You get what you pay for

Since the start of 2016, the US stock market has rallied the best part of 35%, with the bulk of that coming since the election of Donald Trump. The corollary of this is that one of the most common questions we field from clients relates to American valuations and whether now is the time to sell US holdings, especially given relative valuation differences to European stocks.

Time to sell? Think several times! Mathematics suggests that the US market should trade at a premium to Europe, as it has done on average for the last decade. The reason for this lies in the premium Returns on Capital that US corporates earn, which are significantly higher than every other major developed market in the world.

In 2016, my colleague Sam Ford wrote an article extolling the virtues of compound interest as a way of creating wealth over the long term. The failure to appreciate the power of compounding had, he explained, been described as “the greatest shortcoming of the human race”. Understanding is one thing, but how do we create an investment strategy in practice that harnesses this compounding power, which Einstein (allegedly) called the “8th wonder of the world”? One way to do so is to build a portfolio of stocks that can earn high profits for every dollar they invest in the company (termed high Return on Capital), which they can subsequently reinvest in their business. These stocks should trade at a premium multiple to those that earn lower returns.

Let’s show why with a simple example. We can calculate the pace a business will grow its earnings if we know just two factors – the incremental Return on Capital (ROC) that a company can earn by investing a dollar of earnings back into the business, and the opportunity that the company has to reinvest those dollars. For example, a business that earns a 20% ROC and can reinvest 75% of its earnings back into the business will, all else being equal, be able to grow earnings by 15% per annum.

Even over a medium investment horizon, differences in ROCs at the same reinvestment rate will drive meaningful differences in investment returns. For example, imagine we have two companies trading on 20x earnings:

  • Company A – earning 10% ROC, and reinvesting 90% of earnings back into the business
  • Company B – also reinvesting 90% of earnings, but only earning a 5% ROC on those investments

If both companies continue to trade at the same multiple, then at the end of a ten-year holding period the difference in returns will be absolutely staggering. Company A’s investment return would be nearly 9% per annum, compared to a much more modest 5% from that of its peer. This is actually remarkably close to what the USA and UK stock markets have respectively returned over the last decade.

Now, I’m sure some readers will be rolling their eyes at this example. “Of course a high-returning company will outperform a low-returning one if they’re both priced the same!”, you may be thinking… and you’re absolutely right. But the point of this exercise is not to prove that high return is better than low return, but to show that over a reasonable time frame the power of compounding is such that it is vastly more important to pick the right company or country to invest in than it is to pick the right valuation.

In fact, in our prior example, Company A would still be a better investment than Company B even if you had initially purchased Company B for a third cheaper and it had rerated to a multiple 50% higher over the next decade.

This leads us nicely back to valuations in the United States and why it’s not just as simple as looking at earnings multiples. The consistency with which businesses across the pond generate a higher return on capital suggests that they should trade at a higher price. It also suggests that America in general is an attractive market stocked full of high-returning companies with good growth prospects.

This is not to say that valuation is unimportant, or that high Return on Capital, high growth stocks should be bought regardless of price. Valuation remains critically important. The future is extremely uncertain and the prudent investor should want as large a margin of safety as possible. To paraphrase the late Stephen Hawking “I have noticed even people who claim everything is predestined … look before they cross the road.”

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.