The full title of this book is Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market by Meb Faber (2014).
This is a large, thin book, coming in at around 70 pages with large font size and good spacing. As a number of other book reviewers have commented, this is more similar to a lengthy article than a typical book. As such, it is a pretty quick read. One good thing about the book is that it references a number of other relevant articles/papers/books by other authors so you can dig deeper into the material.
There are two main ideas from the book
- Your returns are the best when you buy low, i.e. when some measure of value is at a historic or relative low. The exact valuation measure doesn’t matter, as most of them perform just as well.
- Diversify across countries. Invest more in countries that have a lower valuation.
I found a good summary of the book in Meb Faber’s article here.
- Future returns are lower when valuations are high, and future returns are higher when valuations are lower. Valuations as denoted by the CAPE ratio.
- When inflation is in the 1-4% “comfort zone”, investors are willing to pay a valuation premium compared to when there is high inflation or outright deflation.
Various Value Metrics Work Similarly
- The Leuthold Group had an article titled Stock Market Valuation: What Works and What Doesn’t which showed that various models, e.g. P/E, ROE, Dividend yield, P/B, P/CF, P/S, etc. are decent at forecasting stock returns. Other models including Q-Ratio and market cap to GNP/GDP (Buffett’s) work similarly.
- A 1991 Michael Keppler study titled The Importance of Dividend Yields in Country Selection showed that the highest yielding countries outperformed the lowest yielding ones by more than 12% per year.
- Samuel Lee’s Morningstar article The Hedgehog’s Error sorts countries by P/B which also showed good results.
Profit Margins Mean Revert
- Peak earnings go hand-in-hand with peak valuations. When earnings revert back to mean (and below), the valuation will also collapse.
The Problem with Market Cap Weighted Indexes
- The leader in any sector (largest market cap company in each sector) underperforms the average stock in its own sector by 3.3% per year for the next decade.
- You can improve performance if you exclude companies that have been sector leaders any time in the past decade.
Global Stock Trading System
- Basic method
- Sort all countries by their CAPE ratio.
- Investing in the most undervalued countries (lowest 25% of CAPE ratios), rebalanced yearly, will produce significant outperformance compared to buy-and-hold market cap and equal weighted indexes.
- This does not protect an investor when all countries are expensive in a global equity bubble like 1999.
- It is very important to buy a basket of countries rather than just one or two. An investor needs some diversification to avoid catching a “falling knife” in any one country. We suggest investing in a basket of perhaps the 10 cheapest countries (which is about the top 25% of the developed and emerging universe).
- Methods to reduce volatility and drawdowns
- Apply a filter by only investing long if the country was below a CAPE ratio level of 18.
- Use a trend-following indicator as a method for entering and exiting markets (e.g. moving averages).
- Use various valuation indicators and look for them to line up with a similar conclusion.
- Look at how much a market has already declined (i.e. drawdown from peak-to-trough, on a monthly basis)
- At a minimum allocate your portfolio globally reflecting the global market cap weightings. To avoid market cap concentration risk, consider allocating along the weightings of global GDP. This would mean closer to 60-80% in foreign stocks.
- Consider overweighting the cheapest countries and avoiding the most expensive ones.
- The standard CAPE uses 10-year data. Examining various CAPE ratio measurement periods of 1-10 years, the best parameter is 7 years, and the worst parameter is 1 year. The best range seems to be 5-10 year.
- Morgan Creek Capital Management CEO Mark Yusko: “Investing is the only business I know that when things go on sale, people run out of the store.”
- Annual study by DALBAR of “The Quantitative Analysis of Investor Behavior“
- Criticism on DALBAR’s calculation methodology.
- Shiller’s Cyclically Adjusted Price-to-Earnings (CAPE) Ratio
- Jeremy Siegel’s NIPA CAPE Ratio: Paper
- Jeremy Siegel’s NIPA CAPE Ratio: Slides
- Rob Arnott’s King of the Mountain article
- Russell Napier’s Anatomy of the Bear
- Joachim Klement’s Does the Shiller-PE Work in Emerging Markets
- Angelini, Bormetti, Marmi, Nardini – Value Matters: Predictability of Stock Index Returns
- Credit Suisse’s Global Investment Returns Yearbook 2015
- Robert Arnott’s The Fundamental Index: A Better Way to Invest
- Robert Arnott’s FAJ article: Fundamental Indexation
- O’Shaughnessy’s Combining the Best of Passive and Active Investing
- Samuel Lee’s Morningstar article: The Hedgehog’s Error