Contrarian Signals (Or Why Romania May Be the World’s Best Performing Market This Year)

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap.  This post is mostly about valuation and how bankers and financial experts take away the punch bowl just when an investment becomes attractive.  

I've written before how doing the opposite of what large financial institutions are doing and recommending can lead to higher returns (see here). This post is in the same vein . 

The reason I think Romania has a good chance of being one of, if not the best, performing stock markets this year is that the broker I use to access Eastern European stocks informed me that it will stop service there.  Earlier this year I had to transfer or sell all my Romanian shares.  To me, my broker’s closing operations is a large buy signal. 

The broker is ultimately owned by a large Belgian bank.  It’s likely that back in their corporate headquarters the stuffy-suited managers decided that all group companies would stop offering their clients access to Romanian equities.

This could likely be a very logical decision as it sounds like they have few clients trading Romania equities. My Prague-based account manager noted that I was one of four.

However, it is also short-sighted as there are many positives.  Romania has one of Europe’s fastest growing economies at 4.6% last year.  The country appears to be serious about political reform.   Its stock market is also one of the world’s better performing ones, having increased by close to 16% year-to-date. Despite the increase, many of its large cap stocks pay good dividends with yields north of 6%. 

While logical, it still stinks.  It took a long time to find a broker who provided access to most Eastern European markets and took US citizens as clients.  Part of the onboarding process was flying to the Czech Republic to sign account opening forms in person. (It was actually not much of a burden - Prague in June is actually quite nice.  But I’m still angry about it).

The situation reminds me of other instances where bank and financial product withdrawals and shutdowns turned into good contrarian signals. History doesn’t repeat, but it can rhyme, to paraphrase a famous quote. 

Consider the following:

• Brazil – the EGShares Brazil Infrastructure ETF (BRXX) was closed and delisted at the end of October 2015.  At the time headline news in Brazil was pretty abysmal.  However Brazilian equities were starting to flash buy signals based on my screens.  Stocks in the BRXX were the least expensive among the handful of Brazilian ETFs.  Since its delisting, its top ten holdings have increased by an average of 64% in USD.  Many had good dividend yields which would have likely pushed total returns closer to 70%.  Not as good as the Bovespa’s 84% during the same time period, but not too shabby. (ETFs are like mutual funds that track a specific index or strategy and can be bought and sold like stocks.  More information is can be found here).
• Greece - in 2012 HSBC sold its Greek securities business.  This was at the same time that I wanted to buy Greek shares, as they were trading at valuations similar to Korean stocks at the depths of the 1997/98 Asian financial crisis.  The bank that I’ve had an account with for almost 30 years took away a service just when I wanted to use it.  Over the next two years the headline Athex index rose by close to 200%.
• Russia – in mid-December 2014 when the Ruble was floated and Russian securities and its currency plummeted, my European broker decided to suspend dealing in Moscow listed shares.  I was locked-out just when I wanted to buy.  Many share prices of quality companies I earmarked to buy are since up 2-3 times in USD.
• South-East Asia – around 2001 HSBC closed and/or vastly curtailed its research operations in South-East Asia.  It was during this time that many of those markets started a multi-year bull run.  Since then, Indonesia’s and Thailand’s headline indexes are up by over 12x and 5x respectively in USD.

To be honest I really don’t know if Romania will do well this year.  Nobody does.  As I wrote in a previous post, the country’s stocks seem to be perennially cheap (see here).  Like all articles on investments, consider this article as an idea and interesting information, rather than advice. 

In addition to Romania, other Eastern European stock markets look attractive with several among the world’s best performing so far this year.  Czech stocks are some of the world’s least expensive. Polish stocks seem to be rebounding from political uncertainty since Poland’s late 2015 change in government.  And there’s even life in Ukrainian stocks as that country’s economy starts to stabilize.  Its GDP grew by 2.3% in 2016, rebounding from a 15% decline in the previous two-years. 

