18/01/2015 HowtouseCAPEtobeatthemarketandglobalCAPEvalues|ThisisMoney

If you want the best returns, invest in the worst stock markets: How to use
CAPE to beat the market - and the cheapest countries

By Simon Lambert for Thisismoney.co.uk[1]

Published: 10:12 GMT, 1 September 2014 | Updated: 09:18 GMT, 2 September 2014

If you want the best returns, invest in the worlds worst stock markets.

To many investors this would sound like a deeply counter-productive idea, yet it is the theory put forward by US investor Meb Faber for using
cyclically adjusted price-to-earnings ratios, aka CAPE, to deliver long-term market-beating returns.

Crucially, the strategy all hinges on your definition of worst. Mr Faber argues that the worst places to invest in are not the cheap markets
belonging to troubled economies, but the investors darlings that have been chased to heady valuations.

This boils down to a simple value theory of buy low, sell high and spread your risk. The argument being that if you target the cheapest stock
markets - rather than expensive ones - then you hugely increase your chances of success. This is Money caught up with Mr Faber to find out
more.

Russian roulette: Investing in the world's cheapest markets should deliver the best returns, says Mebane Faber's global value strategy.

Mr Faber has built an investing strategy around global CAPE values, which has in turn delivered a US-traded Global Value ETF run by his firm
Cambria Investment Management. He recently released a brief chart-filled book explaining his concept, Global Value: How to Spot Bubbles,
Avoid Market Crashes, and Earn Big Returns in the Stock Market.

Follow his theory and right now you should be buying a basket of countries that includes among others Greece, Russia, Argentina and Italy,
and avoiding markets like Indonesia, Denmark, the USA and India.

You don't need to be a keen student of global markets to spot this turns most tips on where to invest on their head.

But while investors are currently fretting about complacency and high valuations, Mr Faber has some encouraging words for those willing to
go hunting for value.

Theres good news and bad news. The bad is that the US is among the most expensive markets in the world, but the broader world is pretty
cheap, he says.

'You are a bad investor'

One of the first messages in Mr Fabers book is to accept that you are a bad investor.

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He highlights how investors spend an inordinate amount of effort trying to predict and time the market and pick winners, yet most research
demonstrates that they dont do that very well.

Faber writes: You probably think that you are good at picking stocks (and investing in general). We hate to be the bearer of bad news, but you
are not. In fact, you are terrible at investing. Now, there may be a few of you who outperform, and part of that is due to luck, but we are
speaking to the collective you.

The reason we think we are good investors, he adds, is due to the same natural traits that make people think they are a better driver and better
looking than the average person. To sugar the pill he points out that share-picking is very hard and you are going up against the best investors
in the world.

Compounding the problem of over-estimating our prowess we also have a tendency to buy at the top and sell at the bottom.

Investors get upset when they are losing money and euphoric when they are making money, Mr Faber explains. This causes the repetitive
behaviour of selling at the bottom (I cant take it anymore) and buying at the tops (look at how much this went up, look how much money
Im making! Im brilliant).

Evidence bears this out through the wealth of studies that show how investors tend to buy at the most inopportune expensive moments and
shun the markets when they are cheapest.

The AAII stocks sentiment survey shows investors were most enthusiastically bullish about buying shares in January 2000, just before the
dotcom bust, and most fearfully bearish about buying in March 2009, as markets were poised to race ahead after the financial crisis crash.

Bad timing: How investor sentiment to buying shares has varied. The lines show the most and least bullish and bearish dates (Source AAII)

CAPE: How to use it and where's cheap?

So what can you do about your inherent uselessness?

It may sound anathema to most active investors, but Mr Fabers answer is the suggestion that we stop picking individual shares, or even trying
to unearth market-beating fund managers who will pick them for us. Instead, we should adopt a simple strategy based on what he dubs a value
anchor.

His chosen anchor is the CAPE ratio.

CAPE values for global stock markets to the end of June 2014 (Source: Mebane Faber)

The cyclically adjusted price to earnings ratio measure is based on the work of US economist and academic Robert Shiller, although the
concept is typically credited back to Benjamin Graham and David Dodd, the influential investors and authors of investing bible Security
Analysis.

CAPE delivers a valuation measure that divides current market price by an average of annual earnings across a number of years, typically ten.
Hence the fact that it is also referred to as PE10.

The idea is that if you use just one year's earnings, as a traditional P/E ratio does, results can be skewed by where you are in the economic
cycle, especially in boom or bust time. CAPE gets round that problem and allows you to judge valuations better

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and is especially used for valuation comparisons over time.

One way of using this is to decide whether you should be in or out of a stock market at any given time, or how
confident you can be in decent future returns if you invested now.

The theory runs that if the CAPE valuation is below the long-term average then it should be a good time to buy,
if it is average then expect reasonable performance but not bumper returns, and if it is heading for the heights
then its time to beware.

So for example, the US CAPE valuation of 26 puts it well above the average of 16 and above the 20 Faber
suggests could be an in or out of the market cut-off point.

In contrast, the UK CAPE valuation of 13.5 looks much better, and sits below its long-term average of about 16,
according to Mr Faber.

