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Written by: Jay Younger | Aubrey Capital Management
European stocks have often traded at lower price-to-earnings (P/E) ratios compared to their US counterparts in the past. More recently, a particularly large valuation gap has emerged. On some measures it is larger than at any time since the 1980s, apart from the market low in October last year.
This valuation gap might be justified if US companies were reporting higher corporate earnings growth. However, our analysis of the comparable MSCI indices suggests this is not the case across all market capitalisation ranges.
The charts above show that in both the small and mid-cap areas, Europe is cheaper on absolute PE and also has higher expected earnings per share (EPS) growth. The MSCI Europe Small Cap Index trades on an FY24 PE of 12.8x with an 18.5% expected EPS growth (PEG 0.7x), versus 19.4x with 9.3% EPS growth (PEG 2.1x) for the US small-cap index.
Similarly, MSCI Europe Mid Cap trades on a FY24 PE of 13.9x with expected EPS growth of 9.1% (PEG: 1.5x) versus MSCI US Mid Cap which trades on a FY24 PE of 18.4x with expected EPS growth of 6.5% (PEG: 2.8x). Thus, allocators who are overweight US equities may want to consider the European small and mid cap space. The Aubrey European Conviction Strategy is an all-cap strategy, although 60% of the portfolio is invested in the mid and small caps.
The only US index where the relationship between growth and valuation is more favourable is the large-cap. (MSCI US Large Cap PE22.6x vs MSCI Europe Large Cap PE14.4x) but the expected EPS growth for the US is 11.2% compared to negative growth for MSCI Europe large cap. This is likely attributable to the strong performance of large cap US Tech, but leaves the PEG ratio very high at 2x.
Consistent with the above top-down index comparison, we have also seen individual companies in our portfolio outperform their US peers. For example, Rightmove is a mid cap company we hold. The company has a extremely high cash flow return on assets (564%) which allows it optionality in terms of either making further investment into its platform or paying a dividend. Its US peer, Zillow, trades on more than double the adjusted FY24 PE of 47x and has returned -9.7% YTD whereas Rightmove is up +2.8% (in EURs) and its FY24 PE is 21x.
In the large cap space, SAP is a company we hold that offers Enterprise Resource Planning (ERP) through selling software as a service (SaaS). It recently reported its Q2 results where the Q2 sales growth was 10% and adjusted operating profit growth was 33%. Year to date SAP has returned 42.8%, Salesforce Inc, a comparable SaaS company in the USA, is down 0.5% (in EURs).
We are currently in the middle of the Q2 earnings season and so far the average EPS growth in our European portfolio has been 30%, consistent with what we saw in Q1. The PEG on the portfolio is 0.8x and we believe H2 will be stronger than H1 given the conversations we have had with company management teams. Europe as an investment destination has been somewhat neglected compared to the USA of late. There are good growth and valuation grounds to suggest that this could change in the not too distant future.
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