividend yield when you purchase a stock. The rate at which the stock grows earnings and its p/e multiple can exceed (or fall short of) their long-run averages, and mean reversionists believe these factors will revert to their long run average over time.
The problem with mean reversion in this context is that it is not alert to paradigm shifts
Since 2010 the primary reason that US stocks have been able to outperform stocks in the rest of the world is faster earnings growth, which is partly due to a decline in US corporate tax rates from 35% to 21%. Perhaps surprisingly, the differential in the p/e multiple that US stocks trade on versus those of the rest of the world has contributed relatively little (we estimate as little as 20%) to this difference in returns.
Mean reversionists would argue that these things even out over time and that US stocks will inevitably go through a period in which they grow their earnings slower than the rest of the world, causing their stocks to underperform. Consequently, they would argue that now is the time to buy stocks from the rest of the world and sell those of the US.
The problem with mean reversion in this context is that it is not alert to paradigm shifts. It assumes all forces driving stock returns are cyclical (as opposed to structural) in nature. We would argue that this is not the case.
We stand in the middle of a fourth (digital) industrial revolution. It is the successor to the first, second and third industrial revolutions, in which horse power was supplanted by steam power (first industrial revolution), steam power was supplanted by electricity (second industrial revolution) and subsequently the automation of routine tasks (third industrial revolution).
Corporate juggernauts
Considering the many innovations the fourth industrial revolution has brought us — including internet, social media, e-commerce, cloud computing, the smartphone — almost all innovations have been developed in the US. The US may have stopped running a trade surplus with the rest of the world a long time ago but as an exporter of ideas it has no equal.
All the corporate juggernauts of this age are US-based. In a comparison of Europe’s five largest companies with the five largest US companies, the US list consists exclusively of technology companies while the European list consists of two fast-moving consumer goods companies, a luxury goods company and two pharma companies, which were all founded more than 100 years ago.
US: Apple (established in 1976); Microsoft (1975); Amazon (1995); Alphabet (1998); Facebook (2004).
Europe: Nestlé (1866); Roche (1896); Novartis (prior to 1900); LVMH (1854); L’Oreal (1909).
The unavoidable reality is that the US is navigating the fourth industrial revolution better than the rest of the world, and there are compelling reasons why this will remain the case. For example, US universities have far larger endowments than universities in the rest of the world and it is often universities that are the incubators for entrepreneurial ideas.
The US (in the guise of Silicon Valley) has deeper venture capital markets than the rest of the world, which makes it easier for aspiring entrepreneurs to raise the money they need to realise their visions.
Large US companies (admittedly, partly due to their technology tilt) spend far more on R&D than large companies in the rest of the world.
As long as the US continues to support education, entrepreneurship and capitalism we believe the conditions for its continued outperformance remain intact.
While it has unquestionably been a good decade for US companies (and those invested in them), we believe there are valid reasons for this and we would not prematurely conclude that that is set to reverse soon.
• Wales is global portfolio manager at Flagship Asset Management.
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