Viva La Revolución!
“Long live the revolution!” might be the rallying cry of today’s Silicon Valley investors, but the real rise of the proletariat may be occurring in Europe.
By: Brian Chingono
The last decade witnessed a technological revolution as cloud computing and smart phones became widely adopted. Amazon Web Services was launched in 2006, the iPhone in 2007, and the App Store in 2008, forming the crucial foundations for what was to come in the 2010s. The COVID lockdowns and the shift to working from home cemented the rapid share gains of cloud and mobile technologies.
Investors who bet on these novel technologies earned extraordinary profits. During the ten years ended Dec 31, 2021, the tech-heavy Nasdaq index compounded at an annualized rate of 21% per year, far outpacing other developed markets like the 9% annualized return in Europe, where the market primarily comprises “old economy” sectors like food, industrials, energy, and financial services.
At the beginning of 2022, it appeared the technology revolution was poised to gather more strength as old economy sectors were hobbled by supply-chain snarls while software continued to flow freely above it all across the cloud. Moreover, Eastern Europe became embroiled in the largest land war since World War II while most of the leading technology companies are based 10,000 kilometers away from the front lines.
But the last few quarters have seen a major reversal of these trends—a shocking reversal, given the bullish expectations for technology and the geopolitical concerns about Europe. Over the course of 2022, European firms grew their earnings at a faster rate than the tech-heavy Nasdaq, with 20% EBIT growth in the European market versus 5% growth in the Nasdaq. And despite the spiraling cost inflation that was triggered by the reconfiguration of natural gas supplies, the European market had relatively stable EBIT margins in 2022 versus 2021, with only 30bps of compression between the two years. Meanwhile, EBIT margins compressed by 100bps in the Nasdaq over the course of 2022.
Figure 1: EBIT Growth and Margins (2022 vs. 2021)
Sources: Capital IQ, Vanguard (“VGK” for FTSE Europe Market ETF), and Fidelity (“ONEQ” for Nasdaq ETF)
These surprise outcomes are reflected in the recent returns of the Nasdaq and the European market since the beginning of 2022. As rising interest rates have deflated asset prices across the board, the expensive Nasdaq has dropped by 20% whereas the European market has fared relatively better with a 7% drop, as shown in the figure below.
Figure 2: Value of $100 Invested in Nasdaq and Europe Market (Jan 2022 – Mar 2023)
Sources: Capital IQ, Vanguard (“VGK” for FTSE Europe Market ETF), and Fidelity (“ONEQ” for Nasdaq ETF)
To be sure, the recent reversal in tech leadership is a notable departure from the past cycle in market history. Over the five years ended Dec 31, 2021, the Nasdaq grew earnings at a 20% annualized rate and its equity compounded at 25% per year. Meanwhile, the European market grew earnings at a 10% annualized rate and its equity compounded at 11% per year.
Figure 3: Five-Year EBIT Growth and Equity Returns (2017–2021)
Sources: Capital IQ, Vanguard (“VGK” for FTSE Europe Market ETF), and Fidelity (“ONEQ” for Nasdaq ETF)
We believe earnings growth is an important driver of stock returns at the broad market level. So to inform allocation decisions today, it’s important to consider the likelihood of future earnings meeting the expectations embedded in today’s valuations of the Nasdaq and European market. At a Price/Earnings valuation of 22x in the Nasdaq versus 13x in the European market, will Nasdaq earnings continue to meet the required threshold of growing at roughly double the rate of European firms to deliver stock outperformance?
Given the recent reversal in fortunes between Europe and the Nasdaq, the answer hinges on whether this reversal is merely a temporary blip or whether it’s the first stage of a broader shift in market leadership between the old-economy “value” sectors and the new-economy “growth” sectors like technology. That debate is necessarily forward-looking, so we need to use forward-looking metrics to inform an answer. One such measure is dividend yields. This metric is forward-looking because companies announce their dividend payouts based on management’s expectations of future cash flows. So management teams that are confident about future cash flows typically increase their dividend payouts to signal their positive outlook about the company’s prospects.
Dividend yields are also affected by changes in stock prices, with yields rising when prices decline, similar to what happens with bonds. So having observed an increase in dividend yields since the end of 2021, we can isolate the component of rising yields that is driven by price declines to estimate the remaining component that is driven by positive expectations of future cash flow growth. We believe a market whose rising dividend yield is primarily attributable to higher dividend payouts could be viewed as more attractive over the long term because management teams are expressing confidence in their firms’ ability to generate future cash flow.
Between December 2021 and March 2023, dividend yields have increased by 81bps in Europe versus a 24bps increase in the Nasdaq, according to data from S&P Capital IQ. Since the price decline over this period was more modest in Europe, it must be the case that the relatively larger yield increase in Europe is being driven by a rise in dividend payouts. In the figure below, we present an attribution of the dividend yield increases in Europe and the Nasdaq. For example, based on the European market’s 7% price decline alone, we would expect Europe’s dividend yield would have only increased by 21bps (25% of the actual 81bps increase). So we believe the other 60bps of yield increase (75% of the total) must be from higher dividend payouts, which signal management’s confidence in higher expected cash flows. These proportions are inverted in the Nasdaq, with 57% of the yield increase coming from price declines and only 43% from higher expected cash flows.
