Monday, March 9, 2015

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.

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 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.

BET Index YoY % change (Calendar Year, USD)
not in cheap 5

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

Return Jan 2015
(%, USD)
Return YTD Feb 2015 (%, USD)
Slovak Republic
Slovak Share Index
Bucharest Stock Exchange Trading Index
Bahrain Bourse All Share
Czech Republic
Prague Stock Exchange Index
Budapest Stock Index


“Expensive” 5 as of 1 Jan 2015

Return Jan 2015
(%, USD)
Return YTD Feb 2015 (%, USD)
Amman Stock Exchange General
Zagreb Stock Exchange Crobex
Tel Aviv 100
S&P BSE Sensex
OMX Vilnius


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.