Bad Countries, Good Investments

Last week, White House press secretary Jay Carney offered a bit of investment advice.

“I wouldn't … invest in Russian equities right now … unless you're going short," Carney said in response to a reporter’s challenge that Russian stocks were actually rising, signaling the inefficacy of U.S. and European sanctions.

But according to Mebane Faber of Cambria Investment Management, which subadvises ETF portfolios and issues its own, Carney’s advice was “irresponsible” for several reasons.

“First of all, you shouldn’t recommend to the general public shorting anything,” he says in an interview with ThinkAdvisor. “Most retail investors don’t understand the mechanics of shorting but also how much you can lose — the entire account plus some. Looking at Russia — its market goes up and down 5% in a day — its volatility is double that of the U.S. stock market.”

But apart from those technical and generalize risk-based reasons, the overriding reason to short the White House’s investment advice is because Russia is likely to outperform world stock markets in the coming years,” Faber says.

“I don’t recommend shorting a market that is down 60% from its peak. If Russia settles down, Russia could very easily double or triple [in the next two or three years].

“That’s one of the most moronic statements I have ever heard out of the White House, that’s for sure,” he adds.

Moronic — “idiotic” was added later for emphasis — but also telling.

“These are statements you hear when countries are as cheap as Russia. The headlines are all negative."

And indeed the “buy when there’s blood on the streets” investment axiom fits well, in a qualitative sense, with the quantitative approach Faber is taking in his new Cambria Global Value ETF (GVAL), which launched earlier this month.

Faber, widely followed for his investment research, blogging and controversial stance against buy and hold, has timed the release of a new book to lay out the theory behind his new ETF.

Called “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” the book is premised on the Graham- and Dodd-style value investing later enhanced by Robert Shiller.

The idea is that smoothed-out earnings — Shiller CAPE, or cyclically adjusted price-to-earnings ratio, is a good example — provides a useful signal of future market performance; a high Shiller CAPE in the late ’90s, for example, foretold the bear market of the 2000s, according to this thinking.

What’s more, bubbles can be bigger abroad than in the U.S., Faber says.

“Our starting point is that the investor who is U.S.-focused should start to invest at a minimum half in foreign markets. Most invest 70% to 80% in the home market.”

Yet out of the 44 countries Cambria tracks, the U.S. happens to be one of the most expensive, weighing in at nearly half of world market cap, Faber says. That should worry investors, particularly those who remember when Japan’s market inflated to nearly half of world market cap, reaching a P/E in the high 90s.

Faber assures that the U.S. is not in a similar bubble — its Shiller CAPE is 25. “It’s a headwind, not a tailwind,” he says.

“But markets usually bottom out with secular bears with P/Es in the high single digits or 10, and top out in 30s or high 20s,” he says.

Accordingly, most of the world today is “pretty cheap,” but not so the U.S. And its best market performance came in a year with a CAPE of 11, and its worst starting point was 23, which is why Faber is enthusiastic about applying CAPE forecasting to foreign markets, something he says has not yet been done.

While the principle is simple and straightforward — “it’s nothing more than value investing,” he says — the difficulty goes back to the White House’s seemingly intuitive if questionable investment advice.

“Buying the cheapest countries means buying … the worst of the worst geopolitical headlines,” Faber says.

Faber’s book illustrates the phenomenon by showing that the lowest-quartile CAPEs a year ago included countries like Greece, Argentina and Russia, whereas the U.S. was represented among the highest-CAPE countries.

Yet 2013 returns were in the double digits — usually high double-digits — for the low-CAPE countries, and were mostly negative for the high-CAPE countries.

Two exceptions were the countries today locked in geopolitical dispute: the U.S., whose market outperformed despite its high CAPE, and Russia, which lagged, despite its low CAPE.

“That’s why it’s important to invest in a basket,” Faber says, adding that “Russia is incredibly cheap; nobody can argue with that on any value metric.”

Greece’s financial woes grabbed a lot of negative headlines, but then its CAPE fell to 2 in the summer of 2012 and its market has been up over 200% since then. The Spanish economy attracted almost equally negative headlines in recent years, yet its market rose nearly 32% last year.

While countries like Russia can continue to go down — something Faber’s basket of investments is intended to mitigate — a key part of Cambria’s investment strategy is simply the avoidance of investing in the most expensive countries.

Today that means the Denmark, Indonesia and the U.S. — the three most expensive — whereas the cheapest countries today are Greece, Russia and Hungary.

The strategy is that simple — only the names change year in and year out. Faber’s fund rebalances just once a year.

“Higher frequency rebalancing hurts a portfolio; one year looks optimal,” he says, adding he even considered doing so once every two years.

Within the universe of cheap countries, Faber seeks to enhance the deep value orientation of GVAL by buying the 10 stocks with the most favorable valuations (above $200 million in market cap); the portfolio’s 100 stocks are equal-weighted.

Faber acknowledges it can be emotionally difficult for individual investors, and often professional investors, to buy Russia — “Russia then invades Poland … and you have egg on face.”

But he adds: “One of the nice benefits of the fund is that it removes the individual country risk.”

You don’t have to have the courage to buy Russia or Greece alone. It’s a "bad basket" of sorts whose value exceeds its parts. But its risk is also less than its parts. That’s the kind of coming up short Faber can buy into.

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Check out El-Erian to Global Investors: Be Worried (but Don’t Panic) on ThinkAdvisor.