	Index	% Change Year-To-Date (USD)
Romania	BET	14.7
Poland	WIG	19.4
Czech Republic	PX	8.7
Ukraine	UX	17.5

Bankers and their management are not known as visionaries.  They are known to stop lending and pull products when the market or economy is faltering and their clients need them the most.  This has happened before and it will happen again.  To me these are good, qualitative contrarian signals that are not easily programmable by the quants and algos.  Let’s call it ‘qualitative alpha’ or, my favorite, ‘Research Alpha’ (see here).

It doesn't look like I'll be part of the Romanian party unfortunately, but I hope there are some readers who can make some decent money on this.  Buy me a bottle of wine if you do. One from Transylvania will do nicely.

Sisters Are Doing It For Themselves...And Others

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap. This post is about people and how women are making big strides in developing countries.

One of the most important steps in my research process is checking the background and reputation of corporate leaders, politicians and policy makers. Basically anyone that may influence equity valuations. Over the past several years I seem to be spending more time researching and evaluating female leaders.

The increase in the number of women leaders in ‘emerging’ and ‘frontier’ markets is particularly noticeable. I've been spending a lot of time looking at companies in these markets as for the last few years as they've been trading at valuations significantly less expensive than their counterparts in the ‘developed’ markets.

This is a large and long-term positive development.  Theoretically a larger pool of candidates should lead to better leaders. This should ultimately benefit companies and countries that make full use of their resources.  I read years ago in The Economist that educating girls and young women was almost a sure-fire way to increase a country’s living standards.

The increase in female executives was most noticeable on a research trip to Romania last year. As I've written before, stocks traded in Bucharest were some of the world’s least expensive and I went to see if they were merely cheap or had value (see here). 

On the last day I realized that at least half of my meetings were with women.  This was especially surprising considering that most of them are leaders in the traditionally male-dominated energy companies, the largest sector by far on the Bucharest Stock Exchange.

In fact, three of Romania’s largest listed companies are led by women.  OMV Petrom – the country’s largest private oil and gas company is headed by Mariana Gheorghe.  Transelectra – the country’s largest electricity transmitter is headed by Carmen-Georgeta Neagu, and Nuclearelectrica – the country’s largest electricity generator and sole nuclear generation company, is headed by Daniela Lulache.

At my last meeting – with two women executives – I asked what policies Romania had enacted that led to such a large proportion of female executives.  The response was pretty blasé.  They couldn’t think of any, but suspect it had to do with Romania’s communist past.

This could be true.  Eastern Europe and Russia have a higher percentage of women corporate leaders than any other region in the world if the 2015 Women in Business report by Grant Thorton is accurate (see here).

The report notes that 40% of senior business roles in Russia are held by women, which is significantly higher than Western Europe’s 26%.  The report also notes that seven of the top eight countries with the highest percentage of women in senior roles are in emerging European countries. In addition to Russia, these are Georgia, Poland, Latvia, Estonia, Lithuania, and Armenia.  Another factor could be the high proportion of women to men in the ex-Soviet Union (see here).

Interestingly, one thing that the warring brother countries (sister countries?) of Russia and Ukraine had in common until recently were highly respected female finance ministers. Russia’s Elvira Nabiullina is spoken of as being one of the best in the world and someone who has Putin’s confidence; while Natalie Jaresko is one of the few people in Ukraine’s cabinet who seems competent (see here and here).

The Soviet and communist past likely doesn't explain it all. Half-way around the world there are many women in leadership positions in Jamaica. As I wrote in last year’s post, this includes the mayor of its largest city, the head of its stock exchange, its largest bank as well as its largest electric utility (see here). While the female Prime Minister recently lost to her male rival, a recent article on corporate merry-go-rounds in Jamaica emphasizes the prevalence of women in the country’s private sector (see here).

Further south, trends in Latin America also point to more women in corporate leadership positions.  According to a study by Mercer, by 2025 Latin America should lead the world in the proportion of women in professional jobs.  The report notes that in contrast to the developed markets, where the focus has been on recruiting women for top positions, Latin American companies are adding female workers across the board (see here).

I don't know if female leaders will do any better than their male counterparts over time.  I’ve read articles saying women make better investors, financial consultants and political leaders than males.  This could be true, but I suspect that given all the sexism that exists, the ones that make it to the top faced a much higher barrier to entry so have to be that much better.  As more women enter the workforce and obtain leadership positions, I suspect they will prove no better or worse than men.  Regression towards the mean works in just about every other large sample set, and I suspect it will work here.

