US equity markets are the largest in the world, with a market cap of around $30 trillion, representing around 35 per cent of the global stock market capitalization. With a nominal GDP of around $21 trillion, the US economy represents around 25 per cent of the global pie. No other single country comes close to being such a significant part of the global economic and financial system.
US-listed companies, as a group, can be considered truly global with more than 40 per cent revenues coming from international markets such as Europe and Asia. These companies follow the most transparent disclosure norms and are under constant scrutiny from regulators and analysts.
The US markets get the largest allocation from investors across the globe. However, most Indians, except ultra-high net worth individuals (UHNWI) and family offices, remain unaware and unexposed to the US markets.
Isn’t the US market in a bubble?
To test that assumption, a few valuation multiples and profitability ratios for the US markets are compiled. In the US markets, the S&P 500 represents large caps, S&P 600 the small caps, Nasdaq 100 represents the technology sector large caps, while S&P small cap IT is self-descriptive. For the financial data, an ETF tracking the index has been used.
For valuation multiples, PE (price-earnings), PCF (price to cash flow) and PB (price to book) are used. In the US, the GAAP earnings have numerous non-cash expenses and hence PCF based on cash flows is a more representative ratio. Similarly, the cash flow return on equity CFRoE is a better representation of the profitability of companies.
What are the expected returns?
Focusing on the PCF ratios, the US markets clearly do not look overvalued. In fact, for the S&P 500, a PCF of 13.64 is equivalent to a cash flow yield of nearly 7 per cent. The nominal US GDP has grown at nearly 4 per cent over the last decade, which is likely to continue in the long term. Assuming 25 per cent-50 per cent of the cash flow yield is reinvested for achieving the 4 per cent growth, the S&P 500 would yield an estimated 7.5 per cent-10 per cent in USD returns over the long term, similar to the historical S&P 500 returns. With a historical rupee depreciation of 2.5 per cent-5 per cent, the S&P 500 expected returns in INR terms are estimated at 10 per cent-15 per cent in the long term. This compares well with the long-term Nifty returns of 9.63 per cent since inception. (Source: Nifty 50 Index factsheet at niftyindices.com). Please note that all estimates in this article are based on the assumptions made and actual results could be different.
Similarly, the S&P 600 small caps provide an expected return of 11 per cent-14 per cent in USD and 13.5 per cent-19 per cent in INR. The Nasdaq 100, with higher growth rates of 8 per cent, provides an expected return of 11 per cent- 12 per cent in USD and 13.5 per cent-17 per cent in INR while the small-cap IT stocks provide an expected return of 12 per cent-14 per cent in USD and 14.5 per cent-19 per cent in INR.
Will Fed’s actions weaken the US dollar?
The US Fed has injected trillions of dollars in a matter of months. Normally, any increase in currency circulation without a corresponding increase in the real GDP should result in currency depreciation. However, similar actions from the other central banks towards their currencies makes dollar weakening unlikely. The relative strength of the US economy probably creates a bias towards appreciation of the dollar vis-à-vis other currencies. The dollar is likely to remain strong in the long run on the back of significant international revenue share of US companies and the global dominance of its technology sector. Any weakening of the dollar only makes the export competitiveness of the US stronger and would quickly stabilize the dollar further because of larger export volumes.
How should one invest in the US markets?
As shown above, the risk-rewards differ considerably across different segments of the US market. A curated multi-cap portfolio could avoid companies with weak balance sheets, thus enhancing safety, while adding companies at discount to their intrinsic values, thus enhancing returns.
The global economy is undergoing a multi-trillion-dollar, multi-decadal digital transformation. There are nearly 200 US companies, including FAANGs, in the areas of Artificial Intelligence (AI), Internet of Things (IoT), 5G, Cloud, Cyber Security etc. Many of these companies enjoy persistent advantages arising out of intangible assets like patents or network effects while being available below their intrinsic value from time-to-time.
“While the good player goes where the ball is, the great player goes where the ball is going to be.”
The smart investor would allocate to the US multi-cap—where the ball is—and also to the US technology sector—where the ball is going to be.(The writer is CEO & Chief Investment Strategist, OmniScience Capital)