Low CAPE Indexing: EPOL, EWS, EWZ, ERUS, TUR

After deliberating the issue for the last month, I decided to go ahead and deploy my cash balance and place 10% of my portfolio into global indexes boasting a low CAPE ratios. Today I executed the below trades, which places 10% of my portfolio into the five country indexes boasting the lowest CAPE ratios in the world:

Poland – EPOL – 36 Shares @ $27.245

Singapore – EWS – 39 shares @ $25.215

Brazil – EWZ – 23 shares @ $42.625

Russia – ERUS – 29 shares @ $34.0795

Turkey – TUR – 23 shares @ $41.935

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Growth doesn’t bring much to the party

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Counterintuitive Findings

Prior to reading Deep Value by Tobias Carlisle, I always thought that the key in value investing was to find cheap companies that could grow fast.

Buffett even discussed the merits of combining growth and value in his 1992 letter:

Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

A key point of Tobias’ book is that growth is not how value delivers returns. The discount from intrinsic value and the closing of that gap is the key driver of return in a value portfolio.

De Bont & Thaler

He cites two studies in the book that are compelling because of how counterintuitive they are. They were both conducted by Werner De Bondt and Richard Thaler. The first study looked at the best-performing stocks and compared them to the worst performing stocks in terms of price performance. They found that the worst performers go on to outperform the best by a substantial margin.

They also looked at this in terms of fundamental earnings growth. They reached the same conclusion: the worst companies outperform the best.

A Simple Backtest

I decided to backtest more recent data myself to see if this still holds true. In an S&P 500 universe, I performed a backtest going back to 1999. I compared the performance of the 30 companies with the fastest growth in earnings per share to a portfolio of the 30 worst stocks, rebalanced annually.

Just as De Bont & Thaler determined before, the 30 worst companies continue to outperform the 30 best.

bestvsworst

Keep in mind: there is no other factor involved here except for 1-year earnings growth. We’re not even looking at these stocks in a value universe: it’s simply the 30 fastest growers vs. the 30 worst.

Value Drives Returns

The evidence suggests that value alone is the best determinant of future returns. Growth isn’t nearly as powerful.

For instance, I also tested the performance of a universe of stocks with a P/E less than 10. This universe of stocks delivered an 11.69% rate of return since 1999. Within this winning universe, if you bought the 20 stocks with the best earnings per share growth then the return actually declined to 9.77%. Fast growing value stocks actually underperform the overall value universe.

The same is also true from a macro standpoint. Looking at the performance of the S&P 500 since the 1950s, the greater determinant of future returns is starting valuation, not actual business performance.

decades

As you can see, the valuation of the market at the start of the decade (Shiller CAPE and the average investor allocation to equities – both valuation metrics are discussed in this blog post) are far more predictive of future returns than actual business performance.

Look at where the divergence is widest — the 1980s versus the 2000s.

The 2000s was a much better decade than the 1980s in terms of actual business performance. During the 2000s, earnings grew by 191%. In the 1980s, earnings only grew by 16.40%.

However, the 1980s witnessed a 409% total return for the S&P 500, while the 2000s actually clocked in a net decline of 9%.

Of course, there were macro events driving both markets. In the 1980s, returns were bolstered by interest rates declining from all-time highs once inflation was brought under control. At the end of the 2000s, we suffered the worst financial crisis since the Great Depression and the worst recession since the early 1980s, which negatively impacted stocks at the end of the decade.

With that said, the key factor behind the returns was the overall valuation of the market, not macro events or even business performance.

The undervaluation of the US market in the early 1980s was the true force that propelled the bull market forward.  In 1980, the Shiller CAPE for the US market was 8.85 and the average investor allocation to equities was only 23%.

In contrast, the overvaluation of the US market in 2000 was the key force that drove down returns over the next decade. In 2000, the Shiller CAPE was 43.77 and the average investor allocation to equities was 50.84%. Actual corporate results were impressive but that wasn’t enough. Valuation mattered more.

Conclusion

The conclusion is both simple and radically counterintuitive: valuation matters more than growth in predicting future returns for a single company stock or an entire market.