But rather than simply using CAPE to decide whether to be in or out of your countrys stock market, it can be
prescribed to overcome a common investor ailment - home bias.

This is the tendency for investors to be heavily skewed towards assets in their home country, rather than
spreading their risk and potential for rewards around the word.

The best use for CAPE is to go hunting for returns around the world, argues Faber. There are many different
stock markets to choose from and at any given time some will be cheap and some expensive, so why restrict
yourself to your home market?

He says: CAPE is nice. It tells a simple story and for the most part countries are comparable.

His research into global CAPE values since 1980 showed most averaged about 15 to 20, bottomed out at about 7
and hit a maximum at about 45.

This boiled down to a situation where anything below 15 looks cheap and anything above 20 looks expensive.

Of course, there is a reason that markets end up with bargain basement valuations, and that often makes the
idea of investing in them unpalatable Russia being a current case in point.

Mr Faber says the reason for being cheap is that news flow is usually terrible and countries are often doing
something stupid.

But for investors willing to take the plunge and spread their risk across a basket of cheap countries, this
represents an opportunity.

Countries go from being completely miserable to less bad and as the story fades away that is when the returns
start to come back, says Mr Faber.

What you should be doing is buying countries which are cheapest. In the late 1990s that was Scandinavia.
People look at Norway today and its a safe haven.

There are a number of vital things to remember for investors deciding to adopt such a method and take the
plunge, however.

Firstly, Mr Faber says it is vital to buy a basket of the cheapest markets and not just take bets on one or a small
number. Ideally you want to be holding ten, he says.

He is also careful to reiterate that this is a long-term strategy, not a short-term trade, so while rebalancing and
reassessing what is cheap is important you must be patient.

Investing in a low CAPE basket of countries is a strategy that Mr Faber says should hopefully start delivering in
any given year, but he cautions against over activity.

He says: Its really important if you have a portfolio built on this you only look at it once a year. If you dont give it some time, then you really
dont give deep value time to work.

That Mr Faber says this goes against the grain for many more eager investors where a lot of people want to be switching around monthly or
quarterly.

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Mr Fabers book takes his strategy and applies it to investing a portfolio from 1980 onwards, buying the cheapest third of global stock markets
by CAPE and rebalancing each year and also adding an extra filter to try and dodge widespread over-valuation that means you only invest if
a countrys CAPE ratio is below 18.

The returns from such a strategy are shown in Mr Fabers chart below, which features the returns on investing in the cheapest 25 per cent of
countries by CAPE vs buying and holding either US shares or bonds and switching from shares to bonds if CAPE is above 20.

Hunting for global value: The chart below shows a backtest of Faber's theory. It compares investing in the cheapest 25 per cent of the major
markets he tracked, as measured by CAPE, (purple line) vs buying and holding US shares or bonds (blue and red lines), or holding US shares if
CAPE was below 20 and holding bonds if it was higher (green line).

How would you put this strategy into action?

Finding CAPE values

In theory this is a simple strategy to follow. An investor simply buys an equally-weighted basket of the ten cheapest stock markets by CAPE
ratio using an ETF for each. They then sit back and wait for the value to shine through, with the winners theoretically outweighing any losers,
and rebalance to the new ten cheapest markets after a year.

As with many things in life, it isnt that easy though.

The first problem any investor will find with global CAPE ratios is that they can be difficult to track down.

Professor Shiller [2]publishes a publicly available version for the US market on his Yale website, but CAPE values for a full list of countries are
only available for free on the internet erratically and there is nowhere that publishes them regularly. One place that does is Mr Fabers The
Idea Farm, a US-based investing subscription website and newsletter, and that will cost you $299 a year.

Working CAPE ratios out yourself is not easy without access to professional level investing databases - and there is no online calculator that
will do the job for you.

Buying into cheap markets

Once investors have overcome that hurdle they face a new problem, actually buying the markets in question to build their global low CAPE
portfolio.

Despite the much-heralded arrival of the brave new world of ETFs in recent years, which enables investors to track all kinds of markets,
tapping into the full range of individual global stock markets as a UK investor is not so simple.

[3]

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You can buy an ETF for most but not all of the 45 major markets that Mr Fabers approach targets, but many of them will not be UK-listed
funds. This creates a headache for UK investors, as they are likely to end up paying more in charges and crucially face different tax treatment
and may not be able to put them in an Isa.

The key thing to watch out for with any ETF domiciled outside of the UK is whether it has reporting or distributor status. If it doesnt then any
capital gains you make on the investment will be charged as income, so that means that rather than paying CGT of 18 or 28 per cent you
would pay income tax of 20, 40 or 45 per cent.

You can protect yourself by stashing them in an Isa, but many overseas ETFs wont be recognised as Isa eligible by the HMRC.

Overseas dividend income can also be subject to withholding tax, particularly in France and the US, but if you fill in the correct forms the
effects of this can be minimised.

