Value means buying the ugly ducklings, not the darlings

A new fund consists of the markets currently most loathed – including Ireland, Greece and Russia – but there’s no room for the US, the UK or Germany

Outside the Hellenic stock exchange in Athens: the new Cambria Global Value ETF specialises in undervalued markets, like Greece. Photograph: chris ratcliffe/bloomberg

Outside the Hellenic stock exchange in Athens: the new Cambria Global Value ETF specialises in undervalued markets, like Greece. Photograph: chris ratcliffe/bloomberg

Tue, Apr 22, 2014, 01:10

Aer Lingus, CPL, CRH, FBD, Fyffes, Glanbia, Kingspan, Origin Enterprises, Smurfit Kappa and Total Produce all have one thing in common – they are part of a new exchange-traded fund (ETF) aiming to contain 100 of the most undervalued companies in the world.

The new Cambria Global Value ETF comprises stocks from the world’s 11 most undervalued countries, as determined by US money manager Mebane Faber. This is no orthodox portfolio and the quest for global value means there is no room for the US, Britain, Germany or Japan.

There is a decidedly Irish bent to the fund, which is largely comprised of the ugly ducklings of the investment world.

Even though the Emerging Markets Index is currently cheaper than other regional indices, most of the cheapest countries are European: stocks from Greece, Russia, Ireland, Hungary, Spain, Austria, Czech Republic, Italy, Portugal, Brazil and Israel make up the list.

Philosophy
Faber, who outlines his investment philosophy in his new book, Global Value: How to Spot Bubbles, Avoid Market Crashes and Earn Big Returns in the Stock Market , uses 10-year cyclically adjusted price-earnings ratios (Cape) to determine what’s cheap.

Popularised in recent years by Nobel laureate economist Robert Shiller, Cape averages earnings over a 10-year period, smoothing out the highs and lows of the economic cycle.

Looking at 45 global markets, Faber chooses the 10 or 11 trading on the lowest Cape ratios and then buys liquid, cheap stocks from each country. Part of the fund will be in cash if, as in 1999, too few markets trade on low Cape ratios. The fund is rebalanced yearly to remain invested in the cheapest countries.

Historically, most countries have traded on Cape ratios of 15 to 20, says Faber; they tend to bottom out around seven and max out at 45.

It’s a simple buy low, sell high philosophy. The more you pay, the poorer future returns will be; the less you pay, the better.

Psychologically, however, it’s not easy to buy into beaten-up indices. Who liked Ireland in late-2008/early-2009, when it traded on one of the lowest Cape ratios ever seen anywhere? What about Greece in mid-2012? Or Russia in 2014?

In all such cases, says Faber, the headlines are negative; the fundamentals look awful; there is a “non-zero risk of the investment going to zero”; buying means career risk for ordinary fund managers, or even “divorce risk” for ordinary investors.


Explosive moves
Still, buying when things look great is a “recipe for disaster”, says Faber. In contrast, you can have “fairly explosive moves . . . when things go from ‘terrible’ to merely ‘not as bad’ ”.

In the US, the S&P 500 has traded at an average Cape ratio of 11 at the beginning of the best 10-year periods; the average valuation at the start of the worst 10-year periods has been 23. (Today, it trades on a Cape ratio of 25).

Globally, Cape has also delivered the goods. Since 1980, investors who bought into countries in the top 4 per cent of Cape valuations – “nosebleed territory” – would have averaged five-year annual returns of -0.8 per cent, or 10-year annual returns of 1.2 per cent.

Buying into the lowest valuations would have been followed by five-year annual returns of 20.4 per cent, or 10-year annual returns of 14.4 per cent.

Going beyond the extremes on either end of the valuation scale, the results remain eye-catching. Since 1980, the 25 per cent of countries trading on the lowest ratios have returned 16.9 per cent annually, compared to 10.6 per cent for the most expensive.


Bubbles
Faber is unimpressed by the idea that markets are perfectly efficient and that investors should blindly track global indices. If so, investors should have allocated the same percentage of their portfolio to US stocks in 1999, when they were in a bubble, as in 2009, when they hit a generational low – hardly a “reasonable” approach, he says.

He points to the Japanese equity bubble in the late 1980s, when the Cape ratio neared 100 – the highest reading ever recorded, dwarfing even the late 1990s dotcom bubble. Then, Japan accounted for nearly half of global market capitalisation. Investors allocating half of their portfolio to Japan would have cause for regret. Twenty years after its 1989 peak, the Nikkei remained more than 80 per cent off its high.

Today, the US market accounts for almost half of global market capitalisation. It’s not in a bubble, says Faber, but it is one of the priciest markets in the world, and investors should park their money elsewhere.

Sceptics say Cape has outlived its usefulness, for two reasons. One, the unprecedented earnings collapse of 2008/09 distorts the picture, artificially elevating the Cape ratio. Two, US accounting changes render it obsolete, an argument made in recent times by high-profile finance professor Jeremy Siegel.

Faber is unconvinced, saying profits were artificially high in 2006/07, and that the very purpose of Cape is to smooth out such peaks and troughs. Besides, even if one adjusts the 2008/09 data, the US Cape ratio barely changes.

Similarly, using Siegel’s preferred source of earnings data lessens the scale of the overvaluation, but does not erase it. However one looks at it, the US remains expensive.


Timing
Cape is no market timing tool. For example, anyone implementing Faber’s strategy would have missed last year’s 30 per cent S&P 500 gain. They would, of course, have been handsomely rewarded elsewhere – the Irish market rose by a third, for example, while big gains were also seen in Greece and other unpopular markets.

Still, pricey markets can get pricier, and cheap markets can get cheaper. In Faber’s book, he warns of the danger of catching a falling knife, half-joking: “How did that investment decline by 90 per cent? It went down by 80 per cent, then got cut in half.” That’s why investing in one or two countries is not advised; instead, buy a basket, spreading the risk.

The idea of steering clear of market darlings and opting for the ugly ducklings will unnerve many. Others may be cautious regarding backtested results – buying countries with low Cape ratios may have worked in the past, but will it do so in the future?

However, Faber never pretends his approach is some kind of magic formula. Other value approaches have also delivered.

Over the last century, he notes that the highest dividend yielding countries have outperformed the lowest by roughly eight percentage points annually. Similarly, the cheapest indices based on price-book ratios and cash flow have also substantially outperformed.


Recommendations
Faber’s book, though slender – it’s just 75 pages – is a good read, and concludes with some general recommendations.

One, keep an eye on international Cape ratios “as a guidepost for both opportunities arising from negative geopolitical events, and a sanity check against bubbling stock markets” (the Irish market, despite rising more than 150 per cent since March 2009, still trades on a relatively low Cape ratio of 9.3).

Two, to avoid market capitalisation concentration risk – like Japan in 1989 or, to a much lesser degree, the US today – “consider allocating along the weightings of global GDP”. That would reduce US equity allocation in a portfolio down to 19 per cent from 46 per cent.

Thirdly, consider some sort of value approach to your equity allocation, overweighting the cheapest countries and avoiding pricier indices. That last part sounds easy but looking at the countries on Faber’s ETF is a reminder that it’s anything but.


The Cambria Global Value ETF trades on the New York Stock Exchange and has annual management and custody fees of 0.69 per cent. Global Value is available on Kindle and as a paperback from Amazon.

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