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International Stocks Are Cheap. Should You Overweight Them?

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Includes: ADRU, BBEU, BBJP, DBEU, DBEZ, DBJP, DEWJ, DEZU, DXJ, EDOM, EEA, EPV, EURL, EWJ, EWV, EZJ, EZU, FEEU, FEP, FEUZ, FEZ, FIEE, FIEU, FJP, FLEE, FLJH, FLJP, GSEU, GSJY, HEDJ, HEWJ, HEZU, HFXE, HFXJ, HJPX, IEUR, IEV, JEQ, JPN, JPNH, JPNL, JPXN, PTEU, RFEU, SPEU, UPV, VGK
by: Strubel Investment Management
Strubel Investment Management
Value, portfolio strategy, dividend investing, wealth manager
Summary

International stocks are cheaper than the US market (and have been for some time).

There are significant differences in market composition and expected growth rates that account for some of the valuation difference.

There are also major economic differences that can account for the valuation discrepancy.

Ever since the Great Recession in 2008 (technically even before that), the US stock market has traded at a premium to most other markets (See the chart below courtesy of Yardeni Research). For years, we've seen investors pointing this fact out and predicting higher returns for international stocks going forward, and for years, we've seen those predictions turn out to be wrong.

(Graphic source: Yardeni Research)

International stocks make up roughly 50% of the global stock market, so how should investors weight their portfolios? Should we finally expect international stock returns to catch up, or is it going to be more of the same underperformance?

Making Sense of Market Valuations

Probably the most important thing to realize is that when valuing the US stock market versus international markets, we need to take into account differences in the composition of markets. In this article, we'll focus our analysis on the two biggest markets outside the US - Europe and Japan. When looking at Europe, Japan, and the United States, we can see big differences in the sizes of various market sectors.

(Source: Sector forward P/Es from Yardeni Research, weighting data from MSCI)

The US stock market has a huge number of technology companies spread between the Information Technology, Consumer Discretionary, and Consumer Services sectors. Many of these companies have high P/Es but also high growth rates.

For example, the Consumer Discretionary sector in the US has three large "tech-type" companies with high valuations (excluding eBay (NASDAQ:EBAY)) and high expected growth rates.

Company (Ticker)

Weight

Forward P/E

5YR Consensus EPS Growth

Amazon (NASDAQ:AMZN)

23%

56.8

42.33%

Booking Holdings (NASDAQ:BKNG)

4%

17.6

15.49%

eBay

1.5%

12.5

10.78%

(Source: SSGA, Morningstar.com)

Together the two above-average P/E companies make up more than a quarter of the sector.

With the Communications sector, it's even more pronounced. Again we have three "tech" companies with above-market multiples and expected growth.

Company (Ticker)

Weight

Forward P/E

5YR Consensus EPS Growth

Alphabet (GOOG/GOOGL)

23%

22.6

15.83%

Facebook (NASDAQ:FB)

17%

19.7

17.94%

Netflix (NASDAQ:NFLX)

5%

78.7

49.84%

(Source: SSGA, Morningstar.com)

Together these three companies account for almost half of the sector!

If we strip out the three sectors that contain many of the high-multiple, high-growth companies, the valuation differences between the US, Europe, and Japan shrink. The table below re-weights the market indexes as if they only contained Industrials, Staples, Materials, Energy, Financials, Healthcare, and Utilities in the same relative weights.

(Source: Author's calculations, sector forward P/Es from Yardeni Research, weighting data from MSCI)

We can see that with only these sectors, the Japanese and US markets are valued similarly. Europe is still cheaper, but only by 1.39 times earnings instead of almost 2 with every sector included.

Beyond just differences in the types of companies that make up each market, there are also some serious economic differences. GDP growth for the Euro area has lagged the US since the Great Recession.

It also doesn't look to change much going forward. While the US is expanding fiscal support for the economy through higher deficits, the Euro area is now doing the opposite. In 2017, budget deficits were just .9% for the Euro 18 area and 1% for the Euro 29 area. For 2018, things are even worse with the most recent data showing third-quarter deficits of just .5% and .6%. While the US certainly isn't problem free, it still has economic advantages over Europe.

Summary

In summary, the lesson is that investors need to look beyond just headline valuation numbers. Sometimes the numbers don't show the entire picture. Other times things can be cheap for a good reason. If growth continues to be slower in both Europe and Japan, it makes perfect sense for their markets to be valued lower than a market that represents a faster growing economy. When considering the weights you should assign to other markets in your portfolio, you need to look at more than just the valuation. Looking forward, there doesn't seem to be any compelling reason to expect the valuation gap between the US and other markets to close completely.

Disclosure: I am/we are long AMZN, FB, GOOGL, BKNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are underweight international stocks.