With US exceptionalism reaching record levels, European companies display far more attractive valuations than their US counterparts, MFS’ Anne-Christine Farstad says
By definition being a contrarian investor means often holding positions that are out of step with the market trend, relying on valuations where others depend on momentum.
It might not come as a surprise then that in a world where the Magnificent Seven seem to be on everyone’s lips, contrarian Anne-Christine Farstad, Portfolio Manager at MFS Investment Management, holds a significant underweight position to the United States.
Farstad and her colleague co-portfolio manager Zahid Kassam have an exposure of just 11 per cent to the region, while the benchmark’s weight is over 70 per cent.
They are far more optimistic about companies in Europe. For example, the fund has an exposure of 26 per cent to the United Kingdom alone.
The two portfolio managers significantly ramped up their exposure to cyclical stocks in Europe after the conflict in Ukraine kicked off in February 2022. As Russia invaded Ukraine, cyclical stocks, especially those depended on fuel or energy, started to plummet.
For Farstad, this provided a moment to buy companies that were usually too expensive to fit her contrarian, deep-value approach.
“I remember being asked: ‘This is a very pro-European risk portfolio. What do you know that we don’t?’,” she says in an interview with [i3] Insights.
“We answered: valuation. We don’t know anything; we just know that these stocks are discounted the worst,” she says.
I remember being asked: ‘This is a very pro-European risk portfolio. What do you know that we don't?' We answered: valuation
“So we looked to buy the European cyclical stocks that we’d always wanted to own. For example, we bought more Airbus, and we bought that because we said: ‘Look, maybe we don’t have any particular intelligence on what’s going to happen with European power. But what we do know is that it’s a P/E-of-one event.’
“If you have to close manufacturing, you’ll close it for one winter, not two. Human beings will figure this out. They’ll put more LNG terminals in; they’ll do what they need to do to keep the lights on next winter.
“So that P/E-of-one mentality meant that we looked for businesses that had strong balance sheets, high returns, great market positions that were truly indispensable in the areas that they were in. They were being sold off because everyone said: ‘Oh my goodness, we’re going to have to switch the lights off!’ But what actually happened was Europe muddled through,” she says.
Farstad was proven to be right. In 2023, many of these European cyclical stocks came roaring back. It is a good example of Farstad’s approach to contrarianism and the emphasis on valuations over trends.
By combining a strict valuation discipline with the idea that good companies might experience periods of controversy is likely to lead to a portfolio that over the long term will outperform.
“I am not a super forecaster. So I don’t believe for one second that I know better what’s going to happen with AI penetration, or where US inflation and rates are going to go,” she says.
“But what I do think is that if a business is already discounted based on the idea of a recession or a massive problem of some kind, and that problem doesn’t materialise, or it’s not quite as bad as people were anticipating, then I will make money,” she says.
This philosophy also acts as a risk control, because when you buy a company that has a deep recession priced in and a recession does eventuate then the drawdown is already priced in.
“We strongly believe that valuation is the reciprocal of probability and, all else being equal, if you buy something cheap, you’re more likely to succeed,” Farstad says.
Magnificent Seven – Structural or Anomaly?
The performance of the Magnificent Seven – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – has been a challenge for investors.
The annual performance of these seven stocks over the past 12 months was 48 per cent, compared to 28 per cent for the rest of the S&P 500 Index. Nvidia is the clear outlier with an annual return of 192.5 per cent, while over the past five years it has returned almost 2700 per cent.
With such a large part of the performance of the US stock market concentrated in so few companies it means not owning one, or several, of these stocks results quickly in underperformance.
The question that has been raised is whether the dominance of these stocks is a form of market dislocation, or whether it reflects a more structural trend towards an economy dominated by brobdingnagian technology companies.
Farstad has her doubts that the world has changed to such an extent.
[The Magnificent Seven] are different from the dotcom stocks because they throw off gigantic amounts of cash and have very high, free cash flow margins... But this kind of market concentration doesn't usually end well
“History would say that it’s not a structural change. History would say that we are meeting six of the seven criteria for a bubble,” she says.
Despite this, Farstad is not predicting the demise of the Magnificent Seven just yet. But she does expect to see some moderation in their stock prices in the long run.
“They are different from the dotcom stocks because they throw off gigantic amounts of cash and have very high, free cash flow margins,” she says.
“Nor are we in bubble valuations yet. Usually when you’re in a bubble, the epicentre of the bubble trades at 70 times (price/earnings (P/E) ratios), not 40 times. So this could carry on for a while longer.
“But this kind of market concentration doesn’t usually end well. With any new technology, it doesn’t end well,” she says.
US Exceptionalism
It is not just the Magnificent Seven that are performing unusually well. Farstad posits that the entire US stock market currently has more than its fair share of cheerleaders.
She believes what we are currently witnessing is a form of US exceptionalism and taking an opposing view – as Farstad has done with having a significant underweight to US stocks – is probably the biggest contrarian trade in the market.
“Not only do we have the Magnificent Seven question, which has pulled the whole market up, but we also have this [phenomenon where] everything that happens in the US is good news, and everything else is bad news for everybody else,” she says.
“That has really persisted throughout this year and then been turbocharged through the more recent Trump election. And that does feel like one of the big market anomalies.
“If you look at Morgan Stanley for example, it is trading at 20 times [P/E], while BNP Paribas trades at six times at quite similar ROEs (return on equity). For the record, I think that is bananas. It’s US exceptionalism,” she says
If you look at Morgan Stanley... it is trading at 20 times (P/E), while BNP Paribas trades at six times, at quite similar ROEs. For the record, I think that is bananas
Farstad speculates the reasons for the current situation could be found in the US having greater animal spirits than Europe, which magnifies every piece of good news. But she also suspects some US market data points get recycled more than can be justified.
“You do end up in a market that trades the same piece of positive news again and again and again, and it does start to have some of the characteristics of a bubble. For example, every single day the market is trading the same tax cuts story,” she says.
“[This situation] is an interesting one, because I think it’s an entire geography rather than a sector that is starting to look like it’s just in a different universe to the rest of the world. And again, I’m not predicting when, but history usually would say that that doesn’t end well.”
“Thankfully for us, on the other side of those bubbles is a wonderful market for the contrarian investor. So I think it’s really just a question of applying it religiously and not losing your nerve,” she says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.