A World of Opportunity outside the U.S.
For the past decade, investors have had little reason to buy stocks of non-U.S. companies. During the bull market, far more money could be made at home, and when the bears took hold, most foreign markets fell victim, too. But the next decade could be quite different. Stock valuations in most foreign markets are now significantly lower than in the U.S. and earnings potential is often just as good abroad as it is at home. Any weakness in the long-strong U.S. dollar will make nondollar investments all the more rewarding.
Sure, foreign stocks have been cheaper than U.S. equities for a long time, but now the valuation gap is extreme. As of Mar. 31, the Standard & Poor's 500-stock index had a trailing one-year average price-to-earnings ratio of 27.4 (excluding write-offs), vs. 18.1 for the 20 major foreign markets tracked by the MSCI Europe, Australasia, and the Far East ex-Japan Index. (BusinessWeek excludes Japan because of its 11-year economic malaise and extremely depressed earnings.)
Think of it this way: Non-U.S. stocks sell at a 34% discount to U.S. stocks. During the 1990s, the discount averaged 9%; in the 1980s, foreign markets traded at a 6% premium to the U.S. "Foreign markets are the cheapest I've seen them relative to the U.S. in 30 years," says Ben Inker, director of asset allocation at Grantham, Mayo, Van Otterloo (GMO), a Boston money-management firm. Nor is the valuation gap much smaller looking ahead. GMO's estimated 2002 operating p-e for the S&P 500 is 25.4; for MSCI EAFE ex-Japan, it is 17.2--a 32% discount.
Investors have long felt that foreign companies deserved lower valuations because their earnings growth was slower and less consistent. Times have changed. "A couple of years ago you could look at U.S. companies and say, `Wow, the earnings are great!"' says Steven Bleiberg, chairman of global equity strategy at Credit Suisse Asset Management in New York. "But the U.S. premium in earnings growth has largely evaporated."
Indeed, return on equity, an important measure of corporate profitability, shows foreign companies closing the gap. During the 1990s, ROE on the S&P 500 peaked at 17.3%, but it has fallen to 13.9%. Foreign ROE went up and down, too, to a lesser degree, and it's now 12.9%. Historically, the gap in these numbers has been wide. Since 1974, S&P 500 stocks have averaged a 14.1% ROE, vs. 11.1% for the MSCI EAFE ex-Japan index.
There's still a case to be made for U.S. stocks. Proponents argue that earnings here are at recession lows and will come back strongly, thanks to the Federal Reserve's aggressive interest-rate cuts. This may be so in the short run. "The U.S. will have a temporary pop from the rate cuts, but that will cause inflation to rise, which is bad for equity markets in the long term," says Edgar van Tuyll, global strategist at Pictet, a Geneva-based money-management firm. Thus, van Tuyll is underweighting U.S. stocks and overweighting Europe. "Europe has less inflation risk because it was less aggressive in lowering rates, which are now 3.25%, vs. the U.S.'s 1.75%," he says. The higher European rates also allow more leeway to ramp up future growth with rate cuts.
Where are the best foreign opportunities? In recent months, the strongest rallies have been in emerging-market stocks, which sport the cheapest valuations in the world. These include many Asian, Latin American, and Eastern European nations. Developed nations are also attractive. Stocks in Italy, Spain, and Britain have average p-e's of 16.8, 17.7, and 19.3, respectively. Smaller markets such as Austria, Norway, and Ireland trade at p-e's of below 15. "Austria is our favorite," says Inker. "It's cheap, it's ignored, and its companies are well-run. We also like Norway, Germany, and Australia."
Germany's trailing 21.4 p-e is somewhat higher than those of other European countries, but its earnings are understated. That's because Germany had a maximum capital-gains tax rate of 50% until January. To avoid the tax, German companies tend to undervalue their assets and exaggerate liabilities. With the tax gone, they will likely do some serious restructuring. "The hidden value locked up in the German economy is considerable," says Mark Tinker, a global equity strategist at Commerzbank in London. "Now companies can sell off noncore businesses."
The situation is exactly the opposite in the U.S., where the stock market rewarded companies that overstated earnings and understated liabilities. "The country that uses stock options to compensate its executives most aggressively is the U.S.," says Sarah Ketterer, manager of the Causeway International Value Fund. "So there's a temptation to overstate earnings to get the stock price up. The accounting in other countries tends to be more conservative."
Some global investors take a bottoms-up approach: They buy the stocks, not the market. Michael Welsh, portfolio manager of Oakmark International Fund, thinks Continental banks are attractive. "Europe's banks are about 25% cheaper than U.S. ones," he says. "And their growth prospects are better because the European financial-services industry is less developed, and banks there are beginning to restructure." His favorites include Italy's Banca Popolare di Verona, Banque Nationale de Paris, and Sweden's Svenska Handelsbanken.
The best values are in small to midsize companies. "You find more opportunities as you move down the capitalization ladder," says Ketterer. "There's a big valuation gap between mid-cap stocks in the $2 billion to $10 billion range and large stocks above $10 billion." That's because many global money managers want to own big liquid stocks, while small-caps tend to be locally owned. Such ownership makes small-caps better diversifiers for U.S. investors, as they respond more to local rather than global trends.
Smaller companies also tend to be better run than larger companies, as management often has a big personal stake in the business. In Japan, for instance, "small companies tend to be of a better quality and more focused" than antiquated behemoths, which are saddled with too much debt and money-losing subsidiaries, says HSBC Securities equity strategist Gary Evans. Oakmark's Welsh counts Meitec, a Japanese temporary employment company with a $1.1 billion market cap, among his top 10 holdings. "The company is run by smart people who do share buybacks and focus on financial returns," he says. "That's relatively uncommon in big Japanese stocks."
The Japanese market itself remains a giant question mark. "Most Japanese executives continue to be indifferent to shareholders after an 11-year bear market," says Gilman Gunn, portfolio manager of Evergreen International Growth Fund. "It's pathetic." Yet some managers think Japan is ripe with opportunities. "Japan could be the best-performing market going forward," says Pictet's van Tuyll. "The country is driven by exporters, which are very sensitive to the world economic cycle. As the global economy recovers, their earnings will improve dramatically."
With any overseas investing, currency is part of the equation. For nearly 10 years, the U.S. dollar has soared against most currencies. That meant U.S. investors suffered when the value of their foreign holdings dropped because the securities were denominated in local currencies. But they benefit when the greenback falls. GMO's Inker thinks a dollar decline will add two percentage points per year to the overseas returns for U.S. investors over the next decade.
Forecasting currency movements is even dicier than predicting stock prices. But dollar-watchers say the trends are not the greenback's friends. First, the U.S. current account deficit, which measures how much imports exceed exports in currency terms, is now $417 billion, the most in history. That deficit has been largely offset by foreign investors buying dollars in order to acquire U.S. securities, especially bonds. Since the U.S. lowered rates sharply last year, foreign investment flows have slowed. "Why would you buy an asset with a low yield and the potential for a capital loss when rates rise again?" asks Avinash Persaud, London-based head of global research at State Street Bank.
At the same time, demand for foreign equities has picked up. In the past three months, money flowing into European equities from the U.S. and other countries has been two to three times that of the foreign money moving into U.S. stocks, Persaud says. If both trends persist, the dollar will have nowhere to go but down. "When Americans want to invest more abroad and foreigners want to invest at home, the dollar will slide and that will exaggerate the better returns overseas," says George Greig, manager of William Blair International Growth Fund. The smart thing is to get there before everyone else.
By Lewis Braham
With Brian Bremner
— With assistance by Brian Bremner