Another way to put this: for every Sheila Dikshit (the highly respected Mayor of Delhi), Tri Rismaharini (Surabaya), and Michelle Bachelet (2x President of Chile), there’s a Dilma Rousseff (close to being impeached President of Brazil) and Cristina Kirchner (controversial ex-President of Argentina). 

It’s been over 20 years since I very briefly met Benazir Bhutto on my second investment trip to Karachi in 1992, and over thirty years since Aretha Franklin and the Eurythmics released this blog’s soundtrack (see here). Since then women throughout the developing world have made great progress.  I notice this on an on-going basis as I look for value around the world.

In some countries, the proportion of female corporate leaders has leap-frogged developed markets.  I suspect this trend will continue and if anything provides yet another reason for investors to look at developing countries as a long-term investment just as they do for ‘developed’ countries.

  

Other Influential Women in Emerging Markets (I suspect I just scratched the surface. Please leave additional insight in the comments section below):

• Ellen Johnson-Sirleaf – President of Liberia
• Sheikh Hasina Wajed – Prime Minister of Bangladesh
• Ewa Kopacz – Prime Minister of Poland
• Ngozi Okonjo-Iweala – Economist and ex-Minister of Finance of Nigeria
• Sri Mulyani Indrawati – Managing Director of World Bank Group, ex- Finance Minister of Indonesia
• Nguyen Thi Phuong Thao – CEO of VietJet and Vietnam's first female US$ billionaire 
• Chandra Kochar – CEO of ICICI Bank, India
• Dong Mingzhu – President of Gree Electronic
• He Qiaonu – Founder and Chairperson of Beijing Orient Landscape and China's most generous philanthropist in 2015 
• Valeriya Gontareva, Head of the National Bank of Ukraine

BRICs, PITs, and PIGS: Go Ugly

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap. 

This blog is mostly about valuation and yet another example of how investing in beaten down, unpopular and ugly markets can lead to better returns. 

Usually valuations are low in markets that are not very attractive.   But who knows when the news can get even worse? Uncertainty and negative news flow keep most of us out of markets just when we should be buying. 

And it can take even greater will power to stay invested when nobody around you sees your point of view, friends and peers are calling you crazy, and well-educated, respected and slick investment bank analysts and traders are negative.    

It is psychologically easier to invest in markets when there is a lot of good news and the future looks very bright.  The problem is that these markets tend to be expensive and future returns tend not to be as good.

To contrast these two points let’s look at two acronyms that surfaced about the same time.

BRIC stands for Brazil, Russia, India and China. The acronym is attributed to Jim O’Neill in a paper he wrote for Goldman Sachs in November 2001 (found here).  In it he argued that these four countries should be included in high-level government groupings such as the “G7” because their size and growth would make them increasingly influential.

The acronym came out not long after the tech crash. Wall Street was ripe for a new story and over the next few years the term became more popular.  Goldman Sachs and many others launched BRIC funds and ETFs.  There are now over 200 of them according to a very expensive database.

The term took on a life of its own.  Leaders of the four appear to like the grouping.  Just a few months ago they and South Africa formally launched the BRICS Development Bank (link here).

About the same time BRICs was coined, traders and analysts who survived the late 1990s Asian financial crisis were referring to the ASEAN countries as PITs.  The term stood for Philippines, Indonesia and Thailand.  These were three of the hardest hit economies and markets.  Unlike BRICs I don’t think anybody has come forward to claim responsibility for it.  Calling your home market a degrading term soon after clients lost money would not likely make one popular.

Investing in the four BRIC countries when the phrase was coined until now would have generated decent returns.  The four countries' headline indexes are up an average of 302% since late 2001 for a CAGR of 10.5% (this and other return figures in this article are based on the average return of each country's headline index, in USD, dividends not included). 

