Asset Pricing has undergone a significant evolution, with the integration of increasingly complex models. Initially, the Capital Asset Pricing Model (CAPM) was based primarily on market risk to determine the expected return on an asset. However, to capture the nuances and dynamics of the market in greater detail, new factors have been incorporated beyond simple market risk. These improvements aim to better reflect the thought processes and criteria investors use to make their investment decisions.
Eugene Fama and Kenneth French's three-factor model, introduced in 1992, extends CAPM by adding two additional factors to market risk: company size (Small Minus Big, SMB) and asset value relative to the market (High Minus Low, HML). SMB captures the historical tendency of small caps to outperform large caps, while HML captures the outperformance of Value stocks relative to Growth stocks.
The premium, in the context of portfolio management, can be conceptualized as the additional return an investor can expect to achieve by adopting a specific strategy. Here, we take a closer look at the HML premium (High Book to Market Value minus Low Book to Market Value) derived from the Fama and French model.
This premium tells us that Value companies offer higher returns than Growth companies, which are more highly valued. Once again, this idea doesn't come out of nowhere: low-value companies are often companies operating in more mature markets, or simply companies with little or no growth prospects. These companies, whatever their stage of development, may have assets that are not 100% utilized in times of economic downturn. The systematic risk on these companies would therefore be greater.
On the other hand, it is important to note that companies with high valuations often rely on strong assumptions concerning their future cash flows and financing conditions (strong, sustained growth with easy access to financing). This dependence can make these companies particularly vulnerable in times of rising interest rates, increasing their risk and potentially justifying a higher yield.
This valuation premium could therefore be reversed depending on the economic context, and that's what we're going to explain here. The chart below, which compares the HML premium of the European market (green) and the US market (blue), shows a marked difference between the two markets since 2023.
How to interpret this divergence? In Europe, the HML premium is rising: discounted stocks offer better returns than growth stocks. In the United States, the premium is flat or even decreasing slightly, which means that discounted stocks do not necessarily provide a better return than growth stocks in the country.
How can such a difference be explained? Several economic factors may explain this phenomenon. Firstly, when we look back at previous episodes in which there was a gap between US and European HML premiums before 2023, we note that late 2013, early 2017 and 2021 are periods during which the gap between the two markets widened. As it happens, these episodes coincide with, on the one hand, a marked divergence in the indices' price-to-earnings ratio (PER), and on the other, a falling correlation between the indices.
The P/E measures the ratio between a stock's current price and its earnings per share. A high P/E may indicate that the market believes future earnings growth will be strong, while a low P/E could suggest that the market is undervalued or that the company is facing challenges. When the P/Es of stock market indices such as the S&P 500 in the USA and the STOXX Europe 600 diverge significantly, this reflects differences in earnings growth expectations between these regions, thus influencing investment decisions. The declining correlation between the two indices further supports the idea of a divergence in economic performance between the US and Europe.
These data help us to understand the mechanism behind these HML premium differentials. U.S. equities have posted record performances since the start of the year, and the Fed's cycle of rate cuts is making them easier to finance. More accessible financing promotes growth and, by extension, Growth stocks. With the US market already at its peak, trading at a premium to other markets, it's becoming difficult to see mispricing on this market, and by extension to generate performance with a Value approach.
In Europe, the market is experiencing much weaker growth, and observers/investors are more pessimistic about medium-term economic conditions. This makes it easier to see the discounting of certain stocks, and thus to explain why the Value premium is higher than in the United States. The P/E differential between the S&P 500 and the STOXX Europe 600 hasn't been this wide since the internet bubble of 2001.
Keeping this market dynamic in mind can help you recalibrate your portfolio. The opportunities for discounting in Europe emphasize the Value approach. In comparison, the US market is very "expensive", and therefore does not generate significant alpha with either a Value or Growth approach.
Some European undervalued stocks:
- Scor: The French reinsurance giant has suffered in recent years from poor management and questionable strategic decisions. The executive team has now been renewed, and the portfolio has been streamlined. The company, which should return to profit in 2025, has a price-to-book ratio (P/B) of 0.84, less than one, which tells us that its share price is low in relation to its book value.
- Michelin: The world's leading tire manufacturer is at the heart of the controversy surrounding the relocation of its production outside France. With a P/E of 11, below the peer average, it represents a great opportunity to gain exposure to the automotive sector, especially electric cars, which consume far more tires than combustion-powered cars.
- Vodafone: One of the world's leading cell phone operators has sold its activities in Spain and Italy to refocus on the UK market. It is also in strategic merger talks with another operator, Hutchison Telecommunications.
- Buzzi: This Italian company specializing in the manufacture of building materials is currently trading at a P/E of 7.7x. However, its strong position in Europe and the United States, as well as its new exposure to emerging markets, offer good prospects of appreciation.
- Aalberts: The Dutch manufacturer operates four critical technology clusters in four end markets: green buildings, semiconductor efficiency, sustainable transport and industrial niches. Despite difficulties in the buildings segment, the company intends to maintain its margins and continue to expand in emerging markets.