This past June, Goldman Sachs sounded the rally alphorn on European stocks. The Stoxx Europe 600 index will outperform the S&P 500 index this year, it predicted. Even if Europe’s valuation discount to the U.S. doesn’t shrink, “the U.S. is unlikely to continue to massively outperform Europe.”
Since then, the U.S. has continued to massively outperform Europe—by six percentage points in as many months. Goldman isn’t nearly alone; the top strategists on Wall Street have been steamrolled by this call. The bank’s reasoning was sound: The Stoxx index, at 12.6 times this year’s projected earnings, trades much more cheaply than usual relative to the S&P 500, at 20 times. The sum value of U.S. companies this year has exceeded that of European ones by a ratio not seen since the 1980s.
This is where reversion to the mean is supposed to come in. Things that have gotten statistically weird should eventually move back toward normal. If they don’t, it means that what used to be weird isn’t weird anymore. Maybe years of low interest rates fueled a tech boom that has given the U.S. an insurmountable stock market lead in the age of artificial intelligence. U.S. tech stocks were recently worth 10 times as much as European ones—and that’s using sector definitions that don’t count
Amazon.com
(ticker: AMZN),
Meta Platforms
(META), or
Tesla
(TSLA) as tech.
I asked David Herro, longtime manager of the
Oakmark International
fund (OAKIX), about this. If the goal for investors, as opposed to traders, is to buy a cash-flow stream at a low price, says Herro, then European stocks are probably the greatest pocket of value today. “I’m not saying that Amazon and
Microsoft
(MSFT) aren’t great companies,” he says. “What I’m saying is, the price you’re paying for those cash-flow streams, it’s pretty high.”
What gives Herro confidence in European stocks now is the comparison with bond yields. Flip the price/earnings ratio for the S&P 500 upside down, and the result, put as a percentage, is an earnings yield of 5%. Compare that with the 10-year Treasury yield, recently 4.5%, and the advantage for stocks looks slim relative to, say, Germany. There, the Dax stock index has an earnings yield of about 9%, and the 10-year government bond recently yielded 2.6%. Germany’s much smaller budget deficits than the U.S. should help keep its bond yields relatively low, says Herro.
The war in Ukraine has scared some investors out of Europe, but Herro says that the continent has responded nimbly to a resulting energy crisis, and that companies have gotten more shareholder-friendly than even five years ago, judging in part by a surge in stock buybacks to multiyear highs. I asked Herro for his favorite stocks. Here are three.
Don’t confuse
Lloyds Banking Group
(LYG) with Lloyd’s of London. The latter is an insurance marketplace associated in America with sometimes dubious reports of celebrity body-part coverage—the singer Tom Jones has said he did not, as a tabloid paper once claimed, take out a £3.5 million policy on his chest hair. That particular Lloyd’s was founded in 1688 by Edward Lloyd, whose coffee shop had become a hangout for shippers needing cargo coverage. The Lloyds at issue here, on the other hand, was founded in 1765 by iron dealer Sampson Lloyd II, who teamed up with a Birmingham button maker to open the city’s first bank. Today, Lloyds Bank is one of the largest retail banks in Britain.
Herro likes that Lloyds Bank enjoys a solid reputation among depositors, which keeps it out of rate wars to attract funds, and leaves its net interest margin healthy. Valuations across the sector remain depressed from the days of near-zero interest rates. Lloyds’ shares trade below six times earnings, or at 65% of book value per share. The dividend yield is 6%. “This is a company that in the next five years should give back the equivalent of its market cap to the shareholder in the form of dividends and stock buybacks,” says Herro. Lloyds is his largest position.
Germany’s
Bayer
(BAYRY) started as a textile dye maker 160 years ago and moved into pain medicines. One of its first hits, over-the-counter heroin, has fallen out of regulatory favor. Another, aspirin, is still going strong. Consumer products are only 12% of company sales, and pharmaceuticals, 38%.
The remaining half of the money is made from crop science products, which got a big boost from a 2018 acquisition of Monsanto. But that deal has lost money for shareholders due to lawsuits alleging that Monsanto’s Roundup weedkiller causes cancer.
Bayer said last year that it had faced 154,000 claims and that 110,000 had been settled or dismissed. It has set aside $16 billion for remaining cases and says it will remove Roundup from shelves by year’s end. It had won nine straight cases until last month, when it lost three. Herro says the matter is “kind of in runoff.” Bayer has had a new CEO since June, American drug executive Bill Anderson, who promises a business shake-up and increased cash flow. “He’s just what the doctor ordered,” says Herro. Shares are 6.5 times earnings.
CNH Industrial
(CNHI) is the No. 2 tractor maker behind
Deere
(DE), and well positioned for a long-term tech push on farms. But the short term could be rocky. The stock tumbled 10.6% this past Wednesday after management lowered its sales forecast, citing a downturn in Brazil, and announced job cuts. U.S. farmer incomes are falling this year. CNH has been buying back stock, now at six times earnings, and plans a minor de-Europification of sorts by dropping its Italian stock listing, leaving only its U.S. one. Investors will need help making sense of a complicated back story. The company did a yearslong stretch as part of
Fiat,
the auto maker, lumped in with commercial trucks. But its name comes from Case and New Holland, well-known tractor brands that hail originally from Wisconsin and Pennsylvania.
Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.
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