In contrast, and despite the acronym’s negative connotation, one would have done considerably better by investing in the three PITs markets.  An equally weighted investment in the three grew by 675% over the same time period, which means the PITs investor would have made more than double the money of the BRIC investor.  Even the worst PIT outperformed the best BRIC.  Thailand, the worst performing PITs country, rose by 629%, a bit more than India, the best performing BRIC country, which increased by 611% from November 2001 to November 2015. 

In addition to being weary of investment fads, investors should also be skeptical of what the big banks are pushing. In July 2006 Goldman Sachs launched its BRIC fund.  From launch to close, the fund’s performance was just under 20%.  Over the same time period the three PITs indexes increased on average by 157%, meaning that one would have made almost eight times more money by investing in the markets that were unloved rather than the ones that the big banks were marketing.

Are PIGS Today’s PITs?

PIGS stands for Portugal, Italy, Greece, and Spain.  These are some the world’s worst performing economies and equity markets since the 2008 global financial crisis.  Like PITs it is not a flattering grouping and member countries have reportedly renounced the term (link here).

I suspect PIGS could be an up-to-date version of PITs.  The origins of both are the same and they describe markets that are having problems and are out of favor.  

Also like PITs the countries in the grouping are geographically close and have a lot in common in terms of economic integration, language, and culture. This is a stronger grouping than the BRICs. Except for the large country size, I don’t really see much that binds them like the PITs and PIGS.

Back to BRICs

Ironically now may be a good time to consider investing in BRIC equities. 

Russia has some of the world’s least expensive large companies and very impressive management.  Brazil is starting to look interesting with its currency down some 40% in the last two years.  There are some exciting and inexpensive companies in China and at 7x PE the Hang Seng China Enterprise Index does not seem very expensive. Weren’t US equities trading at the same level in the early 1980s just before that market’s long bull run?

There’s also a good contrarian signal.  Goldman Sachs recently closed the above mentioned BRIC fund.  Big banks have a habit of closing operations and products just when things start turning around. HSBC closed its South East Asian equity research offices in 2001 – just before those markets went on a multi-year bull run. Goldman’s closing of its BRIC’s fund may be a similar signal (more here). 

Go Ugly

This short piece is meant to show that going against the grain and doing what is uncomfortable and unconventional many times leads to higher returns.  The best place to find value is typically in ugly geographies and sectors.   

Are there other places that appear to be ugly and warrant catchy phrases such as PIGS?

How about “RUKs”, for Russia, Ukraine and Kazakhstan, three ex-Soviet countries whose currencies have fallen and have some of the highest interest rates in the world.   Or “PCB”, for Peru, Columbia and Brazil, three of the worst performing equity markets this year for US-dollar investors  Or “JOBQES”, for Jordan, Oman, Bahrain, Qatar, Egypt and Saudi Arabia which are among the world’s least expensive equity markets likely due Middle East uncertainty.  Or "GETOUt" for gold, energy, telcos, oil and utilities, five out-of-favor sectors that dominate my global value screens.

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Making Ugly Fun

"Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them", wrote Howard Marks in his very good book, The Most Important Thing.

Psychologically it is hard to put one's hard-earned money into unattractive and out-of-favor stocks and markets.   It's not easy or very enjoyable to try and catch a falling knife.  But buying quality companies at knock-down prices is likely a good way to limit downside and hopefully generate superior long-term returns. 

To help ease the way, I silently sing the chorus of a song from my youth.  Perhaps it will help you also.  It's sexist, corny and elementary, but with a catchy pop-hook its also very memorable, so make sure to click on the link below.  I've changed some lyrics in the second version to make it a little more investment specific.  

If you want to be happy for the rest of your life,

Never make a pretty woman your wife,

So from my personal point of view,

Get an ugly girl to marry you.

-----------------------

If you want to be happy for the rest of your time,

Never make a pretty stock your life,

So from my personal point of view,
Get an ugly market to carry you.

"If You Want to Be Happy", by Jimmy Soul (link here), 

(Based on "Ugly Woman", by Roaring Lion (link here)  

Valuation Matters. A Winning CAPE Strategy

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below intrinsic levels if not outright cheap.

This post is about value. I've written about the importance of people before (see here) and will at some point delve into the importance of structure.