In the long run, growth simply doesn’t bring much to the party.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

A financial health check up for the S&P 500

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Debt: The Best Measure of Risk

One of my core beliefs as an investor is that debt is the best measure of risk.

Academic attempts to define risk as the volatility of a stock price are ridiculous. Risk is the possibility of a permanent loss of capital. The risk that a company will go out of business is heightened through the use of leverage.

There is no perfect measure of risk, but I think that debt levels give the clearest signals about the risk of an investment. A company without debt can withstand incredible business problems, while a company in deep debt won’t be able to survive the slightest shake-up.

Debt levels are one of my chief concerns when I purchase a stock.

As a deep value investor, I focus on firms that are going through a tough time in their business or sector. Because they are going through difficulty, it is paramount that balance sheet risk is low. If they have a healthy balance sheet, then they will be able to survive whatever trouble they are mired in.

I try to find the firms that are still profitable and are still in a strong financial position so they can survive the temporary business setback.

Corporate debt at all-time highs!

Due to my views on the subject, I was alarmed when I read several articles indicating that debt is rising to all-time highs within the S&P 500. High leverage levels were one of the driving forces behind the crisis of 2008.

The narrative of the corporate debt scare articles goes like this: (1) the Fed made debt too cheap after the crisis, (2) companies are taking advantage of it and spending it on frivolous activities like buying back shares, (3) corporate debt is now at all-time highs and will trigger a severe credit contraction in the future.

The headlines are usually along the lines of “corporate debt is at all-time highs!”

Well . . . based on inflation alone, corporate debt should regularly hit all-time highs in raw dollar terms. Looking at the total dollar volume of debt issuance doesn’t make a lot of sense.

The Real Story

What, then, is the best way to measure the debt risks to corporate America? Many like interest coverage ratios . . . but I don’t like this, as interest rates can change on a dime for the better or the worse. I look at total debt relative to earnings and assets.

When I assembled the data, I was pleasantly surprised to see that the situation is actually not that bad. Corporate America is financially healthy. Despite record low interest rates, corporate America hasn’t gone on a debt binge. Quite the opposite. They have been deleveraging since the crisis.

debtebitda

debtequity

This suggests that if we do fall into a recession, it won’t be the painful credit crunch we endured in 2008. Even though interest rates are at historic lows, corporate America is not taking the bait.

This also explains why the Fed has been able to keep interest rates near all-time lows. Few companies are actually taking advantage of the low rates.

Financial journalism is in the business of creating sensational click-bait headlines. They aren’t particularly useful. This is why individual investors need to do their own homework and think independently.

I think low corporate debt is also is a major reason that the economy isn’t growing more than 2% even though interest rates are rock bottom.

While it means less growth for the economy, it also means less risk for corporate America. That’s a good thing.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Macro is hard and probably a waste of time

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Macro is probably a waste of time, but I can’t help myself

Everywhere I turn in discussions of the stock market, everyone seems to have made a similar conclusion: (1) The stock market is in a bubble, (2) the Federal Reserve created the bubble, (3) When the bubble bursts, we will be faced with financial Armageddon.

The mood among value investors looking at a historically high CAPE ratio is something like this:

I love talking and thinking about Macro, but I suspect it is mostly a fun waste of time and not entirely useful. Peter Lynch offered the following advice about these matters:

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

I think living through 2008 might have polluted everyone’s minds, the same way 1929 poisoned the minds of a generation of investors and made them stay out of the market for life to their own detriment.

Unlike the 2000-02 meltdown, in 2008 there was nowhere to hide. This is because the 2000 collapse was driven by an overvalued stock market falling apart. 2008 was different because it was an economy-wide credit contraction that caused everything to decline.

This left investors with a kind of financial PTSD. As for myself, I had hardly any money at the time, so I wasn’t concerned about my financial assets going down, but I was still consumed by fear.

