It’s well known that US stocks, overall, are some of the most expensive in the world. One reason that’s given is that the US market has a high weighting to technology stocks. The theory being that they justify premium valuation ratios due to higher growth prospects. In reality, the US information technology sector is considerably smaller than people think. A lot of big “tech” stocks aren’t really tech at all.
US stocks are some of the most expensive in the world. In fact, at the country level, only Denmark is more expensive (see here – it’s from December 2017, but little has changed).
Earlier in the week, I took a close look at German stocks (see here). The MSCI Germany index trades with a price-to-earnings (P/E) ratio around 13, which I think is good value. Meantime, the MSCI USA index has a P/E of 20. (The similar S&P 500 index has a P/E of 21.4, according to multpl.com).
It got me thinking about whether there’s something that justifies the higher valuation of US stocks. After all, Germany and the US are both advanced, wealthy, industrialised nations. Both stock indices include loads of multinational corporations, with businesses all around the world. Which means large parts of their fortunes are tied to the global economy, not just their domestic ones.
One supposed justification for the premium attached to US stocks is the higher weighting to the “Information Technology” sector. The idea being that tech stocks have higher growth prospects, justifying higher valuation multiples.
Never mind that many of them are also relatively high risk. Today’s most successful tech is often tomorrow’s trash. In general terms, products become obsolete in this sector faster than in any other field of business. This list of fallen stars is long. Some names that spring to mind include Nokia, Blackberry, AOL, Yahoo, Palm Pilot, Betamax video, AltaVista, Segway…and so on.
But let’s assume that, somehow, tech should have a premium valuation. That’s across a wide spectrum of businesses, from Apple to Microsoft to Intel and everything in between. But let’s go with it.
The MSCI USA index had an official weighting to the Information Technology sector of 20.4% at the end of January. Within the MSCI Germany index it’s a much lower 12.5%.
But, looking at the US tech sector more closely, there are some clear anomalies. At least three big “tech” companies, with a combined sector weighting of 2.5%, clearly belong in Financials. These are Visa, Mastercard and Paypal. Another 0.4% is management consultant Accenture. That should be classified in the sub-sector of Professional Services, within the Industrials sector (as is Booz Allen Hamilton, another consultancy firm).
Those seem pretty clear. But, in my view, the biggest single anomaly is Apple, which is 3.3% of the index value. It should really be classified under Consumer Discretionary, given that the bulk of its business is selling high-priced smartphones. I know many will disagree, but let me explain my thinking.
Apple gets away with high prices and abnormally fat – although shrinking – profit margins for consumer hardware. That’s because people are drawn to its brand. Its customers are prepared to pay a premium to carry its products around. But, in pure functionality terms, most of what iPhones do can be bought much more cheaply these days from other manufacturers. Paying extra for a fancy brand fits what I’d call Consumer Discretionary.
Just so you know, I use an Apple MacBook laptop – which is great – and had an iPhone until recently. I just ditched the latter and replaced it with a Samsung model that’s much cheaper than any current iPhone. It still does much more than I need, so I didn’t see the point of wasting money on Apple. How’s that for a discretionary consumer spending decision?
Stripping out those five companies mentioned above, the US tech sector weighting drops by 6.2 percentage points. That’s from 20.4% of the index to 14.2%. Put another way, about 30% of US “information technology” doesn’t really belong there.
What’s left of the tech really does look like tech. The top 10 companies alone come to 9% of the index (out of 14.2%). These are, in descending size order: Microsoft, Intel, Cisco Systems, Oracle, Adobe, IBM, Salesforce, Broadcom, Texas Instruments and Nvidia.
Below is a chart which summarises the sectors for the unadjusted US index, the US index after my adjustments, and the German index (for comparison to another well-diversified, developed market, but with a much lower price tag).
Sources: MSCI, OfWealth
Sure, there are still differences. German Financials are dominated by insurance, whereas the US has more weighting to banks. US Communications Services (a new sector) includes the likes of Alphabet (Google) and Facebook. German Consumer Discretionary is dominated by car manufacturers (BMW, Daimler, Volkswagen), and the US includes Amazon. Germany has no Energy stocks but a higher weighting to Materials (especially chemicals).
But the actual Information Technology sectors are much more similar than is generally believed. Germany has a weighting of 12.5% whereas the US is at 14.2%, after the adjustments.
There may or may not be other reasons to justify higher multiples for US stocks, when compared with the stock indices of other countries. But that’s a topic for another day.
In the meantime, I don’t believe a bigger tech sector is a justification for the premium valuation of US stocks. It’s simply not as big as people believe. And, in any case, many tech companies don’t justify high valuations in the first place, given the inherent risks in their fast-changing businesses.
Stay tuned OfWealthers,