A good way to minimize downside is to buy undervalued companies.  The hard part is valuing them.  There is no shortage of metrics and financial statement adjustments that analysts and investors use to determine if companies and markets are under or overvalued.

One my favorite ways of valuing listed companies is CAPE.  CAPE stands for Cyclically Adjusted Price-to-Earnings ratio.  It is like PE except that it compares the current price of a company to earnings averaged over a number of years.  PE or "Price to Earnings" ratio is a popular way to value companies, particularly those that are listed on stock markets.  It measures the value of a company in relation to one year's worth of earnings (more information can be found here).

CAPE was popularized by Robert Schiller who teaches Economics at Yale University. But it actually goes back to Benjamin Graham and it is through his writing I first became aware of it.

Benjamin Graham proposed valuing a company by looking at its average earnings over a business cycle - typically assumed to be 7-10 years.  Intuitively this makes sense.

Earnings can be volatile.  In a good year they can be high and in a bad year they can be low or negative.  Even good companies have some years when they lose money.  In those years they are not very popular and their share price usually falls as investors focus on the latest earnings rather than the company’s long-term strength and prospects.  This many times is a good time to buy.

CAPE May Predict Future Returns

There are many studies that have looked at CAPE.  One of my favorites is an easy-to-read academic paper named “Global Value: Building Trading Models with the 10 Year CAPE” written by Mebane Faber (available here).

This study notes that among the 39 countries it covers the 10-year CAPE does a good job at predicting subsequent returns.   Countries where the stock market was trading at low CAPEs subsequently had higher returns than countries that were trading at high CAPEs.

For countries trading at CAPEs below 10x the average real Compound Annual Growth Rate (CAGR) return was 12.3% over the next ten years.  This means that one could have doubled their money almost every 6 years through an passive investment in that country’s equity market if bought at a low CAPE value. This is five percentage points more than the US average long-term real return of 7% each year. Not bad.  (See reproduced table below)

The short term effects were also good.  One-year return for countries that trade below 15x CAPE was slightly above 24%.  Not bad again.

In contrast, buying at a high CAPE led to lower or even negative subsequent returns. A 10-year CAPE of 28x - which is where the US is now - translates into annual expected returns of some 4.4% over the next 10-years (CAPE calculation from Prof. Robert Schiller’s web page. Link is here).

Soon after the study was published CAPE became a bit more popular in the financial press.  2013 was a good year for the strategy and many took notice.  Among the countries followed by the study, the five countries with the lowest CAPE ratios had an average return of 20.7% in 2013.  The five countries with the highest CAPE ratios fell by an average of 17.8%.  This is a difference of close to 40 percentage points.  Massive for just one year.

However the strategy simply did not work in 2014. The five stocks markets with the lowest CAPE ratios fell by an average of 16.3%, while the countries with the highest ratios increased by 3.1%.  An investor in the low CAPE countries would have given up almost 20% in savings/returns.  The difference was not as big as the year before, but still was significant (Please see article here for a good summary of CAPE in 2013 and 2014.  For the last few paragraphs I took the numbers from the website here and added returns from the main index that tracks Jordanian stocks).

Much of the strategy’s poor performance last year was due to falling currency in the two countries with the lowest CAPE ratio - Greece and Russia. They were two of the world’s worst performing equity markets for USD investors with their ETFs falling by 36% and 42% respectively.  The falling Euro and Ruble were large components of this. They were down 12% and 59% respectively in 2014.

Getting 15% Without Much Work.  My Own Test

Not one to rely on others, and wanting to extend this into more countries, I did my own simple back test (actually it is ‘we’ as the very capable JC Ho did most of the heavy lifting).

The sample universe in my back test are 64 countries tradable through Instinet, an institution-focused broker (see here). 

Countries were ranked according to their weighted average CAPE ratio. The five countries with the lowest CAPE ratios were put into the ‘cheap’ basket, while the five countries with the highest were put into the ‘expensive’ basket.  We then calculated what the returns would have been if one had invested in each basket for a year, and then rebalanced the basket according to the next year’s ‘cheap’ and ‘expensive’ countries.  

The hypothesis was that over time ‘cheap’ will outperform ‘expensive’.

