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American Independence: should you invest in the US?

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03/07/2015
On 4 July, the USA celebrates Independence Day, and its 239th birthday. But do investors have reason to let off fireworks?

In the years following the financial crisis, the US stock market – the world’s largest – rebounded significantly, with the S&P 500 returning 162% in the years between 30 March 2009 and 19 June 2015.

However, the market has stuttered in recent months. To date this year, the S&P 500 has returned 1.29%, opposed to a MSCI World Index return of 6.34%.

Lower than expected growth in quarter one (0.2% v 2.2% in Q4 2014), a stronger US dollar, and the prospect of an interest rate rise hike have all contributed to the index’s lagging performance.

These  factors all have potentially negative implications for corporate earnings. Rob Pemberton, investment director of wealth manager HFM Columbus, notes that earnings growth is under further pressure from a strong dollar and weak energy sector.

“The market faces a balancing act, needing an economy strong enough to generate some top line revenue growth but not strong enough to force a faster pace of interest rate rise,” he explains.

Equity valuations are also at their highest level since the financial crisis – the S&P 500 price/earnings ratio currently stands at 21.7, against a historical average of 14.59 since its creation in 1957.

Despite this, there has been an increase in the number of UK investors adding US equities to their portfolios in recent months. 

Keith Bowman, equity analyst at Hargreaves Lansdown, notes that US trades made by the firm’s clients increased by 25% in the six months to the end of April this year. Why?

Recovery

Despite a tough year to date, the US economy appears to be improving just in time for Independence Day.

Adrian Lowcock, head of investing at AXA Wealth, notes that while a strong dollar may hurt exports, the US is not an export-driven economy – and it could in fact stimulate domestic demand. He also says rising interest rates are not necessarily a negative.

“Rising interest rates often suggest an economy is healthy. Many sectors of the US economy would benefit from a rise too, such as financials – and it will more likely than not be a positive for equities,” he explains.

“There are still opportunities for investors as companies continue to grow their profits.”

Pemberton adds that smaller US stocks – which lagged their larger counterparts last year – stand to benefit from a rate hike too, as they are positively exposed to the strengthening US domestic economy.

“US large caps earn around half of their revenues overseas, and thus more exposed to the strengthening dollar – small caps are well-placed to produce producing stronger revenue growth,” he explains.

Pemberton further notes that an interest rate rise is already priced in to markets,and believes as long as increases are small, gradual and limited, they will not necessarily upset markets.

“However, if rates rise more sharply than expectations, then both equity and bond markets will likely struggle,” he acknowledges.

It’s important not to overlook the fact that in addition to being the world’s largest stock market, the US remains the world’s largest economy.

According to Centre for Economics and Business Research figures, the US economy is six times larger than the UK’s, and still 50% bigger than China’s. It is also home to many of the world’s biggest and wealthiest businesses.

Tom Stevenson, director of Fidelity Worldwide Investment, is bullish on the US economy, and suggests US equities should comprise a quarter of an investor’s portfolio – if not more. He also contests the notion that US equities are overvalued.

“While US stocks arguably come at a premium, an investor should ask why this is the case,” he says.

“US companies pay higher dividends, and many have records of increasing dividend payments stretching back decades. The current low income environment in the UK and Europe means investors should be prepared to pay more to receive more.”

Recommendations

As previously noted by YourMoney.com, an S&P 500 Index Tracker is a commonly favoured means of investing in the US among investment professionals. Richard Troue, head of investment analysis at Hargreaves Lansdown, agrees that passive trackers are often the best option for accessing the US market. His preference is the Legal & General US Index.

“It is difficult to identify US managers who are consistently capable of adding value for investors over the long term,” he explains.

Pemberton likewise recommends the use of a passive index tracker for US exposure, alongside an actively managed smaller company fund.

“The Schroder US Mid Cap fund allows you to take advantage of  the favourable trend for smaller, more domestic companies,” he says.

Lowcock, however, believes the S&P 500’s efficiency is a strong argument for active investment in the US market.

“Investors need a skilled fund manager to find the opportunities that still remain, while avoiding the expensive stocks and value traps – stock-picking is critical at this point,” he explains.

Lowcock recommends the JPM US Equity Income fund. Managers Clare Hart and Jonathan Simon focus on companies that pay rising dividends, avoiding stocks that already offer high dividends.

“The fund has around 10% in banks, and 8% in financial services – areas that will almost certainly benefit from a rise in interest rates,” Lowcock notes.

He also recommends Fidelity American. Manager Peter Kaye’s approach focuses on elements of behavioural finance; he tries to identify inflection points in companies that are underappreciated by the market. He looks for companies where the market expectations are often revised upwards.

Likewise, the Fidelity American Special Situations fund has beaten the sector and index over its lifetime, returning 893% since 1995, compared to 350% for the average fund in the sector.

Kaye’s approach is mathematical and well established; the results are then checked using Fidelity’s extensive team of analysts to identify growth opportunities.

Troue acknowledges that the US small- and mid-cap markets offer greater scope for active outperformance. He recommends the Legg Mason US Smaller Companies fund – “we like their approach, which focuses on innovative firms that generate good cash flows and retain strong intellectual property,” he says.

Russ Mould, investment director at AJ Bell, believes that investors needn’t invest in the US directly. An alternative strategy could be to a diverse global equity fund, which combines the best US stocks with comparable international offerings – or to invest in certain sector-specific funds.

“Many industries are heavily concentrated in the US, in particular technology, healthcare and biotech,” says Mould.

“Almost 90% of the AXA Framlington Biotech fund’s holdings, for example, are businesses based in the US.”

Don’t Forget

UK investors can buy US equities via most trading platforms, including TD Direct Investing and Hargreaves Lansdown.

When dealing in shares listed on the US or Canadian market, investors will need to complete a W-8BEN form. A W-8BEN form is used to declare that an investor is not a US resident for tax purposes – and means they could pay less tax on any income gained.

 

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