By day I am an operations nerd for a bank, so I was acutely aware of what was going on. I had very little savings (I was in my mid-20’s and had just started making decent money), a pile of debt and I was mostly worried about basic survival if I lost my job and faced a Depression job market. My main personal lesson from the crisis was about the dangers of being in too much debt and not having sufficient savings. Today I have zero debt and an emergency fund if I lose my job. I sleep better at night.

If anything, this is why the simple low-PE low-debt Graham strategy intuitively appeals to me. Financial problems facing a company or a person are always manageable . . . Unless you’re in heavy debt.

Post-crisis, everyone is consumed with trying to predict the next meltdown after getting burned so badly.

We look at investors who made the right call — people like John Paulson — and are in awe that they made the right call. They knew what was going to happen. We want to be able to predict what is going to happen. We become obsessed with finding tools that will help us prevent losing money.

Post-crisis hindsight also puts the permanent bears in a positive light. They are lauded for getting it right in 2008, but how much money has been lost listening to them since then?

Prediction is Hard

As small investors, I think we may have to just accept the fact that if we want equity-sized returns, we need to take equity-sized risks. A 25% drawdown a couple times a decade is pretty standard. A 50%+ drawdown 3 or 4 times a century is also typical. The average person lives about 80 years, so when they see these events happen a couple of times it looks extraordinary in the context of our lives and permanently affects our thinking. In the grand scheme of things, these events are not uncommon and we should expect them.

Charlie Munger gave this great advice about the subject:

This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

We can’t invest like 1929 or 2008 are going to occur tomorrow. It’s not a useful long-term strategy for building wealth. We need to accept the fact that we will face those kinds of drawdowns and face the fact that there will be more minor drawdowns frequently (or the 20-25% variety) and don’t give into our emotional need to panic. If we constantly live in fear that a big drawdown is imminent, then we should stay out of the market and won’t earn equity sized returns.

Using valuation tools to time to the market

There are tools to predict future market returns (like the CAPE ratio, the average equity allocation, market-cap-to-GDP, etc.) that give us clues as to where we stand in the cycle, but timing the market using those tools isn’t particularly effective either. I’ve talked about them on this blog.

You can use these tools to predict market returns 10 years out, but it doesn’t tell you if a correction is going to happen tomorrow and they are not particularly useful for timing the market.

The 10-year S&P returns predicted by valuation tools don’t happen in a straight line. My favorite indicator (the average equity allocation), suggests a 10-year rate of return for the S&P 500 of 3.34%. With the 10-year treasury yielding only 2.361%, that actually makes sense. We are likely in store for a decade of low returns across all asset classes. “Low returns over 10 years” does not mean “We are facing Old Testament biblical meltdown.”

(Hell, if we were facing an Old Testament Mad Max kind of situation, what good is your 401(k) going to do you anyway?)

You can use market valuation tools to get a fair understanding of what returns will look like, but it is not a crystal ball. It doesn’t predict if a crash will happen tomorrow or what the road to those returns will look like.

Current valuations are basically where we were around 1973 and 1998. The 10 years after ’73 and ’98 were not particularly good for the indexes . . .  but they were great for value investors, the indexes still delivered a small return, and the world didn’t end. Value stocks had an excellent bull market from 2000-2003 and 1975-1978.

The difference between the two eras is that in 1973-74, value stocks went down with everything else before their bull market in 1975 and in 2000-03 value experienced a bull market during the decline of everything else.

This happened because the 1973-74 event was caused by a real economic shock, while the 2000-03 meltdown was the stock market coming back down from crazy valuations. The 2000-03 collapse was unique in that the market caused the economy to contract, while most meltdowns (like ’73-’74 and ’07-’09) are the economy causing the market to contract. The stock market wasn’t overvalued in 2008, the real estate market was. The decline in real estate caused the economic contraction, which ultimately impacted stocks.

Whether the current situation is like the ’70s or the early 2000s is tough to predict. I suspect that it will be more like the ’70s (value will go down in the bear market with everything else, but then perform nicely). Hopefully I’m wrong and it pans out more like the 2000-03 event. This is discussed in depth in this blog post.