Figure 4: Dividend Yields and Attribution of Yield Changes (Mar 2023 vs. Dec 2021)
Sources: Capital IQ, Vanguard (“VGK” for FTSE Europe Market ETF), and Fidelity (“ONEQ” for Nasdaq ETF)
It appears management teams in Europe are more confident about their companies’ ability to generate higher cash flows in the future as they have announced larger dividend payouts. And the market seems to agree, as stock prices in Europe have declined modestly over the past 15 months despite a sharp increase in interest rates. On the other hand, management teams in the tech-heavy Nasdaq appear to be less confident about generating higher future cash flows, as evidenced by their more modest increases in dividends and their announcement of multiple rounds of layoffs (after doubling their staff numbers in some cases during the pandemic). And shareholders seem to concur with this somber outlook as stock prices have declined significantly, although perhaps not as much as they should, given today’s lofty valuations in the Nasdaq.
In a prescient paper published in 2008, University of Chicago professors Luboš Pástor and Pietro Veronesi point out how financial markets usually end up being unkind to revolutionaries. They find that “technological revolutions tend to be accompanied by bubble-like patterns in the stock prices of firms that employ the technology. After an initial surge, stock prices of innovative firms usually fall in the presence of higher volatility.” Their paper argues that bubbles necessarily accompany new technologies that become widely adopted. Since it takes time for the market to learn whether a new technology will be widely adopted, the high uncertainty of potential outcomes means that even the rosiest expectations can be considered plausible for a while by rational investors. But once the new technology is widely adopted, the revolution ends because there is no longer much growth potential for the innovators who produce the technology. For example, once everyone has access to the internet, it becomes hard for service providers to maintain fast earnings growth from selling internet subscriptions. Conversely, the benefits of wide adoption eventually go to the “old economy” through an acceleration of productivity growth after the technology is widely adopted.
For example, the authors note that “the value of $1 invested in the Nasdaq quadrupled between 1996 and March 2000, then fell back to the 1996 level by October 2002” after the internet bubble had burst and a critical threshold of widespread internet access had been reached in the United States in 2002. On the other hand, productivity growth in the US economy accelerated sharply after the internet revolution ended in 2002. According to Pástor and Veronesi’s analysis of data from the Bureau of Labor Statistics, total productivity growth in the US economy “averaged about 1% per year in the 1990s, but it increased sharply after 2002: from 1% per year in 2002 to 1.5% in 2003 and 2.5% in 2004 and 2005.” It appears most of the surprise productivity gains in the US after 2002 went to the old economy sectors. Over the next five years from 2003 to 2007, US large value stocks outpaced US large growth stocks by three percentage points per year, with a 15.8% annualized return in the old-economy value index versus a 12.6% annualized return in the new-economy growth index, according to Ken French data.
We believe a similar logic could be applied to the global developed economy at today’s juncture where the latest technology revolution appears to be at a turning point. From a global standpoint, we believe the European market is effectively a large value index today, as it trades at 13x Price/Earnings, which is cheaper than the US large value index at 14x Price/Earnings. Since European businesses have widespread access to cloud computing, e-commerce, digital advertising, machine learning, and many of the other fruits of the latest technology revolution, we think it's plausible that European productivity, and hence equity returns, could surprise to the upside in the coming years—even if the French make a big fuss about retiring a little later.
Marxist revolutionary Che Guevara would be surprised to learn that today’s leading advocate for reducing global inequality through revolution would be billionaire co-founder of Microsoft, Bill Gates. Mr. Gates says that artificial intelligence is the most revolutionary technology he has seen since 1980, when he was shown a demo for a graphical user interface that would eventually become the bedrock for Windows and every other modern operating system. Importantly, Mr. Gates has been “thinking a lot about how AI can reduce some of the world’s worst inequalities.” He offers advances in healthcare and education as two potential benefits of AI since the productivity gains from automating routine tasks will “free people up to do things that software never will—teaching, caring for patients, and supporting the elderly, for example.” Analysts at Goldman Sachs seem to agree with Mr. Gates’ expectation that AI will boost global productivity. In a research note, Goldman analysts estimated that, by automating a quarter of the work done in the US and Europe and a fifth of the work done globally, AI could spark a productivity boom that would eventually raise global GDP by 7% over a 10-year period. Rather than paying bubble prices today in hopes of a bubble extension through AI, we think investors could benefit most from this revolution over the long term by siding with Europe’s proletariat old-economy sectors that are undervalued by global capitalists today and could see an uprising of productivity in the future.