For returns we followed the most commonly used index of each country.  These are typically the ones that fly across the screen on Bloomberg TV and CNBC.  For example in Hong Kong we used the Hang Seng Index, and not the MSCI Hong Kong or MSCI China Index.

We adjusted all returns for USD. Currency movements can have a large impact when investing globally and I wanted to see what the returns are in the world’s ‘base’ currency.

Financials as defined by the database we used were excluded.  The reason being that I don’t enjoy analyzing banks and insurance companies and am not very good at doing so.  At the end of the day I’m looking for good investments and I might as well look where I think I can add value.

The test went back to 13 years covering the period from 2002 to 2014.  We were told by the folks at our super expensive data provider FactSet, that their data before 2002 are not as reliable as they were buying them from other vendors rather than entering the data by themselves.

Results

The findings support the hypnosis that ‘cheap’ outperforms ‘expensive’.

For the 13 years to 2014 investing in the 5 cheapest countries based on our simple CAPE screen resulted in a compound average USD return of 14.5% (CAGR).  Meanwhile investing in the 5 most expensive countries generated a return of 7.8%.

If one invested USD100 in this strategy at the beginning of 2002 it would have been worth over USD550 by the end of 2014 versus just over USD260 if one invested in the ‘expensive’ strategy.  Another way to look at is that the person who invested in ‘cheap’ countries would have more than twice as much over the test period.

An investment in the ‘expensive’ strategy would have done okay – a CAGR of close to 7.8% isn’t bad, but it leaves a lot of money on the table.  6.7 percentage points on average every year.  Instead of doubling one’s money every 5 years with the cheap strategy, it took a little over 9 years with the expensive strategy.

However both strategies did better than the S&P500. During the same time period the S&P500’s CAGR was 4.6% meaning that one could have made a butt-load more money by investing in cheap non-US countries.

Currency

Currency changes in aggregate were not as big as a factor as I expected.  But there were several years when currency played a large role.

Over the course of 13 years, currency changes of the cheapest five countries added a positive 0.5% per annum.  However this was volatile with the largest positive currency effect of 9.5% in 2006.  The greatest negative effect from currency was last year - 2014 - when the strong USD took away all the market gains and then some.  The 5 cheapest markets were up 7.9% on average when measured in their local currencies, but were down 9.9% in USD.

For the expensive countries the currency changes added more to the returns.  Currency changes added 2.1 percentage points on average to the returns of the expensive countries. Much of this occurred in 2002 and 2003 when currency changes added 10.6% and 12.1% respectively to the expensive markets’ return.

Dogs of the Dogs

One interesting aspect of the study was that cheap countries tend to stay cheap for a while.  Romania has been on the list of the five cheapest CAPE countries for six out of the last seven years and it shows up again in 2015.  In those six years the Bucharest Stock Exchange Trading Index has on average increased by 8.3%, with most of the negative returns occurring during the year of the global financial crisis.

Year	BET Index YoY % change (Calendar Year, USD)
2014	-4.6
2013	30.9
2012	17.7
2011	not in cheap 5
2010	4.3
2009	57.8
2008	-74.7
2007	27.0

Drawdown 

One drawback to this has been the fact that both strategies have not exceeded their 2007 peaks.  This means that they are both into their 8th year of drawdown.  The cheap strategy is a little closer being only 11% below its peak NAV. At the end of 2014, the expensive one remains 25% below its 2007 peak.

This is in contrast to the S&P500, which is 35% above its last peak in October 2007. “Don't fight the Fed” has been good advice since US quantitative easing/currency debasement/money printing was started in earnest at the end of 2008.

Research Alpha Could Help

I think these results can be improved on.  By sticking to high-quality companies in cheap markets I suspect one could do better than the 14/15% return above.  I add ‘alpha’ by only investing in companies that I think are controlled by high quality shareholders, have a simple structure and trade at cheap valuations (Research Alpha write-up is here).

This worked well for me in Greece and in many other of my investments elsewhere.  As of early February 2015, my six Greek stocks were up 156% in USD compared to the 3% increase for the US-listed Greek ETF (GREK).  This is not bad for 2.5 years in a volatile market.

