18 JUL

2018

Opinions , Tristan Abet

Is the monopoly premium sustainable?

European equities touched historical monthly lows measured against American equities in the month of June. Financial markets continue to send very strong signals: whatever the macroeconomic and financial context in terms of growth, interest rates and currencies, European equities underperform. Despite that, many investors remain wedded to the same arguments for favouring Europe in their allocation, claiming that Europe “isn’t expensive” or that “the European economy is doing well.”

Yet the message from the markets is so strong . . . and it tells us that this American outperformance is linked to structural factors. Before developing this point, here’s some information to show that the argument that “Europe is cheap” is groundless.

MSCI Indexes (July 9, 2018)

The table above shows that, if we apply the sector composition of the American index to the European index, based on the forward PE ratio the European “discount” drops from 16.9% to 4.4%. So, the lower European valuation is essentially due to sector make-up, implying that favouring Europe for valuation reasons is a red herring that amounts to a significant sectoral bet.

We show the forward PE of the level one GICS sectors below. The real “anomaly”, if there is one, concerns the energy and utility US sectors which show a real valuation premium compared with their European counterparts. This is surprising and, in our view, hard to justify.

The other sectoral divergence is to be found in consumer discretionary. Here, the microeconomic contexts are very different: the sector is dominated by automotive in Europe and by Amazon in the US. In fact, Daimler and Amazon are impossible to compare . . .

Here we are at the crux of the matter: technology issues render standard analyses (i.e. those based on the economic cycle) null and void.  We are dealing with companies with very specific economic models (“disruptive” as some would say), and, above all, which are in a quasi-monopoly position. That is precisely the point. 1) Europe has a strong deficit in terms of monopolistic companies and 2) These are the issues that are attracting a valuation premium in this cycle.

We took the 50 member companies of the Eurostoxx50 and the 50 biggest stocks in the S&P500 by market capitalisation. Then we gave them a rating of 1 to 6 based on the state of their market:

  1. Company active in highly competitive market(s)
  2. Company active in moderately competitive market(s)
  3. Company active in only slightly competitive market(s)
  4. Company in oligopolistic position
  5. Company with a monopoly for some of its businesses
  6. Company with a monopoly for most of its businesses

This is a subjective classification. We are not a research group with 100 analysts. We simply supply ideas and if others wish to go further with more objective measures of market concentration, we would be delighted. There exist several enquiries which calculate the famous Herfindahl-Hirschman index, such as that of the US Census Bureau (http://www.census.gov/econ/concentration.html. The most recent enquiry dates from 2012.)

We present below the 50 biggest companies on both sides of the Atlantic as a function of their score (1 indicating a very fragmented market and 6 the least fragmented), with their valuation. We have used 2018 enterprise value/EBITDA and therefore exclude banks which, in any case, operate in a highly fragmented market and which were given a rating of 1. 

The graph speaks for itself. It seems that the most expensive stocks operate in markets with little fragmentation and, above all, that these stocks are American!

This is the real problem with the European indexes: the companies of which they are composed are rarely unchallenged and hegemonic champions, contrary to the situation in the US. The story is well known: our champions are LVMH, Airbus and Anheuser-Busch, and their champions are Google, Amazon and Facebook.

We calculated averages (simple and weighted) for the scores attributed to Europe and the US. The difference is significant and supports the idea that, in structural terms, it is hard to compare the two indices. 

We show the same graph as previously, with valuation replaced by operating margin. We are trying to understand if there really is a monopoly premium or more simply a position of hegemony resulting from a specific company strategy (a volume strategy).

The conclusion is less clear. We can see “abnormal” margins in the US, much higher than are to be found in Europe (even among our champions) but we can also see weak margins for shares in a quasi-monopoly position.

Theoretically, a monopoly position should correspond to a valuation premium due to higher visibility and recurring profits. In the US today, this premium seems very large. EV/EBITDA for companies with a score of 4 to 6 is 27.6, compared with 10.9 for companies with a  score of 1 and 2, or a premium of 153% (84% in median terms).

In our view, the equity risk in this cycle lies in the valuation premium granted to these companies. This is a new risk because, previously, shares were tied to cyclical themes: the leaders were the shares that gained the most benefit from the cycle (financials and raw materials in 2006-2008, consumer and industrial cyclicals in 1997-2001). To understand equity risk in the US, it was necessary to follow the economic cycle and anticipate recession. Today, the nature of equity risk has changed and seems to be connected to the risk of regulation of leaders in the cycle, which makes tracking the risk much more complex. In fact, it is hard to identify if and when the American and/or European authorities are going to attack the monopoly rent. The theme generates a lot of buzz. The hegemony of American technology titans creates a problem for which the remedies are not clearly identified.  The financial markets don’t really believe it and are not applying a real risk premium as they do, for example, for the European auto sector faced with the risk of higher tariffs.

In short, equity risk analysis is now more difficult because the S&P500 (the number one reference index) has this specific risk. We describe below the risk associated with equities. We do not claim that the pure equity risk in median terms has changed, but we simply think that the weight of shares in quasi-monopoly positions is so large in the reference index as to disturb standard risk assessment.

In conclusion, it is very possible that we are reliving a period similar to 2000-2001 during which the reference index suffered a de-rating of the largest stocks, shares which had captured a valuation premium (a growth premium in that period). This de-rating took place in a context of robust growth, which explains why other stocks weren’t affected.

It could be that we will now see an identical situation: US tech giants suffering a de-rating amid better performance for other stocks still supported by the cycle.                   

The comments and opinions expressed in this article are those of the authors and not necessarily those of Candriam.