Global Value

Book by Meb Faber

Article and Review by GlobalMacroForex

In his book, Meb Faber presents his value equity strategy, which is investing in the stock ETFs of countries with a low CAPE ratio.  Some of the main points of this book are:

·     Why is the CAPE ratio better than the P/E ratio?

·     Do global CAPE ratios predict future returns?

·     Criticism of the CAPE for accounting changes

·     Most investors have a home country bias

·     The flaws of market capitalization indexes

Why the CAPE ratio over the P/E?

The CAPE stands for Cyclically Adjusted P/E ratio.  The concept, created by Nobel prize winner Robert Schiller, looks at the P/E ratio of an index by taking 10 years of averaged earnings compared with the price.  In Schiller’s view, the problem with a basic P/E ratio is that the business cycle distorts earnings.  The P/E ratio is low in the good times since the company is earning a lot.  Also, this distortion could label the P/E as high in bad times since the company isn’t earning as much that quarter or year. 

By using the average earnings over 10 years, one can get a better picture of when it’s a good time to buy the equity index or if it’s a bubble.

Global CAPE ratios predict future returns

Mr. Faber found that the CAPE ratio does a great job at helping investors determine which country will give them the best value equities using a country-wide ETF.  As the chart from his book shows, usually the lower the CAPE, the higher the return!

Faber sympathizes with investors who are nervous about investing in countries such as Greece or Russia but assures the reader that the longer the time horizon, the more accurate the CAPE is.  The fact that investors cringe to invest in these places is why it’s so cheap and distorted.

This map from Norbert Keimling of Star Capital shows the updated Global CAPE:

Criticism of the CAPE for accounting changes

Mr. Faber points out how some like to criticize the CAPE for changes in accounting measures over the 10 year period that could potentially bias the earnings, so the CAPE is not comparing apples to apples.  One critic, Siegal, even took the time to create his own updated version of the CAPE using earnings adjusted for changes in accounting.  However, Meb Faber found that the adjusted earnings version and the original CAPE both have the same overall highs and lows.  There really isn’t a trend difference, it just has lower numbers as the peaks.  The changes in accounting measures don’t change the overall bubble levels of equity indexes.

Home Country Bias

Mr. Faber points out that most investors have a home country bias.  He thinks the Global CAPE is a great way to diversify to other countries.  The United States is a much smaller part of global GDP than it’s market capitalization, even on world indexes.  Therefore it makes more sense than ever to eliminate one’s home country bias.

Market Capitalization indexes mislead

Market Capitalization indexes are dangerous because they encourage investors to buy the most expensive companies.   The expensive companies dominate the price of the index.  To show how destructive this is, Mr. Faber points to a chart from Ned Davis of Research Affiliates that shows “what if” you had invested in the company of the S&P500 compared to if you had invested in the full index.

In a sense, Meb Faber suggests the S&P500 is more like an actively managed fund because the losers don’t survive and the winners take up larger portions of the fund.

Conclusion

Meb Faber does a great job at making the case for using the CAPE ratio to spot bubbles in equity prices and to see when to invest in value.  He acknowledges that it would feel uncomfortable to invest in cheap countries (e.g., Greece/Russia) but that is where the real value is.  He encourages investors to tune out television’s talking heads and follow the cold math and logic.  I highly recommend this book; it has lots of additional information I did not mention here, such as comparisons between the CAPE, Tobin Q, and GDP-to-Market Cap ratios.

You can find the updated CAPEs for each country from the website of  Norbert Keimling of Star Capital.