By Kyle Wales
As published by BusinessLive.co.za on 07 June, 2020
America is likely to remain the captain of the fourth industrial revolution.
Much has been said about the degree to which US stocks have outperformed their global counterparts. Over the last 10 years, owning US stocks has returned 13% compounded per annum (in USD) versus only 5% for the rest of the world (excluding the US).
Given the nearly 8% annual divergence in returns, many would ask if now is the time to invest in Europe, Japan or Emerging Markets? This is a particularly interesting question for your typical valuation-based investor who believes in mean reversion (as we do) to a lesser or greater degree.
At its most basic level, the notion of mean-reversion implies that the factors driving the return an investor makes from a stock will revert to its long-run average over time.
There are 3 factors that drive stock returns:
(1) the dividend yield when you purchase it;
(2) the rate at which it grows its earnings (which in turn is driven by its ability to grow its revenues or expand its margins); and
(3) the price-to-earnings (P/E) multiple that the market is prepared to pay for the stock (which can expand or contract).
Of these 3 factors, the only factor that is fixed is the dividend yield when you purchase a stock. The rate at which the stock grows earnings (no. 2) and its P/E multiple (no. 3) can exceed (or fall short of) their long-run averages, and mean-reversionists believe that these factors will revert to their long run average over time.
Faster earnings growth explains 80% of the divergence in returns between US and non-US stocks
Since 2010, the primary reason why US stocks have been able to outperform stocks in the rest of the world is due to faster earnings growth – which is partly due to a decline in US corporate tax rates from 35% to 21%.
Perhaps surprisingly, the differential in P/E multiple that US stocks trade on versus those of the rest of the world has contributed relatively little (we estimate as little as 20%) to this difference in returns.
Mean-reversionists would argue that these things even out over time and that US stocks will inevitably go through a period where they grow their earnings slower than the rest of the world, causing their stocks to underperform. Consequently, they would argue that now is the time to “buy” stocks from the rest of the world and “sell” those of the US.
The problem with mean-reversion in this context is that it is not alert to paradigm shifts. It assumes all forces driving stock returns are cyclical (as opposed to structural) in nature. We would argue that this is not the case.
Mean reversion is not alert to paradigm shifts
Today we stand in the middle of a “fourth (digital) industrial revolution”. It is the successor to the first, second and third industrial revolutions which saw horse power supplanted by steam power (first industrial revolution), steam power supplanted by electricity (second industrial revolution) and subsequently the automation of routine tasks (third industrial revolution).
If we consider the many innovations that this “fourth industrial revolution” has brought us – including internet, social media, ecommerce, cloud-computing, the smart phone – almost all of innovations have been developed in the US. The US may have stopped running a trade surplus with the rest of the world a long time ago but, as an exporter of ideas, it has no equal.
All the corporate juggernauts of this age are US-based. If one takes the 5 largest companies in Europe and compares them to the 5 largest companies in the US, the US list consists exclusively of technology companies while the European list consists of two FMCG companies, a luxury goods company and two pharma companies which were all founded more than 100 years ago.
|Apple (est. 1976)||Nestle (est. 1866)|
|Microsoft (est. 1975)||Roche (est. 1896)|
|Amazon (est. 1995)||Novartis (est. prior to 1900)|
|Alphabet (est. 1998)||LVMH (est. 1854)|
|Facebook (est. 2004)||L’Oreal (est. 1909)|
The unavoidable reality is that the US is navigating the current “fourth industrial revolution” better than the rest of the world, and there are compelling reasons why this will remain the case. For example, US universities have far larger endowments than universities in the rest of the world and it is often universities that are the incubators for entrepreneurial ideas. The US (in the guise of Silicon Valley) has deeper venture capital markets than the rest of the world, which makes it easier for aspiring entrepreneurs to raise the money they need to realise their visions. Finally, large US companies (admittedly, partly due to their technology “tilt”) spend far more on R&D than large companies in the rest of the world.
As long as the US continues to support education, entrepreneurship and capitalism, we believe the conditions for its continued outperformance remain intact. While it has unquestionably been a good decade for US companies (and those invested in them), we believe there are valid reasons for this and we would not prematurely conclude that that is set to reverse any time soon …
 28 May 2010 – 27 May 2020. US = S&P 500. RoW = MSCI world ex US.
 As at 28 May 2020
Kyle is a co-portfolio manager of Flagship Asset Management’s global funds.