Allocating to European Stocks Without Sacrificing Returns
- Yannick Laurent
- Jan 23
- 5 min read
Updated: Jan 23
European equites have underperformed their American counterparts, especially in the years following the 2008 financial crisis. Explanations for this divergence range from differences in the two regions’ economies, to variations in their capital market structures, to mismatches in their cultural values [1]. This article discusses the strengths and weaknesses of the European economy and uses the resulting insights to develop a strategy for investing in European equities that can allow investors to allocate to the continent without sacrificing returns.
Economic Growth as a Driver of Equity Returns
The most compelling reason for the divergence between European and American long-term stock market performance is economic growth. At their most fundamental level, stock prices (P) are a function of corporate profits (EPS) and the price that the market is willing to pay for those profits (the P/E ratio) such that P = EPS x P/E. Because earnings are driven by the economy, the above equation can be re-written as P = [(EPS/GDP) x GDP] x P/E. Since it is reasonable to expect that both multiples (P/E) and corporate profits as a percentage of GDP (EPS/GDP) will remain stable in the long run, we can conclude that GDP growth is the strongest driver of long-term equity market returns.
This reasoning is supported by the data. In keeping with U.S. indices outperforming their European counterparts, American GDP grew 34% between 2010 and 2023, eclipsing the EU’s 21% and the Eurozone’s 18% [2]. While the underlying drivers of this disparity could (and do) fill multiple research papers, they largely boil down to Europe’s lack of competitiveness in the global markets and its relatively small high-tech footprint.
The European Economy’s Strengths and Weaknesses
It is expensive to produce goods in Europe. Eurozone wages are high compared to those in the rest of the world, and the region’s energy prices are two to three times higher than in United States and China [3]. This issue has resulted in many of Europe’s legacy industries being overtaken by foreign competition. The most poignant example is the auto sector, which employs 7% of all European workers [4]; in some countries, this figure is as high as 10%. In recent years, China has become the world’s leading car exporter, eroding the market shares of western incumbents [5]. The same trend is present in other sectors which once dominated the European economy. While the United States has encountered many of the same headwinds, its economy and equity markets have been bolstered by the high-tech boom. In contrast, Europe is only home to four of the world’s 50 largest tech companies [6].
However, Europe maintains some strong advantages over other economies. While its workforce demands high wages, it is also highly skilled. The quality of European higher education, combined with its accessibility, substantially enriches the continent’s human capital. European countries also lead world rankings in upholding the rule of law. Finally, Europe’s lack of presence in high tech exists in spite of, rather than because of, its track record of innovation. European universities develop triple the number of patents that are used commercially. Furthermore, many of the region’s most successful entrepreneurs move their companies to the United States to better access its VC ecosystem. Public spending on R&D is similar in Europe and the United States [7]. Fundamentally, Europe is very innovative but struggles to create and retain its blockbuster tech startups.
According to analysis conducted by Oxford Economics, European industry is undergoing a shift in favor of the sectors in which benefit most from the region’s advantages, and away from those in which it is uncompetitive. Europe has seen a steady decline in firms that sell low value-added, easily transportable goods whose production uses large amounts of energy and low skilled labor [8]. These include industries such as autos and basic materials, which have dominated the economy for decades [9]. In contrast, industries that rely on highly complex processes, intellectual property, and/or advanced know-how are flourishing. These include pharmaceuticals and biotechnology, aerospace, and high-tech goods. While the net economic effect is positive, the transition is painful, often being misconstrued as deindustrialization [10]. These findings match the strengths and weaknesses of the European economy.
Investing in Europe Without Sacrificing Returns
So how do these findings align with equity market performance? To answer this question, I compare the performances of sector indices which match Europe’s areas of strength with those of the Stoxx Europe 600, S&P 500, and Dow Jones Industrials Average. The industries that benefit from Europe’s high human capital and technical know-how, and the indices that represent them, are outlined in the table below:
To streamline the comparison, I have aggregated the six European indices into a single portfolio. This portfolio, which I refer to as the European Advantage allocates its starting capital equally between each constituent sector index. Comparing the value of €10,000 invested in these sectors versus the Stoxx Europe 600 reveals that the European Advantage approach outperformed the wider European market by 5.74% on an annualized basis. This supports the theory that Europe has an edge in sophisticated industries, and that this edge translates into positive investment outcomes. At a more granular level, the Stoxx Europe 600 underperformed five of the six sectors, only beating the STOXX® Europe Total Market Industrial Engineering index by a marginal amount.
The next natural question for American investors to ask is how well this approach performed versus major American indices. Over a five-year horizon, an investment in Europe’s most competitive sectors performed more like American equities than their regional peers. The European Advantage portfolio kept pace with the S&P 500 over most of the time horizon, with notable lags occurring during the onset of the war in Ukraine, the height of the ensuing European energy crisis, and American markets’ post-election rally. Increasing the holding period past five years narrows this gap in performance. The Dow Jones is perhaps a more apples-to-apples comparison due to its similar sector allocation. Here, the European Advantage approach mostly outperformed, but suffered during the periods mentioned above. As of mid-January 2025, the Dow Jones and European Advantage portfolio have almost exactly the same cumulative return.
Research by Kroll reveals that the European Advantage industries’ multiples are in the mid-to-high range, when compared to other European sectors, but are slightly below those of their American counterparts. When taken in the context of their strong performances, these findings imply that the European firms in question have strong fundamentals, further supporting the theory that they represent areas in which Europe has an advantage.
Investors can overcome the comparative weakness between European and American equity markets by better understanding the region’s economy. While legacy industries such as autos and basic materials are being eroded by cheaper foreign competition, Europe maintains its edge in sophisticated industries, producing stellar firms such as ASML, Airbus, and Novo Nordisk. Investors who recognize this can allocate to European equities more intentionally, achieving results that are comparable to those found in the American markets.
[2] Analysis of Productivity and Growth Disparities Between the United States and Europe (2010–2023)
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