The Global Value ETF

Instead of building a DIY portfolio of low CAPE trackers, Mr Fabers Global Value ETF would do the job for you, but this is where those
overseas ETF problems crop up again. It is only available as a US stock market-listed ETF and the bad news is that it doesnt have reporting
or distributor status and cant go in an Isa.

This is Money asked whether he had considered a UK version of the ETF and Mr Faber said hed love to launch one, but as it is only early days
so far for the fund this will not be on the cards for the near future.

CAPE has become an increasingly hot topic in recent times, so someone else may also launch a UK-listed ETF in the future.

Troubled: Argentina led by president Cristina Fernandez de Kirchner is in technical default due to a row over restructured bond payments
with holdout investors, it has dubbed 'vulture' funds. Its stock market is cheap though.

Is CAPE the answer for investors?

Mr Faber makes a convincing case for investing globally using CAPE as your guide, but as ever anyone considering following a strategy or tip
should do their own research and consider whether it is right for them.

The practical difficulties of doing so aside, a Faber-style low CAPE strategy is a relatively low maintenance one to adopt. You rebalance once a
year and sit back and wait for the value to shine through.

But it is worth bearing in mind that this is a strategy that requires a great leap of faith. You have to believe that what has happened in the past
will continue to happen again and that those low CAPE markets will outperform.

There is a wealth of evidence that suggests that value investing can deliver good returns, whether it is based on ratios that use dividend yields,
price-to-book measures or price-to-earnings measures.

However many investors make the case for adding a margin of safety by combining value and quality - hunting out cheap investments with a
solid backing.

Deciding to invest in the ten cheapest markets by CAPE around the world is a value strategy, but it doesnt necessarily deliver quality.
Countries will typically be cheap for a reason, for example Russia and Argentina, which are in conflict with international opinion and in

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default, respectively.

Investing in the cheapest countries may also involve a personal moral question - some may believe that investing in Russia after its annexing
of the Ukraine is unethical.

You also need patience for this strategy and to be able to stomach more bad news. As Mr Faber points out, expensive markets can keep rising
and get more expensive and cheap markets can keep falling and get cheaper.

There is also the issue that if a market wises up to a strategy that works, returns are crimped as trades become increasingly crowded. A low
CAPE strategy could ultimately be undermined by enough people realising they are Mr Fabers 'bad investors' and changing their ways.

That may be unlikely to happen though.

Further reading on CAPE:

> Meb Faber: Global Value: How to spot bubbles.... (Book on Amazon - brief with charts)[4]

> Meb Faber blog[5]

> James Montier: A CAPE crusader (PDF)[6]

> Jeremy Siegel: Don't put faith in CAPE crusaders (FT.com link)

> Jeremy Siegel: The Shiller CAPE ratio: A new look (PDF)[7]

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MR MOTO[8], LONDON, United Kingdom, 1 month ago

SOON 15% OF AMERICANS WILL BE OVER 65(45+MILLION),INVEST IN HEALTHCARE AND CARE/NURSING HOME COMPANIES IN USA.

Amrik[9], Birmingham, 3 months ago

stay away from russian companys they will steal your money!

UKValueInvestor[10], Ashford, United Kingdom, 3 months ago

It's good to see CAPE getting some mainstream publicity and a low-CAPE weighted strategy is certainly a good idea, just not one which is
likely to gain much traction with most investors.

alfonso55[11], Cornwall, United Kingdom, 4 months ago

Didn't these experts say the same thing about iceland

null[12], United Kingdom, 4 months ago

Seems like a contrarian pitch. Great for people with a lot of money who can afford to gamble some on a high risk for good reward. Absolutely
terrible and shocking advice for the majority that dont have money to lose.

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Harry Hall[13], Maidenhead, United Kingdom, 4 months ago

Best advice I've seen all year LOL

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1. http://www.thisismoney.co.uk/home/search.html?s=&authornamef=Simon+Lambert+for+Thisismoney.co.uk

2. http://www.econ.yale.edu/~shiller/
3. http://www.thisismoney.co.uk/money/diyinvesting

4. http://www.amazon.co.uk/Global-Value-Bubbles-Crashes-Returns/dp/0988679914

5. http://mebfaber.com/

6. https://www.gmo.com/America/CMSAttachmentDownload.aspx?
target=JUBRxi51IIA1YdxRKKPedC4G2eurBn2%2bd3ARrjvveda8sumcugE6dXREamdLtHkcrzQlZPEp7Lk%2bmHtezRPbWPlPtbu4%2bIbUMS%2f7FxlvmLDUJ1

7. http://www.q-group.org/wp-content/uploads/2014/01/2013fall_siegelpaper.pdf

8. http://www.thisismoney.co.uk/registration/1365208321367621/MR-MOTO/profile.html

9. http://www.thisismoney.co.uk/registration/5688995/Amrik/profile.html

10. http://www.thisismoney.co.uk/registration/1411495621930251/UKValueInvestor/profile.html

11. http://www.thisismoney.co.uk/registration/5304488/alfonso55/profile.html

12. http://www.thisismoney.co.uk/registration/3146700/null/profile.html

13. http://www.thisismoney.co.uk/registration/1406385696805572/Harry-Hall/profile.html

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