'CAPE' of Good Hope: A Way to Buy Ugly Markets

 | Dec 06, 2016 | 12:00 PM EST
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Last night was the first in over a week that there was no rehearsal or performance for our in-house budding thespian, so instead of the mad dash to get her where she needed to be I was able to catch up on some overdue reading.

One of the articles I read was by Mebane Faber on the effectiveness of the CAPE PE, or cyclically adjusted price-to-earnings, ratio. While this is not a metric I use on a regular basis, Faber's work shows that it is a useful way to identify overvalued and undervalued markets. The major drawback to the CAPE ratio is that it can signal overvalued in some markets for an extended period, resulting in investors missing out on huge bull-market moves. It does, however, do an excellent job of identifying markets that are just ridiculously cheap with the possibility of tremendous upside in the years ahead.

In this particular article, Faber looked at owning the lowest 25% of global markets as ranked by the CAPE ratio. He finds that using this approach and rebalancing annually would have outperformed the stock market by a substantial amount from 1993 to the end of 2015.

The total return from this approach was three times the S&P 500's gain and the annual outperformance was by a margin of more than 50% of the U.S.-only market's return. His study also found that the approach had lower drawdowns in bad markets than just owning the U.S. index.

After going over some of the data and thinking about the "Global CAPE Approach," I came to the conclusion that this is a valid method for piling up long-term gains, but that it requires a particular type of investor. It uses a "buy in a crash" methodology that I prefer as most of the time you will be buying markets that are wildly out of favor.

The combined portfolio may have lower drawdowns, but some of the individual holdings will be from among the worst markets in the world, and you will have lots of volatility is some of the funds or ETFs you own. The most significant risk is what I call "story" risk. When you tell some of your friends what you own, they are going to look at you like you have lost your mind.

The cheapest country in the world right now, as ranked by CAPE, is Russia. While Russia may be resource-rich and see some benefits from higher oil prices the economy is still in pretty bad shape and it has uncertain relationships with the West, to say the least. While President-elect Trump has said he wants to improve relations with Russia, President Vladimir Putin is an unpredictable leader. So, Russia may be cheap, but it also an ugly market.

Turkey is one of the cheapest markets and right now is what the kids like to call a "hot mess." President Recep Tayyip Erdogan this week has been busy locking up opposing political leaders in the country along with journalists. There was a coup attempt not so long ago, and the European Union has frozen talks of Turkey joining the EU. The Turkish stock market is down 22% in the past quarter as investors have fled all the turmoil.

Along with these paragons of instability, the other markets in the bottom 25%, as ranked by the CAPE ratio, include the Czech Republic, Poland, Brazil, Italy, Portugal, Hungary, Spain and Singapore. If you googled potential global hot spots or financially distressed nations, most of these countries would show up. Using this strategy is buying ugly.

In today's ETF-crazed world I am sure you can easily find an index to put money to work in the top-10 cheapest countries. But if I were going to use this approach I would cheat wherever possible and use closed-end funds trading at a discount to net asset value to provide an extra edge.

Central Europe Russia and Turkey Fund (CEE) is trading at a 14.1% discount to NAV and has exposure to Russia, Czech Republic, Turkey, Poland and Hungary, so you buy several of the cheapest markets at a bargain price.

Aberdeen Latin America Equity Fund (LAQ) is trading at a 12.9% discount and 60% of its assets are in Brazil.

Aberdeen Singapore Fund (SGF) is trading at a current discount of 16% to the value of the underlying shares.

The Global CAPE Strategy will work for patient long-term investors, and I think that drifting around the globe buying crashing markets will continue to offer market-beating returns in the future. Still, it has enormous story risk, and takes an investor with high conviction, thick skin and cast iron stomach to use it successfully.

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