By Carla Fried
With the PE ratio for the S&P 500 expanding from 13.8 in 2012 to 15.5 today based on estimated 2013 earnings, U.S. large caps have firmly moved into less-compelling fair value territory. And it's not like U.S. small caps offer much valuation juice. The S&P Small Cap index trades at 22.3x this year's earnings estimate. Given that the long-term norm is for small caps to trade in line with large-cap valuations, that's not exactly compelling either.
If you're in the market for a better valuation story, Europe is where to focus your research. The long-term trend is for European stock valuations to trade pretty much in line with the U.S. But right now the Europe cyclically adjusted PE ratio (CAPE), which smoothes out inflation adjusted earnings over a 10-year period, is 35% below the U.S., which at 23 is well above its 16 long-term average.
While the debt challenges of Italy and Greece remain, and no one is suggesting that all has been solved in Europe, the fact is the key economies of Germany, France and the United Kingdom are now showing inflation-adjusted growth.
Even Portugal's GDP report surprised with growth in the second quarter.
The situation in Europe bears some resemblance to the U.S. circa late 2009/early 2010: still plenty of question marks, but an economy officially out of recession and a stock market firmly in rebound mode, but yet to move into multiple-expansion overdrive.
And it's not as if buying Europe means you're betting solely on European businesses and consumers. According to Northern Trust, the companies in the MSCI Europe index derive just over half their revenues from Europe. Emerging and frontier markets account for 24% of MSCI Europe revenue and the U.S., 16%. (By comparison the MSCI North America index derives 70% of its revenue from U.S. business.)
So if you're of the mind that there is global economic growth to be had - in the U.S., China and now Europe - Euro-based companies currently offer one of the cheaper ways to invest in that global growth. The Vanguard Europe ETF (VGK) has a forward PE ratio of 14 compared to 15.5 for the S&P 500. The SPDR Euro Stoxx 50 ETF (FEZ) is even cheaper, with a forward PE ratio below 13.
It's also worth noting that the deep value $25 billion Oakmark International mutual fund currently has about 75% of its assets invested in Europe. In terms of active-management, the globetrotting Oakmark International - led by long-time manager David Herro - has a stellar record: Its 11.3% annualized gain over the past 12 years is nearly four percentage points ahead of the EAFE Index. Over 15 years its 12% annualized gain is more than double the 5.5% EAFE index gain.
While the 55% gain for the U.S. index over the past five years swamps the 21% gain for S&P's index of 350 European stocks, more recently Europe is flashing some extra mojo. Ever since the Euro recession was officially deemed over at the end of the second quarter, Europeans stocks have been leading the charge:
^SSPE data by YCharts
Along with the Vanguard Euro ETF, the SPDR Euro Stoxx ETF and the WisdomTree Hedged Europe Equity ETF (HEDJ) have been strong the past few months:
VGK data by YCharts
French-based energy behemoth Total (TOT) is the largest holding in the SPDR Euro Stoxx ETF. A sub-10 PE ratio spells cheap. But like Exxon Mobil (XOM), Chevron (CVX) and Royal Dutch Shell (RDS.A) (RDS.B), Total has had to seriously amp up its capital expenditures over the past three years in search of ever-harder-to-find reserve replacements, let alone production growth:
Total's capital expenditures per share have grown from $7 in 2010 to $11.64 today. Only Chevron at nearly $16 per share is higher.
And during much of that stretch the price of crude oil has been slumping; since its April 2011 peak it is down about 8%.
An investment in any of the majors at this juncture is a bet that an uptick in global demand will boost oil prices enough to more than compensate for the recent outpouring of cap-ex. And before you get too enamored with Total's 4.4% dividend yield, keep in mind that Total isn't a steady eddy payer.
For a Euro-domiciled consumer cyclical with a broad global market, Daimler AG (OTCPK:DDAIY), the parent of Mercedes-Benz, is interesting. It is currently the second largest holding in Oakmark International at more than 4% of assets. Oakmark has owned Daimler since 2006, but as recently as the second quarter of this year it was still adding to the position, boosting its stake by 25%. It is also one of the top 5 holdings of the WisdomTree Hedge European ETF.
A sub-10 PE ratio speaks to the valuation proposition. As seen in this chart, while per-share earnings have grown impressively over the past three years, the stock's trailing 12-month PE ratio has not, and is well below its 5-year level.
DDAIY Normalized Diluted EPS TTM data by YCharts
Daimler could be the poster child for Euro-based companies that still trade under the valuation dark cloud of where they happen to be based, rather than on their fundamentals.