StockTake: Waiting for Europe’s upturn

European earnings continue to lag the US, where 62 per cent of companies have beaten estimates – one of the highest percentages of the last three years.

Impressively, the revenue beat rate of 64 per cent was the highest since the second quarter of 2011, and contrasts sharply with the previous quarter, when around half of companies beat estimates.

In Europe, 58 per cent of Stoxx 600 companies have met or beaten estimates, but mainly due to cost-cutting. Sales fell in seven of 10 sectors, despite the third quarter of 2013 being the weakest for revenues since 2009.

Share prices have been steady, however, precisely because investors believe this cannot persist.

Europe’s share of global profits is at a 28-year low, with profit margins at non-financial companies only slightly higher than 2009.

US profit margins, in contrast, are at record highs and look unsustainable.

With European economic data improving over the last year, investors are, for now, patiently waiting for the earnings upturn.

Stock building in a lot of positivity, or hot air
Valuation talk is just so yesterday.

Take AO.com, which jumped over 40 per cent on last Wednesday’s London market debut. That gave AO a valuation of over £1.7 billion (€2.06bn), compared to the £300 million (€363m) estimate mooted as recently as September. It trades on 160 times gross earnings (250 times net earnings), and six times last year’s £275 million (€333m) sales.

AO is not offering exponential growth through some super-sexy business model. It sells fridges, washing machines and kitchen appliances online – not a high-margin business, and one facing competition from Amazon as well as traditional rivals like Dixon’s.

AO founder John Roberts famously said the company recruits on DNA, not qualifications. "It's a positivity test – if you're not positive, you're not for us," he said, adding: "I don't believe in hot air. I believe in upfront." However, only an awful lot of positivity and even more hot air could justify AO's price.


Cape crusader bearish on US
US equities will decline in real terms over the next seven years, says GMO analyst James Montier.

Montier, one of the most respected strategists in the world, takes a detailed look at the much-discussed cyclically adjusted price-earnings (Cape) ratio in a new paper.

Cape, which averages earnings over 10 years and shows strong US over-valuation, has its critics, prompting Montier to joke of “stockbroker economics”, the second tenet of which is “the market is always cheap” (all news is good news is the first).

Critics say 2008’s collapse distorts figures, but Montier finds 10-year earnings are actually “significantly above” long-term trends due to high earnings over a prolonged period. That is, Cape may be understating market overvaluation.

Examining five variants on Cape, even the most optimistic suggests real seven-year returns of just 3.2 per cent.

On average, they suggest zero real returns, but GMO expects a -1.1 per cent real return over the next seven years.

Forget the “sorcery” of analysts and talk of GMO being “valuation bears”, he says, “we are simply valuation realists”.

Risky advice from Buffett
Warren Buffett's latest letter to shareholders offers some surprisingly dodgy advice.

Buffett rightly advises investors stick to low-cost index funds and avoid “forming macro opinions or listening to the macro or market predictions of others” – a “waste of time”.

In his will, Buffett recommends 10 per cent of his inheritance be put in short-term government bonds and 90 per cent in a low-cost S&P 500 index fund. For ordinary mortals, a 90:10 asset allocation strategy is too aggressive, and will guarantee sleepless nights.

Buffett has previously noted it’s not uncommon for stocks to go nowhere over a 20-year period, so such advice is only for those with very long horizons.

More importantly, why ignore the rest of the world and stick to one index – the S&P 500? This, coupled with Buffett’s statement that “American business has done wonderfully over time and will continue to do so”, can only be construed as a bullish macro bet on the US, despite his earlier advice on the subject.

The US is richly valued relative to history and to other global markets, making his lack of diversification all the riskier.

Bet on value, not growth
Twitter, Facebook, Amazon, Tesla, and British online retailers like AO.com, Asos and Ocado – it's not hard to find growth stocks trading at stratospheric valuations.

These are not isolated examples.

AllianceBernstein says the most expensive quintile of global stocks trades at a book value four times higher than the global market as a whole – the second-highest premium in 43 years.

The cheapest quintile trades on a 57 per cent discount to the market.

The last time value lagged growth to such a degree was during the dotcom era.

Animal spirits mean the gap may yet widen. In the long term, however, rotating out of growth and into value looks increasingly prudent.