I recently finished three short books by Meb Faber, entitled Global Value, Global Asset Allocation and Shareholder Yield.
There are many talking points from these, however I’d like to focus specifically on Global Value today. The book is as its title suggests, focussed on identifying value outside of his home country, the US.
Home Country Bias
One bizarre, yet predictable problem most individual investors have is something called “home country bias”, the tendency to invest most of your assets in the country and markets in which you live. I myself am guilty of this (just look at the portfolio) and it is something I am attempting to move away from over time.
I do however remain a “bottom-up” rather than “top-down” investor. I look to find undervalued companies and then look at broader market conditions, rather than the other way around. I also have in my favour the fact that the CAPE ratio for the UK is historically below-average. Aah, but what is the CAPE, I hear you ask (hopefully!).
The CAPE, or “Cyclically-Adjusted Price-Earnings” ratio was developed by Yale Professor Robert Shiller, in an attempt to more accurately reflect the valuation of markets. He developed this by taking the Price-Earnings ratio (share price divided by per-share earnings) and smoothing it out across a longer time-frame, usually ten years, by using the average earnings across this time frame. He then accounted for inflation.
(If that doesn’t make sense to you yet, have no fear. It will be something I revisit again in future.)
What you need to know is that using this ratio it is possible to broadly identify whether markets are expensive or cheap, relative to historical prices. The CAPE for the UK is currently 13.2 (starcapital.de) compared to it’s historical average of around 16. This may not sound a lot, but consider the highest point during the dot-com bubble it hit 28. (Japan hit 100!)
So for the moment I am happy to hold UK-based stocks, and as I say, I’m looking for individual companies rather than the market as a whole.
Using this information, could we consider investing in countries with markets which are even cheaper? I personally would not do this on an individual company basis, but it is certainly achievable to invest in markets as a whole. How would our returns have fared by investing in an ETF in each of ten countries?
Looking again at the data provided by Faber in Global Value, the ten cheapest countries by CAPE on December 31st 2012 were as follows, along with their valuations today:
- Greece – 2.6 (38.2)
- Ireland – 5.0 (25.8)
- Argentina – 5.2 (N/A)
- Russia – 7.2 (4.9)
- Italy – 7.4 (10.1)
- Austria – 8.4 (11.3)
- Spain – 8.5 (9.9)
- Portugal – 9.5 (10)
- Belgium – 10.3 (20.6)
- Israel – 11.1 (14.9)
As you can see, almost all are more expensive than they were nearly four years ago, Russia being the outlier. How would this translate into performance?
If you had put an equal amount of money into an ETF for each of these ten countries, you would have seen the following results, based on a 3 year cumulative return:
- Greece – -22.62%
- Ireland – 32.56%
- Argentina – 9.64%
- Russia – -23.18%
- Italy – -1.63%
- Austria – -7.17%
- Spain – -0.19%
- Portugal – N/A
- Belgium – 39.29%
- Israel – 15.71%
A mixed bag, giving an overall average annual return of 4.71%. Not terrible, but not fantastic either. You can see rough correlations between those countries with massive changes in their CAPE, and the performance over the three years (Ireland, Belgium and to an extent, Israel). The only outlier is Greece, which is now on a very high CAPE ratio but who’s returns have been negative. Russia is now far cheaper (in fact, the cheapest), explaining its negative performance.
Should this be reason to abandon the CAPE? I don’t think so. Certainly, I would be selling my Irish and Belgian ETF’s (possibly even my Israeli as well), but Russia, Italy, Austria, Spain and Portugal certainly could still be considered cheap and have further to go. I’d look to rebalance by investing in Brazil (8.5), Poland (8.6) and the Czech Republic (8.7).
The topic of CAPE and relative valuations of countries is something I will be revisiting again in future.
All three books discussed are available on Amazon, and if you own a Kindle can be purchased for £1.99 each.