What’s Cheap and Expensive in 2015?

Going into 2015 the list of five ‘cheap’ countries has not changed much as compared to the previous year.  Three of the five are the same (Slovak Republic, Romania, and Bahrain). In contrast none of the ‘expensive’ countries are the same in 2015 as they were in 2014.

If January is a good predictor of a year’s returns, ‘cheap' CAPE may not be a good strategy in 2015. Headline index returns of all five ‘cheap’ countries were negative in USD falling by an average of 4.6%.  ‘Cheap’ underperformed ‘expensive’ during this time period.

Things turned around in February and the 5 ‘cheap’ markets are now up an average of 2.1%, in the first two months of the year, having outperformed ‘expensive’ in February.

Note that the strategy is geographically concentrated with four of the five cheap countries neighboring each other (Slovak Republic, Romania, Czech Republic, and Hungary). The strategy’s performance in 2015 really depends on the strength or weakness of Central Europe’s equity markets.

“Cheap” 5 as of 1 Jan 2015

	Index	Return Jan 2015 (%, USD)	Return YTD Feb 2015 (%, USD)
Slovak Republic	Slovak Share Index	-4.6	7.4
Romania	Bucharest Stock Exchange Trading Index	-6.4	-5.5
Bahrain	Bahrain Bourse All Share	-0.2	3.3
Czech Republic	Prague Stock Exchange Index	-5.9	0.1
Hungary	Budapest Stock Index	-5.9	5.3
Average		-4.6	2.1

“Expensive” 5 as of 1 Jan 2015

	Index	Return Jan 2015 (%, USD)	Return YTD Feb 2015 (%, USD)
Jordan	Amman Stock Exchange General	0.0	1.2
Croatia	Zagreb Stock Exchange Crobex	-6.2	-8.0
Israel	Tel Aviv 100	-2.4	3.0
India	S&P BSE Sensex	8.2	8.3
Lithuania	OMX Vilnius	-4.4	-0.5
Average		-1.0	0.8

Caveats

This blog post should be taken with a grain of salt.  I think we've been pretty careful in our work, but there is likely a lot of biases and errors. Below are some. I suspect there are a lot more.

• Small sample set.  The most important caveat is the small sample set.  Thirteen years simply does not make for a robust test
• Poor/incomplete data. The database we use - FactSet - is pretty powerful but I've found several errors and omissions in their data especially in the lesser-followed markets.  And I suspect I've only found a small fraction of the errors
• Look-ahead bias.  This means that the sample data may contain information that became available to investors at a point in time, when in fact the information was not yet publicly available.  No matter what the database providers say, I think they backfill much more than they let on
• Investability. Many of the cheaper markets are smaller countries.  The perennially undervalued Romania has over 400 listed companies, but only 23 of them are worth more than USD100m.  The Slovak Republic only has 7. This means that the strategy is fine for a small fund or individual investors, but not something that’s attractive to larger intuitions

However there are two things that lend credence to this study.  Firstly, the simple intuition that one can minimize downside and maximize upside by paying a low price for an asset.  Secondly, the findings are in line with similar studies looking at CAPE as well as other valuation metrics.  Value works. 

Wrap Up

This blog hopefully enlightens readers on the importance of buying undervalued equities and introduced a lesser known ratio to calculate value. Close to 14.5% per annum isn't bad for a fairly simple strategy.

   

Intuition makes CAPE attractive in my opinion.  Valuing a productive asset over the business cycle makes common sense.  It's also fairly simple and straight forward to calculate. This can however make cheap companies difficult to find in a fast growing economy.  In my neck-of-the-woods, Mainland China’s listed companies are not that expensive on an 1-year PE basis, but it is hard to find more than a handful that are attractive on a 7- or 10-year CAPE basis. Either the country has found a way to stop the business cycle or stocks there are overvalued.  The same could be said for the US as well as India and most of Asia.

CAPE is one of the better valuation metrics to use in my opinion. There are many others. Using these ratios successfully many times comes down to how they're used and the investor's own self-discipline. Sticking to one's investment process overtime should lead to out-performance.  Valuation should be part of every investor's arsenal and CAPE may be one of its better tools.