Meb Faber: Own The Most-Beaten-Down Stocks

April 08, 2014

Faber (cont'd.): Typically, the market’s value averages around 16 or 17. Markets peak above 30 for bubbles, and bottom-out for secular bears turning into secular bulls in the high single digits around 7. The lowest values we’ve ever seen are 5 and then 40—I think 46 in late 1999.

But value metrics play out over one to 10 years, and on shorter time frames, markets are driven by sentiment and price moves. And the only difference between a market trading at a CAPE of 46 and a CAPE of 5 is simply what people are willing to pay for stocks. And that’s purely a sentiment-driven metric.

Now, there are other variables. If you think back to the late ’90s, people were incredibly excited about stocks, and future returns were terrible. And that’s kind of how a valuation metric works. The more you pay, the worse returns are in the future, and the less you pay, the better they are. It’s not rocket science, but it’s also difficult for people to behaviorally do. Is the U.S. stock market overvalued right now?

Faber: The challenge is that most investors want to think in binary terms: Either I'm bullish and I’m buying, or I’m bearish and I'm selling. But the reality is that there’s a full spectrum of probabilities. The U.S. valuation right now is expensive; it’s higher than average, and future returns should be lower than average—let’s call it around 3 or 4 percent nominal. That’s not great, but not horrific like the late ’90s. We wouldn’t define it as a bubble; it's more of a head wind.

If you look at the rest of the world, the bad news is the U.S. is expensive. The good news is the rest of the world is really cheap. Some of the markets are incredibly cheap, like eastern Europe, Greece, Russia, Brazil. Historically, if you look at a portfolio of foreign countries and simply invest in the cheapest, you outperform a market-cap or equal-weighted portfolio by quite a bit. Your ETF invests in the 10 or 11 cheapest countries, or those that have been really beaten down. We were debating the other day whether it should be called the “Terrible 10 ETF.”

Faber: That’s funny. But this is an important point, and it ties in to why the strategy works. When you’re investing in the cheapest valuations—Greece at 4 and Russia at 6—you’re invariably investing in markets that have already declined a lot. Valuations correlate very highly with drawdowns. The most volatile part of the price/earnings ratio is the price, how much things have moved. Many of these markets have declined 40, 60, 80 percent at some point, so you’re investing in what many would consider to be terrible markets.

Usually these declines are consistent with terrible geopolitical headlines. Think of Russia right now. But if, behaviorally, no one wants to own these individually, imagine the career risk you would be taking if you were an investment advisor and you were going to people saying, “We should be buying Russia and Greece.” You’d probably get fired. That’s one of the reasons value investing works.

The problem with calling it the Terrible 10 ETF, of course, would be that it would be challenging for an advisor/investor to buy these names. “Global value” to us seems a lot more tolerable.


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