It’s also tempting to short stocks in this environment, but that’s not something I do. You shouldn’t do it, either (unless your name is David Einhorn). Shorting is a dangerous game. For instance, tech shorts in 1999 were correct in their analysis. Even though they were right, most were completely wiped out when tech stocks doubled in 1999. They were ultimately vindicated but, as Keynes warned us, markets can stay irrational longer than you can remain solvent.

It’s tempting to try to time the market with macro valuation tools. I found a great post at Tobias Carlisle’s blog exploring this issue of timing the market using CAPE ratios. You can read the post here and here.  The conclusion is simple: timing the market using valuation tools is a waste of time. He makes the following point:

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns.

Japan

Japan in the 1980s is the common comparison among bears to today’s market. There was a similar sentiment among bears in the late ’90s.

In the 1980s, the success of Japanese firms combined with an easy monetary policy caused a massive asset bubble. There was a widespread perception that Japan was going to take over the world.

Easy monetary policy and rising asset prices are where the comparison ends, however. Valuations in late 1980s Japan were genuinely insane. In 1989, the real estate around Japan’s imperial palace was worth more than all the real estate in the entire state of California.

During the 1980s, the Nikkei rose from around 6,600 in 1980 to 38,000 by 1989. Everyone thought that Japan had figured it out: their management was superior, their workers were better, their processes were more efficient. The zeitgeist was captured in the Ron Howard movie “Gung Ho.”

Like all bubbles, the Japanese bubble collapsed. The Nikkei fell from its high of 38,000 in 1989 to 9,000 in 2003. This is the nightmare scenario that the bears fear will happen to the United States stock market.

Valuation puts this in context. Today’s investors fret of a Shiller PE around 30. In Japan circa 1989, the Shiller PE was three times that at 90. Indeed, there is no comparison between US stocks today and Japanese stocks in the 1980s. Valuations today suggest bad returns in the future for US stocks. Valuations in Japan indicated that a complete collapse was inevitable.

Lost from the typical talk of Japan’s lost decade is a discussion of its actual economy. The focus is solely on the markets. Japan’s economy continued to chug along despite the complete meltdown in markets. Its central bank scrambled to contain the collapse, but likely merely prolonged the pain as the market was destined to return to a normal CAPE. Their unemployment rate has never even gone above 6% during the meltdown!

It took nearly 20 years for Japan to go from a Shiller PE of 90 to a more normal Shiller PE of 15. Markets are worth what they’re worth and they will eventually fall to normal levels of valuation. That’s what happened in Japan. Very little changed in their real economy, it just took a long time to work off their crazy 1989 valuations.

Value in Japan

Even if the US is in a Japanese style asset bubble (even though it is nowhere near those levels), I was curious how a value strategy performed in Japan during their asset meltdown if this were the future for the United States.

It’s encouraging that value-oriented strategies actually performed very well during the Japanese market collapse. In James Montier’s epic The Little Note That Beats the Markethe observed that Joel Greenblatt’s magic formula returned 18.1% from 1993 to 2005 in Japan. EBIT/EV alone returned an excellent 14.5%.

This suggests that as long as you stick to a value framework, even in a market that is in long-term decline, a value strategy should hold up over a long stretch of time.

Conclusions

My apologies if this post is a bit of a mess, but it summarizes many of the things that have been on my mind lately.  To summarize my conclusions:

  • It is probably best for most investors to not obsess over macroeconomics. The smartest people in the world are playing that game . . . and they’re bad at it. We cannot do any better.
  • Market valuation tools are useful for predicting returns over the next decade but aren’t particularly helpful in predicting short-term market moves.
  • The United States is not in a Fed-induced, Japanese-style asset bubble. Our market is high, but a definite return is still likely over the next 10 years.
  • Even if we were in a Japanese style asset bubble (which we’re not), a disciplined value-oriented strategy should still perform very well in the United States.
  • 50% drawdowns 3-4 times a century and 25% corrections are standard. They’re the cost of earning equity returns. If equities went up by their historical 8% average every year in a straight line, they would eventually stop delivering those returns. If you can’t handle corrections of that magnitude, you shouldn’t invest in stocks.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.