The US market really has been all the rage since the pandemic. As the home of the technology giants Faang — Facebook, Amazon, Apple, Netflix and Alphabet (Google) — that became Faang+ and then the Magnificent 7, US indices have ridden the waves of cloud computing and now AI with the most success (and therefore the highest rewards for investors). Over the same period, European governments have been doing a spectacular job of throttling any form of innovation on the continent, unless it relates to force-feeding electric vehicles to consumers.
If you look at the top constituents of the S&P 500, you’ll find names such as Apple, Nvidia, Microsoft, Amazon, Meta Platforms, Alphabet, Broadcom, Berkshire Hathaway, Tesla and banking giant JPMorgan Chase at the top of the list. Flick across to the Stoxx 600 and you’ve got ASML Holding and SAP heading the list. They also happen to be the only IT companies in the top 10. There are a bunch of pharmaceutical houses, accompanied by Nestlé, HSBC, Shell and LVMH. Aside from a couple of interesting names that have particularly strong positions in the markets they serve (specifically ASML in chip manufacturing and LVMH in luxury), this isn’t a set of names you would find on most stock watch lists.
Of course, this doesn’t mean you can’t find pockets of opportunity. In case you’ve been living under a rock, there’s been a huge shift in the geopolitical landscape. The US is no longer interested in expensive proxy wars on Europe’s borders. If the EU is going to keep Russia at bay, it’s going to happen from its members’ own budgets. Naturally, because this literally becomes a matter of national and regional security, increased spending in the EU and UK is unlikely to be directed at Lockheed Martin in the US. The whole point is to reduce reliance on Uncle Sam, which means buying from Uncle Saab in Sweden instead — as well as Leonardo in Italy, Rheinmetall in Germany, BAE Systems in the UK and others. We will try not to panic about what happened the last time European countries really ramped up their military spending in response to regional conflict!
Let’s start with Saab, which doesn’t make weird cars any more. The share price is up 320% over three years, which is a tad ridiculous. Over the same period, operating income has more or less doubled, so you already know from those two data points that the market is pricing in a lot more future growth than it used to. This is because share price growth has far outpaced operating income growth. Sure enough, the latest earnings multiple of 41 is a lot higher than the three-year average of 31. At this stage, alarm bells should be ringing that this might be a bubble.
If we look at BAE Systems, the pride of the UK, the share price is up 90% over three years while operating income is up 35% over the same period. The earnings multiple of 22 is ahead of the three-year average of 18.9, though not by much. Perhaps the EU companies are where the bubble risk is higher?
The big names in Europe have clearly latched on to this idea of increased spending by EU governments
To check this thesis, we can look at Leonardo (with an earnings multiple of 21 vs three-year average of 11) and Rheinmetall (perhaps the worst of the lot, with an earnings multiple of 66 vs a three-year average of 30). The big names in Europe have clearly latched on to this idea of increased spending by EU governments, and at least some of this is being priced in.
Is BAE therefore the dark horse in this group, with the smallest gap between the current multiple and the three-year average? It also happens to have the best gross margin, running at about 65% compared with the paltry 22% at Saab (the worst in this peer group). The Germans do it best when it comes to converting gross profits into operating profits though, with Rheinmetall running at about 11.5% operating margin vs BAE at 9.5%. On free cash flow margin BAE is top of the pops once more at more than 11%, while the others languish in single digits.
Boasting a record order book and with the BAE CEO quoted in various media articles as talking about its ability to expand in response to European demand, it seems Brexit and the general fracturing of the relationship between the EU and the UK is why BAE hasn’t enjoyed the same relative rally as the European names. If President Donald Trump is the factor that undoes some of the Brexit pain, BAE could be the winner in this group.
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