The following is adapted from our Q2-2016 Newsletter...
It’s hard to remember what happened in the second quarter before Brexit. Had the quarter ended a week earlier, there wouldn’t have been much to say: stocks were slightly up, the Fed held steady on interest rates, and news on the economy and unemployment was mildly positive.
Pre-Brexit, we had a different newsletter in mind. We wanted to explain the confusing world of mutual fund share classes. It’s an important and evergreen topic that will have to wait. Brexit brought up more pressing concerns.
Pain, but Where's the Gain?
Many believe that international markets are riskier. There is plenty evidence of late: Grexit, China’s stock market bubble, commodity prices, negative interest rates, and now Brexit. A U.S. investor is understandably nervous about investing abroad.
With that in mind, we think it’s important to review the case for European stocks. In August 2015, we initiated a slight overweight to European stocks in our clients’ portfolios. Owning European stocks is a reminder that bargains are often uncomfortable.
The idea behind the Brexit referendum was to provide clarity. Instead, the opposite is true. The “Leave” vote opened up a can of worms the size of Big Ben. A few weeks later, no one has a good grasp on Britain’s long-term game plan, let alone what this means for British and European stocks.
The uncertainty thumped an already beat-up European market. Stocks took the elevator down, and then tip-toed back up the stairs. European stocks fell close to 15% over the two trading days post-Brexit. They then made up over half that ground to finish the quarter (they ended the quarter down 4% and down 1.9% year-to-date).
There’s a saying: “you can’t break your arm falling out of a basement window.” June’s decline could have been worse had European stocks not performed dismally in recent years. Over the last decade, European stocks have been mostly flat while the S&P 500 has doubled.
The European stock market mirrors the sluggish European economy. In 2006, 17 of the world’s 50 biggest companies were European; 7 are today (31 are American). Unemployment has exceeded 10% since 2009. This year, the U.S. economy will surpass Europe in GDP for the first time since 2004.
In sum, Brexit was a low point in a feeble decade-plus run. Investors have a right to wonder whether their European investments will ever pay off.
Cycles Prevail Eventually
Buying European stocks in lieu of U.S. stocks has not been a winning trade. But that has only been a recent trend. The following chart uses a 5-year investment horizon and shows the cyclical nature of the trade. Areas above the line represent 5-year periods where U.S. stocks beat European stocks.
Europe has bested the U.S. in three of the previous four full decades. The last 45 years have produced comparable annualized returns. The wild swings in the previous graph belie a striking similarity in long-term returns.
More broadly than Europe, international stocks have traded outperformance with U.S. stocks. U.S. stocks have had the upper hand since 2010 (see gold areas in the chart below).
Cycles happen across most every investment category because, especially over short time periods, investor sentiment drives markets. Optimism causes investors to overpay. And pessimism causes investors to sell low. It’s the opposite of a rational buy low, sell high strategy.
While cycles are inevitable, their duration is unpredictable. No two cycles are identical. There is no indicator that reliably points to when a cycle will turn. European stocks’ underperformance has persisted a disturbingly long time, and there is no time limit on how long it can last.
The only thing to do is remain diversified and patient. Uncorrelated asset classes can lead to higher long-term returns with lower volatility. Yet, being uncorrelated means that one asset class will always look relatively weak.
History tells us that the best bargains appear in times of widespread pessimism. Fear and frustration drive many investors to sell out of underperforming markets, at low prices. Doing so locks in losses and avoids the benefits that may be around the corner.
Invest in Companies and Their Intrinsic Value
Overpaying, underpaying, and bargains are abstract concepts. Their meaning depends on what underpins them: businesses that build and create value.
In focusing on big picture news and trends, many investors lose sight that they invest in companies, not countries, cycles, or current events. Let’s unpack one fund in our portfolios:
Even if you don’t know much about investing, you likely recognize many names above. You may not have realized some are foreign because their products are so common here. Yes, the company that produces Budweiser, which recently changed its can’s label to “America”, is not American.
Despite Brexit or whatever crisis comes next, these businesses will continue to produce and deliver goods to the global market. The key word is “global”. They, like your investment portfolios, practice diversification by not over relying on any one market. And as circumstances evolve, they adapt per their owners/investors’ mandate to deliver value.
Companies’ value for investors – whether it’s Nestle or Coca-Cola, Shell or Chevron - is their assets, dividends, and earnings, current and future. Stock ownership grants a right to a small slice of the company’s value.
Through the stock market and the laws of supply and demand, investors determine companies’ prices. Over the short term, prices vacillate with temperament. Yet, over long periods of time, they conform to companies’ intrinsic value. The effect is like gravity – value keeps prices within its orbit.
No factor drives our stock allocation more than how prices compare to value. The best path to long-term returns is to buy undervalued assets and sell overvalued ones. It sounds simple. But most investors do the opposite.
In recent years, investors have flocked to U.S. stocks, driving prices up. As a result, investors today receive less value per dollar spent in the U.S. than in Europe. Put more simply, stocks are cheaper in Europe than they are here.
We’ll highlight one metric in the above chart: dividend yield. Dividends are profits that companies pay to shareholders. They are a reward for owning stock. Dividend yield is a major component of investors’ returns. Compared to erratic stock prices, dividend yields are a steady and predictable benefit. Today, the reward in Europe is a third higher than in the U.S.
The Paradox of Bad News
The long history of investing shows that the relationship between price and value (i.e. buy low) strongly correlates with long-term returns. However, that correlation only holds for long time periods i.e. > 5 years.
Over shorter periods, expectations drive markets. And expectations for Europe today are bleak. Between political uncertainty, poor demographics, and low economic growth, there isn't much to be excited about.
Paradoxically, the lack of good news makes Europe a great place to invest. Bad news has smothered European stock prices. Because prices respond to news, to wait for the situation to improve would mean waiting for higher prices. A cardinal rule of investing is: there is no such thing as a good or bad investment, just a good or bad price.
When European stock underperformance flips is anybody’s guess. It could be a maddeningly long time. Nonetheless, investors with a long-term approach should heed precedent and the data showing value in Europe.
European economics and politics may be a mess. But European stocks are cheap. History tells us that a patient investor will be rewarded.