While you weren’t paying attention, European stocks have been achieving one record high after another. And yet, they are trading at a large discount to their U.S. counterparts. Shareholders of some of these companies have already been hugely rewarded, leading others to look out for opportunities across the pond. Some analysts say that European stocks can serve as an inexpensive hedge against U.S. overvaluation, even if they don’t present the same growth opportunities as U.S. tech stocks. Should U.S. investors look beyond U.S. shores for opportunities and diversification?
U.S. Exceptionalism is Pricey
Everyone seems to be bullish on U.S. stocks, relentlessly propelled by technology shares, with Artificial Intelligence (AI) optimism serving as a beacon for tech-loving markets. However, many analysts caution that even though the S&P 500 (SPX) isn’t in a bubble, historically elevated valuation metrics don’t leave much room for further upside. Thus, according to Bank of America (BAC) strategists, “It’s hard to be bullish on the S&P 500 based on valuation.”
As the rally has broadened beyond the Magnificent Seven market leaders, encompassing swathes of shares across almost all economic sectors, investors find it increasingly hard to find fundamentally sound stocks that are not overvalued.
Morgan Stanley (MS) analysts suggest that they should look overseas, where average valuations are at a 20-year low compared to the U.S. stock market. Specifically, stocks in Europe are trading at an all-time high gap when compared with American shares, offering a far more attractive earnings yield.
Source: Goldman Sachs Global Investment Research
Granted, there are large differences in macroeconomic and earnings-growth outlooks, but they still don’t fully justify such a large valuation spread. At the same time, market gains in the U.S. have been concentrated in the tech sector, while in Europe market leaders are much more diversified, reducing the vulnerabilities. While not impossible, it is hard to imagine European stocks outperforming U.S. ones over a prolonged period of time. That being said, given the concern over concentration and valuations, it may be prudent to diversify abroad.
U.S. Stocks: Earnings Superpower
There have been several periods of underperformance of the U.S. stock market versus its global peers. Still, the domestic stocks outperformed any given developed market in the past three, five, ten, and fifteen years on a cumulative basis. As a result, American investors seem to be convinced that the U.S. is the only game in town.
This assumption is likely correct regarding the stock indexes in general, as the differences in benchmark constituent lists are naturally tied to American leadership. In short, there are far fewer tech firms in every other developed market’s benchmark index than in the U.S.
Thus, tech represents only about 8% of the European stock market index STOXX Europe 600, which mirrors the whole continent’s large-cap universe. It would be unreasonable to expect an index mostly consisting of large banks, healthcare giants, and industrial conglomerates to outperform SPX with its earnings-growth tech champions at the lead.
The S&P 500 companies have reported an 8% year-over-year earnings growth in the fourth quarter of 2023, with most of the bottom-line expansion concentrated within the Magnificent Seven who clocked in a 56% surge in profits. Meanwhile, STOXX 600 earnings are estimated to have declined by 6% over the same period, with the energy sector heavily weighing down the average results. However, European technology stocks haven’t done that great either – their earnings are estimated to have declined by 1.8% year-on-year.
Europe Still Creates Giants
Despite all that, the STOXX Europe 600 has recently reached another record high. In fact, the broad European benchmark has enjoyed a four-month-long rally, producing a gain broadly comparable to that of the S&P 500, up from both indexes’ October 2023 lows.
Although longer-term gains of STOXX 600 don’t come anywhere near those of its U.S. counterpart, many investors are now seeing an opportunity for an outbreak. More importantly, the swift rise of two European stalwarts, Novo Nordisk (NVO) and ASML Holding (ASML), coupled with the rapid rebound of the previously sleeping giant SAP (SAP), has shown that the Old Continent has a lot to offer investors in terms of innovation and earnings growth.
Denmark’s pharmaceutical firm Novo Nordisk, whose injectable medications ignited the current global weight-loss drug craze, is now the 12th most valuable company on the planet, with market capitalization surpassing that of Tesla (TSLA) and by far exceeding its domestic economy’s size. Since the drugs were approved by the FDA in June 2021, NVO stock has gained ~240%, becoming the #1 holding in the STOXX 600 (which rose by about 12% over the same period).
Netherlands-based ASML is a global monopolist in photolithography equipment, which is crucial for advanced semiconductor manufacturing. The Dutch giant has long worked out of the spotlight, enabling chip fabs like Taiwan Semi (TSM) to manufacture powerful semiconductors. But the advance of AI has brought it global fame, propelling its stock upwards and making it Europe’s second most valuable company.
“Made in Germany” is not what it used to be, but the enterprise software behemoth SAP still lives up to the country’s quality badge, with its products used by companies around the globe. A while after the onset of cloud technology reinvigorated the company’s business, the AI leverage has jolted it to the forefront of innovation, electrifying its earnings growth outlook. SAP’s market cap has almost doubled since November 2022 (the introduction of ChatGPT).
These success stories beg the question: are there more potential outperformers in Europe’s undervalued and underappreciated markets?
High-End GRANOLAS
NVO and ASML are not the only leaders of the European stock market, but rather part of a group dubbed “GRANOLAS”. In contrast to the Magnificent Seven, most of them are biopharmaceutical companies, not technology leaders. The group consists of biopharma giants GlaxoSmithKline (GSK), Roche Holding (RHHBY), Novo Nordisk, Novartis (NVS), Sanofi (SNY), and AstraZeneca (AZN), as well as a chipmaking equipment monopolist ASML Holding, coffee and sweets producer Nestlé S.A. (NSRGY), luxury goods company LVMH (LVMUY), cosmetics empire L’Oreal (LRLCY), and enterprise application software provider SAP.
