Lee Freeman-Shor: The 2014 taste test - which will you prefer?


While I make no commitment to stick rigidly to the 140-character limit associated with the world’s favourite micro-blogging site, it is true to say that the following investment options – which have at their core one of the fundamental quandaries facing many investors in 2014 – can nevertheless be outlined in pithy terms.

Option A

A market that trades on a trailing price/earnings (P/E) ratio of 14.3x and a P/E ratio two years forward of 13x, and offers a dividend of 3.2%. It has a return on equity of 17.5%, has grown its earnings by 5.3% over the past three years and is estimated to enjoy earnings-per-share (EPS) growth of 10.9% over the next 3 to 5 years.

Option B

A market that trades on a trailing P/E ratio of 17x and a P/E ratio two years forward of 15.4x, and offers a dividend of 1.9%. It has a return on equity of 18%, has grown its earnings by 11.4% over the past three years and is estimated to enjoy EPS growth of 12% over the next 3 to 5 years.

Based on the relative valuations and growth prospects of the markets constituting options A and B, most savvy investors would agree that option A stands out as the obvious, ‘rational’, investment choice. Indeed, the consensus choice would almost certainly be option A, especially when you consider that, at the end of 2012, option B was trading at a trailing P/E ratio of 13.9x and has since enjoyed a considerable re-rating.

But why is it that investors, on a ‘consensus’ basis, would prefer to invest in option A rather than option B?  One possible explanation may be that there is a simple but powerful ‘hidden’ force driving investors into option B: that force is the sheer power of option A’s brand, which is so beguiling, it has an uncanny ability to seduce investors, especially in a world characterised by uncertainty and worry. In other words, the option A brand represents a ‘good’, or ‘more certain’ investment that somehow manages to make investors forget that starting valuations matters to investment returns in the long term.

What is that label that so spellbinds investors? The answer is ‘The United States of America’. For those investors sucked in by the Sirens’ call of ‘buy USA’, 2013 represented everything they were promised. The S&P 500 was up 30% and was one of the best performing stock markets globally.

The question facing investors now though is whether they continue to follow the Sirens’ call? For those willing to look beyond the label and at the attractiveness of an asset on the raw facts, option A above is Europe. Many readers will now mentally ‘switch off’, because Europe represents a ‘bad’ investment in many investors’ psyches. This is the quandary.

Such brand perception issues bear more than a passing resemblance to the many twists and turns of on-going brand war between two of the world’s largest fizzy drink manufacturers, a significant point in which was reached with the arrival of ‘the Pepsi challenge’ taste test, which ran for some 35 years from 1975. For those investors prepared to look beyond the label and take the investment equivalent of the Pepsi Challenge, I believe Europe may make for a surprisingly tasty choice in 2014.

As the figures quoted in options A and B above show, the simple reality is that the European market is cheap relative to the US market. However, active fund management is about stocks, not markets, and it is perfectly possible to invest in European businesses to gain exposure to global themes.

Spain is hardly the most obvious starting point in the search for an example of a stock to illustrate the viability of the global economic recovery. After all, there is a strong argument to say that the Spanish economic ‘brand’ lies in tatters. What may come as a surprise, therefore, is to see how a Spanish company like Meliá Hotels, the stock of which rose by nearly 62% in 2013, can be performing so well. Part of the answer is that Meliá is an international brand that just happens to be domiciled in Spain. With revenue per guest and occupancy rates at its hotels – typically located in prime, city-centre locations – both back at pre-2008 levels, the company has been a clear beneficiary of an international economic recovery.  As it happens, Meliá derives some 39% of its revenues from its US operations, making it a good example of a business that is quoted in Europe, but which actually gives investors exposure to the US. In other words, while Spanish unemployment figures, for example, may make for unpleasant reading, they have relatively little bearing on the fortunes of Meliá.

It might be argued that investors don’t necessarily have to choose between Europe and the US, between Pepsi and Coke. Ashtead, the UK-domiciled plant and equipment lessor is another example of a stock that shows how it is possible to buy one brand and experience something that is more akin to what might be expected from another. Although technically a British company, some 85% of Ashtead’s revenues (and costs) are US based. As such, an investment in Ashtead is in fact a play on the recovery in the US construction market, itself largely a reflection of the broader US economic recovery. Interestingly, the US market, as measured by the S&P 500 Index, rose by approximately 173% from its post-credit crunch low on 9th March 2009 to the end of 2013, in US dollar terms. Over the same period, shares in Ashtead rocketed by more than 2200%, in sterling terms. The point here is that Ashtead shares are largely unaffected by so much of what goes on in Europe. As a play on US economic recovery, however, there is no disputing that an investment in this British company has clearly delivered on its promise.

In a recent article on the outlook for the S&P 500, Wells Fargo strategist Gina Martin Adams – one of the Street’s most bearish commentators of 2013 – pointed out that “the current [price to earnings] ratio is 17x, 18% above long-term average of 14.4x and 6.9% above the post-WWII average of 15.9x”.

In short, the US market is expensive. Yet, in much the same way that the iconic, turquoise-coloured boxes of Tiffany & Co will always delight some luxury goods fanatics, the US market will always have an appeal to some investors, such is the strength of its brand. Shares in Tiffany currently trade at around 22x trailing earnings and 12-month forward earnings. By contrast, shares in the Swiss-based luxury goods business Richemont trade on 18x trailing earnings and 12-month forward earnings. Like fellow Swiss portfolio stable-mate Swatch, the company derives over 50% of its earnings from Asia; as such, it is another example of a stock whose fortunes are somewhat isolated from European economic fundamentals.

For an investor expressing a view on the international luxury goods sector, the shares in Richemont look rather more keenly priced than those in Tiffany. So, in 2014, will it be Europe or the US, Coke or Pepsi, Tiffany or Richemont? Before tarring European shares as ‘bad’ investments, I believe these examples illustrate why it is so important that investors look beyond the turquoise-coloured box, or the first sip, and fully appreciate the quality of what they are buying. They may be surprised at what they end up preferring. 

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