Four myths on US stock market investing (and how to overcome them)

For many investors, the big markets across the pond can feel unfamiliar, unwelcome and a recipe for expensive mistakes.

But the opportunities in US stocks should not be forgone for the sake of a few pain points. This article aims to help you overcome the challenges that come with gaining access to the most exciting stock market in the world.

Pain point 1: Foreign exchange costs eat into my returns

There is no denying the presence of foreign exchange risk when you buy stocks in overseas markets whose shares are listed in a different currency to the ones you trade in. If, for example, the value of the USD decreases against the GBP, British investors’ return on their US holdings will be diminished (even if the company’s share price hasn’t fallen).

Not only that, but there are currency conversion costs to contend with. Most platforms and brokers charge you a percentage fee for buying and selling shares which are listed in an overseas currency and these can eat into your returns.

But is this enough to diminish the benefits of US investing? Not in my book.

For a start, currency movements don’t always act against the investor - a rise in the USD against the GBP will boost your investment, even if the share is underperforming. And if you are concerned about the fluctuation in foreign currencies, there are a number of hedging strategies that we will discuss below. When it comes to FX fees, don’t assume all platforms and brokers are out to rip you off. Today there are many which offer very competitive fees for foreign share dealing and FX conversion.

Solution: Hedge against FX movements

When a British investor buys a stock that is listed in USD they might consider that they are ‘long’ the USD - that is, they are assuming that the value of the USD will rise against the value of the sterling which they have converted from. To hedge against that movement, investors might consider buying a short USD ETF, whose return will act in the opposite way to the movement of the USD against the GBP. Any currency movement which impacts the returns on the stock will be outweighed by the return of the ETF.

Alternatively you can use a spread betting account to short the USD (or other USD denominated shares) to hedge against any currency movements. Spread betting allows you to take positions on leverage (you don’t own the assets directly but have ‘borrowed’ funding from the spread betting provider). Beware that both spread betting and shorting can incur far bigger losses than a simple long investment.

Whether or not you chose to hedge your foreign investments, it is worth being aware of the value of the USD when you buy or sell your shares.

Pain point 2: Platform fees eat into my returns

Just like domestic investing, it’s important that investors looking to buy US stocks don’t see their returns eroded by fees.

Comparing fees isn’t always simple. Different brokers and platforms make their money in different places. For example, some platforms offer cheap dealing fees (the fees charged each time you buy a stock), but high holding fees (the regular fees for looking after your money). Others offer deals for regular trading, so if you buy a lot of shares every month it becomes cheaper the following month.

The newer platforms and apps offer very cheap fees, but beware that you’ll pay for that privilege with a wide bid-ask spread. That means that the real-time share price might not be the one that is available to you to buy.

But the effort required to pick a platform or broker shouldn’t put you off US investing. There are plenty of services available that allow you to buy US shares at reasonable rates. Just make sure you do your research to find the service that is best for you.

Solution: Pick your platform based on the foreign share dealing and FX fees

The following table lists the basic fees of the top platforms and brokers available to UK investors looking for US exposure. For more detail on all the fees, you can view the full spreadsheet here.

At the time of writing, Interactive Brokers (a US share dealing platform) is currently the cheapest option for buying overseas shares. It also offers the opportunity to open a portfolio in USD which means you don’t need to pay FX fees on each transaction (but this cannot be in your ISA). IG also offers competitive rates (especially if you buy and sell more than three shares per month) and it offers spread betting accounts and fractional share dealing. Freetrade’s share dealing is free and the FX fees for the premium account are among the lowest offered by UK platforms. But beware, the range of shares available to buy via Freetrade is not as comprehensive as some of its peers.

Pain point 3: There are tax hurdles to overcome when you invest in the US

Fears that UK investors holding US shares might end up paying tax twice (in both countries) can be easily overcome by filling in a W8-BEN form. Your platform or broker should help you submit this form which proves you are a non-US resident and exempts you from US taxes.

Just like with UK shares you will have to pay capital gains tax on any profits made on US stocks. When you fill out your annual self assessment you will need to disclose any gains made on foreign investments - this can be quite complicated. What’s more, income made on US shares is subject to a 15% withholding tax.

Solution: Use your allowance and tax sheltered accounts

Every UK resident is entitled to £6000 of capital gains tax free every year, this includes the profits on foreign investments. In addition, UK residents can hold US shares in their ISA, which is exempt from capital gains tax. US stocks held in a Sipp are exempt from both capital gains and income tax.

Pain point 4: Analysing US stocks is hard

Analysing US stocks can seem like a challenge, given the different accounting standards, market dynamics and valuations. US stocks report every quarter and file announcements with the Securities and Exchange Committee (SEC) via a series of lengthy legal forms which makes the US equivalent of the Regulatory News Service (RNS) a minefield to navigate.

There are also differences in accounting standards that are used either side of the pond. British companies are allowed to capitalise their development costs, while US generally accepted accounting principles (US GAAP) must expense all development costs.

Attitudes are different when it comes to the investment of excess profits. Where in the UK, most companies favour dividends, American businesses tend to reinvest their profits back into the business, invest in external businesses (sometimes fellow listed stocks) or buy back their own shares.

And finally there is the issue of valuation. If we take traditional valuation metrics like the price to earnings ratio, US companies look far more expensive than their counterparts in the UK.

Solution: Do your research

Although a set of US financial results can seem a little overwhelming, the metrics used to assess for a quality business are the same as they are in the UK:

• Sales growth: Look for companies which have reported average sales growth over the medium to long term and are currently reporting a year-on-year increase in quarterly numbers.
• Margins: Stable or widening operating margins are important. Just like in the UK, don’t expect companies with a high level of fixed costs or tangible assets to report high margins, but if you’re looking in the tech sector (or among companies with low fixed costs and a high degree of operating leverage), look out for double digit margins.
• Earnings growth: Just like with sales, you should hunt for companies which have a strong track record of annual earnings growth and are currently reporting decent numbers.
• ROCE: A high level of return on capital employed (ROCE) is an indication that a company is well adept at squeezing profits from its capital. Just like in the UK, investors should avoid stocks with a consistently low ROCE.
• Cash conversion: Always seek companies which can convert their profits into cash - which can then be redeployed back into the business. As US companies have different accounting standards, their earnings can be harder to compare to their British counterparts, but cash flow is a metric which is very hard to interfere with. Companies which can convert all of their operating profits into operating cash flow (reported on the cash flow statement) and - perhaps more importantly - all of their net profits into free cash flow, are the ones you should hunt for.

And by doing research into these key metrics, it is possible to make better sense of the valuations of companies in the US. The higher price to earnings ratios can be justified by faster earnings growth rates and higher levels of profitability. When you take growth rates into account, there is an argument to suggest it is actually the UK stocks that are trading at a premium.