Would You be Brave Enough to Invest?

Recently, I had the pleasure of reading Meb Faber’s excellent e-book ‘Global Value: How to spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock market’.

The book discusses the importance of value-based investing in stock markets globally and for me, it highlights the importance of price when purchasing shares in a business and the dangers of simply operating a strategy of buying stocks no matter the prevailing market price.

Meb Faber has utilized Robert Shiller’s development of the Cyclically Adjusted Price Earnings Ratio (CAPE) to apply it to global stock markets and the findings are illuminating. For those not familiar with Robert Shiller’s work, he expanded on the pioneering work of Benjamin Graham and David Dodd in their 1934 book ‘Security Analysis’, to create his CAPE formula and method of stock valuation, which uses the past 10 years average earnings to assess whether stocks are valued attractively or whether they are overpriced, rather than 1 year in the simpler and more commonly known P/E ratio.

The table below illustrates just how far investor sentiment and economic conditions can influence how many multiples of earnings investors are willing to pay for a business.

We examined 32 countries with data from Global Financial Data and Morningstar, including as much data as we could find. We realize there is some bias in this study (if you have German PE data to 1685 or French to 1724 please contact us), but we did the best with what we have. We utilized local real returns (and found dollar based real returns to be nearly identical) to net out the effects of inflation. While only two had century long data (US and UK), most of the other countries go back to the 1970s and 1980s.

globalcapetableweb

The divergence between minimum and maximum CAPEs are huge!

The lowest CAPE being 1.95 and the highest being 94.25!

For me, this highlights just how extreme pessimism and optimism can become. So much for efficient markets.

So what are the investment implications of purchasing cheap stocks as indicated by the CAPE ratio? Well Meb Faber and his team at Cambria Investment Management researched historical stock market performance for 32 countries and the possible implications for your investment choices are illuminating.

We then set out to test CAPE in a similar manner. Starting in 1980 we sort all countries by CAPE, and invest in the most undervalued x%, rebalanced yearly. We also show the effects of investing in the most overvalued x% as well as a long/short portfolio. These returns are real returns net of inflation, and with yearly data (which will naturally understate drawdown figures). The sample includes approximately 10 countries in 1980, 20 in 1990, and 30 by 2000.

Investors utilising the investment strategy of buying a diversified range of low CAPE stock markets globally could have experienced extremely attractive compound annual growth rates, with the top 33% cheapest CAPE portfolio providing 13.5% per annum.

Here is the portfolio of the top 33% cheapest countries’ stock markets  based on CAPE, or the cheapest 10 markets, as of early 2015. (I have only utilised the 32 countries outlined within Meb Faber’s book).

So just where would you be investing your money today?

CountryCAPE
Greece2.4
Russia4.6
Portugal6.3
Austria6.5
Brazil8.8
Italy8.5
Ireland10.4
Spain10.7
Turkey11.9
South Korea12.2

The data for these 32 countries and many others can be found at http://www.starcapital.de/research/stockmarketvaluation.

I think people who live in a cave may appreciate the bravery necessary to invest in some of those countries (with all the newsfeed in relation to Greece and Russia in particular, it is not worthwhile adding to the rhetoric).

The main issue with investing in these places is emotionally handling the negative news flow.

Will you be able to stomach owning shares in countries where for perhaps long periods of time the news is entirely negative?

For instance can you think of a single article that portrays Greece’s situation in a positive light? Has anyone written that Greece will actually grow or improve in the future?  This will happen. They aren’t doomed to an eternity of financial mess and chaos.

This news flow could possibly make your investment fall in value in the short term, perhaps to disturbing levels, with extreme volatility. However, it is at times of the highest negative sentiment that stocks are available at their cheapest prices, simply because everyone has been frightened off and demand for the stock has plummeted.

Fortune Favours the Brave

It is clear that some of these markets are experiencing significant problems and many people would view you as foolish to invest in them.

That is however part of the appeal.

Due to these perceptions the demand for the stocks are low and therefore the price is cheap, especially in relation to many other stock markets.

The research put forward by Meb Faber in his book is compelling and I feel should warrant attention from all investors and for the brave few, there could be some very attractive 10-year returns on offer.

It is important to remember that the past isn’t a reflection of what will happen in the future and when you invest, especially in overseas markets, you can lose money, possibly even your shirt.

By Mark Underdown

Financial Coach, Small Acorn Money

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