Europe’s magnificent bunch has lower average volatility than the U.S. market leaders, while paying relatively high dividends. Despite vast differences, there is much in common between the two groups: they wield respectable market caps, their operations are global, and they are responsible for most of the gains of their respective benchmarks over the past year. In the last 12 months, the Mag7 have clocked in a gain of 97%, triple the gain of the S&P 500. In the same period, GRANOLAS have risen by ~30%, more than twice the increase in STOXX Europe 600.
Another similarity is that both these groups now have an average valuation that far exceeds their domestic stock indexes’ price-to-earnings ratios. The Magnificent Seven trade at an average trailing P/E of over 42x versus the S&P 500’s 25x, while the GRANOLAS’s average price tag is over 33x, compared to STOXX 600’s 13x. In short, GRANOLAS are about as overpriced as a group as the U.S. technology giants.
“Animal Spirits” For Export
Stock performance overall is the reflection of earnings performance, and earnings growth feeds on economic growth. The U.S. economy is estimated to have expanded by 2.5% in 2023, whereas the EU has barely skipped recession, growing by just 0.4%. The outlook for this year doesn’t spell much optimism for the European economy, with large portions of it already in decline.
So, investors looking for growth aren’t likely to find it within European companies catering to the domestic market. That shouldn’t be a problem, as European companies, on average, are much more global than their U.S. counterparts, deriving almost half of their revenues from abroad (versus less than a third for American firms).
However, it is also important not to fall for companies heavily exposed to the Chinese market, as the country’s economy is in deep trouble. The exclusion of firms dependent on China for a large part of their revenues deletes many miners, automakers, and luxury goods sellers from the list of potential investments.
After taking these provisions into account, investors are still left with a choice of large European companies tapping global secular growth trends, that are still trading at a discount to their peers in the U.S. Two main industries that come to mind in this realm are, of course, technology, and defense.
What’s “Semiconductor” in Dutch?
In the tech sector, investors who feel they are too late to the ASML and SAP parties as these companies’ valuations soared along with their share performance, can still find valuable propositions across the sea. All of these gems have their stock or ADRs traded in the U.S.
One of them is Infineon Technologies (IFNNF), a German giant that develops, manufactures, and markets a broad range of semiconductor products for the communications, automotive, and memory markets. It boasts stellar fundamentals, estimate-beating earnings, and great earnings potential. The company is rated a “Strong Buy” by top-rated analysts, who forecast an upside of over 34% for the stock over the next 12 months. With a price-to-earnings ratio of 15.6, it features a ~50% discount to the U.S. tech sector.
Another tech large-cap with the potential to capitalize on the world’s accelerating demand for all kinds of chips is the Swiss STMicroelectronics (STM). STM is the largest European semiconductor contract manufacturing and design company, serving various industries, from consumer appliances to space tech and data centers. The company features perfect finances and robust earnings, while selling at a 60% discount to its U.S. peers.
There must be something in the air in the Netherlands that helps the country successfully grow its own semiconductor industry. Thus, a Dutch company ASM International (ASMIY), which supplies equipment and materials used to produce semiconductors and integrated circuits, has seen its stock surge in the past year. Investors have flowed into the stock on wagers that growth in demand for AI chips will translate to a windfall for ASM, which offers atomic layer deposition (ALD), the most advanced technology enabling the production of the most advanced semiconductors.
Profitably Defending the Continent
With the rise of conflicts and geopolitical tensions around the globe, and with a war raging for over two years on the border of the European Union, it should be no surprise that defense spending is on a strong upward tilt. The defense outlays in Europe rose in 2023 to a level last seen during the Cold War. The demand for arms and warfare is so high, that both American and European defense contractors have their order books filled far in advance. The companies from the Old Continent are, of course, the first in line to get their governments’ contracts, which lead them to significant outperformance compared to their U.S. peers.
Germany’s Rheinmetall (RNMBY), which provides defense technology solutions and advanced weaponry systems, has clocked in a gain of 75% over the past 12 months. The Swedish ex-automaker Saab AB (SAABF), which now supplies air defense systems and aviation radars, rose 45% in the same period. Norwegian defense contractor Kongsberg Gruppen (NSKFF) surged by over 60% in the past year.
While these three companies have seen their valuations rise along with their stocks, the U.K.’s defense contractor BAE Systems (BAESF) is very reasonably valued, with a strong potential upside. The same can be said about Leonardo S.p.a. (FINMY), an Italian producer of helicopters, aircraft, and defense electronics. Another potential wartime winner is British Rolls-Royce (RYCEF), which produces – besides the luxury cars for which it is known – military aircraft, naval engines, and submarine nuclear power plants.
The Investing Takeaway
The undisputed success of the U.S. technology stocks doesn’t mean that there are no other power plays on the globe. While Europe doesn’t have a Meta (META) or a Microsoft (MSFT), it has several companies for which there is no peer anywhere around the globe. After all, Ferrari (RACE), Pernod Ricard (PRNDY), or Hermes (HESAF) are global brands that come from the heart of Europe.
In addition, while U.S. stocks tend to outperform their peers from around the world over time, their current high valuations leave them little potential upside overall while simultaneously rendering them vulnerable to a strong correction. We have already witnessed how a decline in Nvidia (NVDA) drops the whole market, and with the current levels of concentration, future decreases could hurt even more. Therefore, it might be prudent to diversify with some European stocks, especially given their current levels of affordability.
