The Biggest Deals in the World
This portfolio takes advantage of what Bill calls “the most powerful and reliable force in the investment world.” This force is reversion to the mean.
Bill says, “The idea is simple. Things get out of whack from time to time. When they get out of whack, there seems to be a strong gravitational pull that brings them back into whack, back to earth, back to ‘normal,’ back to a well-established mean. After all, in order for there to be a normal, things have to return to it after they have gone astray. Otherwise, trees really would grow to the sky.”
In the investment world, reversion to the mean is another way of saying, “value investing.” As Bill likes to say, “What is cheap becomes expensive and what is expensive becomes cheap.” That is the basis of our country ranker.
This system is not a perfect market timer. Value investing takes patience. But this system will put you in a position to beat the returns of the world market over the long run.
Here’s how the portfolio works. We take four value measures and rank each country by each measure. Then we add up the ranks across the four measures for each country. The lowest numbers represent the cheapest countries.
You should buy the cheapest three countries and hang on. If you want a market neutral portfolio, you can short the most expensive three countries.
Below are the measures we used and the reasons we included them.
The CAPE Ratio
CAPE is an acronym for Cyclically Adjusted Price to Earnings. The ratio takes the price of a market and divides it by the average adjusted earnings over a period of time. In our case, we’ll use 10 years. Because the value of the profits 10 years ago is greater than a similar amount now, we adjust each yearly earnings number for inflation. That’s the cyclically adjusted part.
Earnings are the most important reason you invest in a company. If the company didn’t make any profits, you would lose all your money. A company must earn money if you want to have a successful long-term investment.
The reason investors like using the CAPE ratio is that it looks at earnings over an entire business cycle. This smooths out the effects of any abnormal years. For example, the market had a PE ratio of 100 in 2008 even as prices declined because earnings tanked. It is also harder to get away from the mean. So when the CAPE ratio is low, the market is primed to bounce back and revert to the mean.
Research has proven countries with a low CAPE ratio outperform countries with high ones. Quantitative guru, Meb Faber, has completed exhaustive studies on future returns based on the CAPE ratio. Faber studied the CAPE ratio by looking at 32 countries from 1980 – 2011. As you can see in the chart below, the lower the CAPE ratio, the greater the future return. You can’t use the CAPE ratio to predict what day to buy a market, but you can use it to know when to buy within a year’s time.
Meb Faber looked for all instances where international CAPE ratios were below seven at the end of the year since 1980. It was rare – it only happened 4% of the time – but the returns are astounding.
Almost as important as profits are sales. After all, if you’re not making sales, you can’t make profits. The Price-to-sales (PS) ratio takes the price of a company and divides it by sales.
One of my favorite books is What Works on Wall Street by James O’Shaughnessy. In this book, he looks at many different factors and runs back tests to see how different strategies performed over time. He found that low price-to-sales is a good way to determine value.
The cheapest stocks by this measure outperform the market by 3.3%.
Perhaps most impressively, the most expensive underperform Treasurys by 50%. This is terrible performance. This portfolio is just as much about avoiding bad investments as picking great ones. The PS ratio is great at weeding out bad investments.
This study is just American companies, but multiple studies show this relationship holds true in international markets.
The price-to-book (PB) ratio is another popular metric used by value investors. The book value of a company is its assets minus liabilities. The PB ratio is the price of a share divided by the book value per share. This shows how much you are paying for assets. If the PB ratio is two, you are paying $2 for each dollar of assets you receive. Value investors typically look for companies with low PB ratios.
This ratio helps make sure we are not overpaying for assets.
Going back to What Works on Wall Street, low PB ratios do not always equate to higher returns. As you can see in the chart below, the cheapest decile performs slightly worse than the second and third deciles. I believe that is because low PB companies may be losing money. Sometimes companies turn into a “value trap” – what investors call a company that appears cheap but is actually expensive because business is deteriorating.
This chart goes from 1927–2009. Returns on this indicator are highly cyclical. For instance, in the 1930s, buying the cheapest PB stocks would have lost you 12% per year. The market at this time was flat, so you underperformed by 12% a year. In the 1980s, it would have earned you 22% a year, outperforming the market by 5% a year.
As we said at the beginning, this won’t be a perfect market timer. This isn’t a system to show us the exact day to buy. You may have to wait awhile before the market turns up. But we can get paid dividends while we wait. That’s why we like countries with a high dividend yield.
A high dividend yield can also be a sign of value. For a company to pay a dividend, it generally needs to be making money and it has to be confident in its future. Theory says only strong companies pay dividends. This is not true all the time, but according to Elroy Dimson’s book Triumph of the Optimists, higher yielding U.S. stocks have higher total returns than low-yielding stocks.
This is the most robust study I could find. It only includes American stocks. Once again, many studies show high-yielding dividend stocks outperform in all markets. Credit Suisse released one in 2009 showing this for 13 international markets. Nuveen Investments showed how dividend growers in the MSCI EAFE Index – which tracks 21 developed markets around the world – outperformed others.
Here’s the June 2016 Recommendation in the Bill Bonner Letter. Please contact firstname.lastname@example.org for access.
|P/B Rank||Div Yield Rank||P/S Rank||CAPE Rank||Total|