Morningstar's "Perspectives" series features investment insights from third-party contributors.
October 31, 1985, was a pivotal date for financial markets. It marked the last time the UK’s FTSE 100 stood above the Dow Jones Industrial Average.
Fast forward to October 16, 2017; the Dow stood at 22,957, while the FTSE trailed at 7,527. This means the Dow has risen 1,570% since the end of October 1985, while the FTSE has gained a comparatively miserly 446%. This begs three questions: to what extent has the US market actually outperformed; what are the reasons for this; and will these factors persist?
To answer the first, it should be noted that using the two indices’ level provides us with no more than a crude yardstick of performance. Crucially, the figures do not include the impact of dividends.
In the UK, there is a cultural preference for dividends; in the US, there has been more of an acceptance for share buybacks. When one considers British companies have tended to pay higher dividends than their American peers, we see the US market has outperformed by a smaller margin on a ‘total return’ basis. Even then, however, the Dow has delivered more than 4,000%, compared to more than 1,500% by the FTSE 100.
This differential does not shift when we compare performance in a common currency. Although the exchange rate fluctuated over the intervening period, at $1.33 on October 16, 2017, the pound was worth fractionally less than the $1.44 it bought at the end of October 1985.
UK Outpaces US for Economic Growth
As to whether US outperformance can be explained by differences in economic growth; again the answer is no. While US output more than quadrupled between 1985 and 2016, the UK grew faster in dollar terms, increasing over fivefold.
Could it be that US stocks have simply become more richly valued? Currently trading on a price/earnings ratio of 19 times, they are more expensive on this metric relative to their UK peers trading on 15 times. But that is no different to 1985 when the S&P traded on a P/E ratio of 12 versus the footsie’s 10. An expansion of the P/E valuation multiple similarly boosted both markets.
It seems the outperformance of the US is primarily down to one factor: US companies have been able to grow cash-flow and earnings faster. It is difficult to provide definitive answers to explain why; however, we can point to evidence that suggests US firms are simply better than their overseas counterparts.
US Firms Trump Global Competitors
America has attracted more skilled workers from overseas. In October 2016, the World Bank said the US has historically hosted close to half of all high‐skilled migrants to the OECD and one‐third of high‐skilled migrants worldwide.3 It appears the country’s high standard of living and predominance of elite universities – among other factors – have created a self-reinforcing virtuous circle.
It is surely no coincidence, for example, that today’s tech giants – Facebook (FB), Google (GOOG), Apple (AAPL) and Microsoft (MSFT) – were founded and listed in the US.
Additionally, US companies tend to have superior financial performance. In the oil industry, the return-on-equity earned by the US majors Exxon and Chevron has averaged 17.6 per cent over the past decade. By contrast, the average return on equity of European rivals BP (BP.), Royal Dutch Shell (RDSB), Total and ENI was just 13.8%.
In the pharmaceutical sector, US firms typically achieve twice the level of sales and profit per employee than their European counterparts.
The US is an instinctively capitalist nation. The flexibility of the labour market enables its companies to be more aggressive in cutting costs during downturns. The country also scores highly on ‘Ease of Doing Business’, ‘Economic Freedom’ and other assessments of bureaucracy.
While it would have been impossible in 1985 to know the extent to which US stocks would leave international peers trailing, it would be unwise to bet against a repeat.
Yes, investors need to pay attention to relative valuations as measured by traditional financial yardsticks such as P/E in the short-run. However, over longer time periods, a company’s underlying strength is what determines performance. In that regard, most US businesses continue to stack up favourably.
Disclaimer
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