Meb Faber: Own The Most-Beaten-Down Stocks

April 08, 2014

The search for value stocks should and can be global using ETFs, Mebane Faber says.

When it comes to investing in equities, it pays to be a value investor, and on a global scale. That’s the message Mebane Faber, Cambria’s chief investment officer, conveys in his latest book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.”

The 80-plus-page book¸ released last month, came alongside the launch of Cambria’s latest ETF, the Cambria Global Value ETF (GVAL), a passively managed fund that invests in 100 stocks of the world’s 11 most undervalued developed and emerging countries. Think of the portfolio as the “Terrible 11”—teeming with heightened expected returns and poised to bounce back up.

While most might find the idea of buying into the most-beaten-down markets daunting, Faber argues GVAL could replace your foreign stock allocation, if not replace your entire equities allocation. You’ve published a book that focuses on the benefits of value investing on a global scale. You also have a brand-new ETF that sets out to do just that. Why is it so important to focus on value when looking at an equities allocation?

Meb Faber: It seems fairly obvious to me as a practitioner that bubbles do exist. Valuation is so important because if you look back to the late 1990s, the markets in the U.S. were very expensive, and we’ve had terrible returns since.

The challenge is identifying the bubbles and avoiding their crash—the resulting price declines—as well as being able to invest in their aftermath. To do so, we need to come up with a framework or a metric for being able to identify markets with what we call “fundamental anchor.” Our preferred metric is the 10-Year Shiller CAPE [Cyclically Adjusted Price/Earnings] ratio.

It’s all about avoiding the times when there can be massive wealth destruction because of the expensive markets and also investing when markets are cheap. In your book, you say things like sentiment and inflation rate ultimately help determine how much a stock is worth. How do you measure value as an investor?

Faber: There are different metrics, but a lot of the valuation indicators will end up lining up on the same side for a stock or country. If you're looking at a country like Russia, most of the valuation metrics line up on the same side, and universally say that it’s cheap. Whereas for an expensive stock, like Tesla, or Amazon, a lot of the valuation indicators will say the same thing.

There's nothing magical about CAPE, but it’s our favorite metric, because it’s been around—variations of it—for over 100 years. It balances out the business cycle over a 10-year period—contractions as well as expansions. It gives the investor, using the U.S. as an example, a framework for trying to assess where we stand in terms of valuation.


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. How do you know for sure what you have in your hand is a value play—where it’s cheap and it shouldn’t be this cheap—versus a value trap?

Faber: That’s one reason we wanted to make sure to simulate in backtests what these portfolios would have looked like historically. The results are very clear that investing in cheap countries is a much better idea than investing in the broad market, especially in the expensive countries. That’s something a lot of people don’t focus on: It’s not just about investing in what’s cheap, it’s also avoiding what’s expensive.

A great example is Japan in the late ’80s. Japan was half the world’s market cap in the late ’80s. It was also, by far, the biggest bubble we’ve ever seen. They hit a CAPE of almost 100. If you were investing in an indexed broad global market portfolio, you had half your assets in the most expensive bubble we’ve ever seen. That’s not a smart thing to be doing, right?

It’s similar to where we find ourselves today. The U.S. is half the world market cap and it’s also one of the most expensive markets in the world. U.S. investors, which already have home-country bias, put 70 percent of their assets in U.S. stocks. From a value perspective, they should be putting less in the U.S.

It’s not just about buying what’s cheap, because any market could continue to go down even more. But it’s also about avoiding what’s expensive; and the reason you want a basket of these countries. Is there an average time frame for how long it takes an overvalued or an undervalued market to go back to fair value?

Faber: A few charts in the book demonstrate this, and we looked at a lot of countries’ bubbles. I figured the number was around three years to work off some of the valuation.

But in Japan it took something like 17 years, the U.S. in late 1990s took about eight because it bottomed out in the ’08 bear market. So it depends. But it’s certainly, on the order of multiple years, somewhere between three to 10 depending on the magnitude of the bubble.

But that's why this fund only rebalances once a year. Anything under a year is not going to give the deep value stocks long enough to rebound in many cases. The ETF portfolio right now is heavily allocated to Europe. What do you think is the most surprising country in there?

Faber: The headlines in Europe over the past few years have been consistently negative, both politically as well as economically. And that happens when markets are down and things are going poorly. But that’s when you want to be investing.

When you invest in these countries, the best returns can come from when things are horrific, and go from “horrific” to “not as bad,” to merely just “bad.” The Russia example is relevant. Everyone is hating Russia. It’s down a bunch this year; they’re doing very inflammatory things politically. But if things start to smooth out, you can see events unfolding, and you can see the market begin to rebound. The Russian stock market is already up about 15 percent from the bottom. You can have fairly explosive moves in these markets when things go from “terrible” to merely “not as bad.” Where does this ETF fit in a portfolio? Does it replace anything?

Faber: Theoretically it could replace the entire equity allocation. Most investors will not likely feel comfortable moving too far away from their home country and global market-cap-weighted portfolio. A lot of them will use it as part of foreign, developed or emerging allocation, or some sort of satellite allocation.

Theoretically, it could also be the entire foreign portfolio because, in general, while it’s heavy in Europe now and has bits of South America and Russia, its name is agnostic, and in certain periods, like in the late 1990s, it would probably own a lot more in Asia, and in the early ’80s, it would have owned U.S. What are some of the risks with this approach?

Faber: The biggest risk is the emotional one. Markets can always get cheaper, and while the average global valuations are as low as they were in ’08 and back to the early ’80s, which we think is a great thing, they could certainly get cheaper.

When the U.S. went to a CAPE of 5—or in Greece or Russia, when the valuations got to 15, then 12, then 10, then 8—everyone was saying it could not go that low, and it kept going down in some cases. In Greece’s case, it hit one of the lowest values we’ve ever seen, which was 2. Typically, anything below 7 is a generational buying opportunity, and certainly below 10 or 12 is a great investment idea.

The biggest challenge is investing when everyone else isn't.

There's a famous investment quote—I think Mark Yusko uses it a lot—that says that investment is the only area where when things go on sale, everyone runs out of the store. With cheap markets, as they decline, people run away and want to sell. But typically, that’s the best time to be buying. What is the main takeaway you hope investors get from your book, from this approach?

Faber: The first step is to recognize you likely have a home-country bias. In the U.S., that means around 70 percent of your portfolio is likely in domestic equities. Then, realize that breaking that market-cap link is the best thing you can do. Investors should have a lot more money in foreign stocks, and we think it should be in value stocks.

Our fund evaluates the stocks within each country. It goes and picks the 10 best value stocks out of the top 30 market cap in each country.


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