Use This Valuation Anomaly to Your Advantage

Hello, Reader. 

Summer just started, but warnings of the coming winter are already being issued. 

This week, the head of the International Energy Agency (IEA) urged Europe to prepare for a winter heating crisis should Russia cut off natural supplies to the neighboring continent. 

We haven’t heard as much about it recently, but Europe continues to face a potentially severe energy crisis in the wake of Russia’s invasion of Ukraine. European nations are highly dependent on Russia for energy resources; for example, Russia supplied about 40% of Europe’s natural gas prior to the war. 

The world reacted to the Ukraine invasion by trying to isolate Russia economically, which meant Europe began efforts to find critical energy resources from elsewhere. And now, Russia is threatening to take its ball, go home, and simply cut off natural gas exports to Europe. 

Demand for natural gas dips in the summer, so the situation isn’t as urgent now as it could become. The potential is there for not just an economic crisis but another war-related humanitarian crisis, even if it is nearly a thousand miles away from combat. 

Knowing this, you would think that European stocks would be down a lot more than U.S. stocks. That’s not the case. Both markets are down a little over 20% this year. 

On a short-term reading, this doesn’t make much sense. But if we zoom out a little bit to see how we got here, there is another explanation.  

It teaches us something about valuation, and it may even point us to opportunities… 

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First Comes Expansion and Contraction… 

Let’s start by looking at the divergent fates of three exchange-traded funds… 

  1. The first is the SPDR S&P 500 ETF Trust(SPY), the enormous $364-billion ETF that tracks the performance of the S&P 500 Index… 
  1. The second ETF under examination is the Invesco QQQ Trust (QQQ), which tracks the 100 largest non-financial stocks in the Nasdaq Composite Index… 
  1. And our final ETF is the SPDR EURO STOXX 50 ETF(FEZ), which tracks the investment performance of Europe’s 50 largest companies. 

Since mid-2014, SPY has delivered a total return of nearly 150%, while QQQ has rocketed more than 250%… but over the same timeframe, FEZ has managed to gain just 7%. 

We might like to think that this striking performance disparity between American and European stocks was the inevitable result of America’s legendary technological prowess, or perhaps our economic dynamism. But that assumption would be somewhat misguided. 

A phenomenon called “multiple expansion” would be a better explanation. 

Multiple expansion is the term Wall Street analysts use to describe the boost a stock (or index) receives when investors award them with a higher and higher valuation. 

To better understand this phenomenon, let’s imagine that “Acme Widgets” is a $10 stock that produces $1 per share in annual earnings. At that price, Acme would be trading for 10 times earnings – also called a “price-to-earnings (PE) multiple of 10.” 

Now, let’s imagine that investors become so enthusiastic about Acme’s prospects that they bid its price up to $20 a share, even though the company’s annual earnings haven’t budged from $1. 

In this circumstance, Acme’s PE multiple would have expanded from 10 to 20. That’s “multiple expansion.” 

Whenever a stock’s PE multiple is rising, that stock is benefiting from multiple expansion. Conversely, whenever a stock’s PE multiple is falling, that stock is suffering from the evil twin called “multiple contraction.”  

Not surprisingly, PE multiples tend to expand during bull-market phases when investors are optimistic and contract during bear-market phases when investors are pessimistic. We’re seeing a lot of contraction in the current market. 

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… And then Convergence 

Over the last eight years, the U.S. stock market has benefited handsomely from multiple expansion, while European stocks have been suffering from unrelenting multiple contraction. 

Back in 2014, the S&P 500 Index and the MSCI Europe Index were both changing hands for about 10 times annual cash flow. 

But over the ensuing years, the American price-to-cash-flow multiple expanded to as much as 20 times, which was an all-time record, by the way. Today, even after the steep selloff of the last several months, the S&P 500 trades for more than 15 times cash flow. 

Meanwhile, back in the Old World, valuations spent the last eight years contracting from 10 times cash flow to as little as five times. Even now, European stocks are selling for less than six times cash flow – or about one-third the level of U.S. stocks. 

This stark valuation disparity does not automatically mean that European stocks are a “buy,” but it does suggest that they are a better value than their American counterparts. 

It is possible, of course, that U.S. stocks will continue outperforming European ones, if only by falling less. But valuation convergence seems like the path of least resistance from here.  

One way or another, it’s more likely than not that European stocks will begin closing the valuation discount to U.S. stocks. I’m not saying they will rocket higher from current levels, but I would expect it to happen over time. 

Outsized discounts and disparate valuations tend to revert to the mean over time, something to keep in mind when looking your next investments. 

Regards,  

Eric Fry 

Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends… before they take off. In fact, Eric has recommended 41 different 1,000%+ stock market winners in his career. Plus, he beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today he’s revealing his next potential 1,000% winner for free, here.


Article printed from InvestorPlace Media, https://investorplace.com/smartmoney/2022/07/use-this-valuation-anomaly-to-your-advantage/.

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