Many believe that the way you allocate your money is just as important as picking the right stocks.
That view was shared by Mebane Faber in chapter 10 of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.” In previous chapters, he argued that American investors should be allocating some of their money to other countries, countries where the valuations are lower.
In his research, he found that investing in stocks or indexes with lower valuations lead to higher returns and vice versa. In addition, he found that there are usually significant valuation differences in countries at the same point in time.
But even if you aren’t interested in putting your money into the cheapest countries, you should still think about “global stock allocation with a value mindset.” As Faber pointed out, there is something called “home country bias” and it occurs in all countries. The implication is that investors miss opportunities because they don’t look at stocks beyond their own borders.
While that is true, I would add there is an important reason justifying a home country bias: currency risk. If you invest outside your home country, you face the constant risk that your currency or the one in which you are investing will change to your disadvantage. Changes could also be to your advantage, but this is a persistent risk; some get around it by investing in funds or exchange-traded funds that hedge currency risks.
Getting back to Faber’s argument, he noted the U.S. domestic market in late 2013 and early 2014 (just before his book was published) was one of the most expensive worldwide. So, wouldn’t it be worthwhile to consider other countries? He added, “A value approach works not just by investing in the cheapest markets, but also by avoiding the most expensive.”
If you use index funds to invest either at home or abroad, you may have to contend with weighting by market capitalization. This refers to the way indexes are constructed, which can have a material effect on returns. In discussing this issue, Investopedia suggested we think of an index like the S&P 500 as a pie. In a market-weighted index, the biggest companies make up the biggest part of the pie. On the other hand, an equal-weighted index will include all companies in equal proportions.
Why is this important? Faber cited the work of Rob Arnott and his article, “Too Big To Succeed.” Arnott found that the leading company in any sector will underperform the average stock in that sector by 3.5% in the following and subsequent years, up to 10 years in fact, and sometimes even longer.
The logical conclusion from that finding is that investors might beat an index by simply constructing a portfolio that excludes its leader (which I understand to be the company with the largest market capitalization). Arnott argued that such a portfolio could be further improved by leaving out all companies that had been leaders at any time in the previous 10 years, since that drag lasts for a decade, more or less.
Faber added that the most important problem with a market cap index and buy-and-hold is that it ignores valuations. Thus, when overvalued assets get to be bigger and bigger parts of the market, then you should probably think about getting out of that market. For example, I would offer the case of former stock market darling, and later bankrupt, Nortel Networks. It was one of the tech companies involved in the dotcom bubble of the late 1990s and came to represent more than 30% of Canada’s main stock market, the Toronto Stock Exchange. When it came crashing down, its inclusion in many Canadian indexes ensured that much of the Canadian market would also be hammered.
The author pointed to the huge Japanese bubble of 1989, when the cyclically adjusted price-earnings ratio rose to about 100, more than double the CAPE ratio in the United States in 1999 (as the dotcom bubble crested). After that bubble burst, Japan experienced more than 20 years of negative returns, an average of -2% per year. He also cited Alliance Bernstein, which published a table with this title: “Cap-Weighted Indices Are Prone to Concentration Risk.”
Into this mix, Faber introduced the idea of passive versus active management, pointing out that even passive indexes are actually active because they are based on a set of rules. He wrote that while the original indexing idea was revolutionary, the market cap weighting methodology was not optimal.
So over the past three decades (before 2014), fund managers have found ways to put together what he called “mechanical portfolios”, which are indexes that outperform the main market cap indexes.
Winding up the chapter, he listed three actions that investors could apply to enhance the “future risk-adjusted returns of their equity portfolio”:
- Allocate your portfolio to reflect the global market cap weightings; for Americans, this would mean about a 50% weighting in global stocks or funds (based on 2013 valuations).
- To minimize the risk of market cap concentration, consider allocations based on the weightings of global gross domestic product. In 2013, that would have involved 60% to 80% in non-American stocks.
- Take a value approach to equity allocation, which involves overweighting the least expensive countries and underweighting those that are most expensive.
As he warned in the previous chapter, global allocation should involve a basket of perhaps 10 countries, rather than just one or two.
Conclusion
In this final chapter of “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market,” Faber built on his argument that investors should look beyond their own borders.
He addressed the problem with home country bias and recommended, at the time the book was published, that investors use a value mindset in putting together a portfolio. That would mean shopping in low-valuation countries and avoiding those that are expensive.
As part of that value mindset, investors should also be wary of market capitalization indexes because of overvaluation caused by the biggest players in them. Leaders in market cap indexes are likely to underperform the rest of the index, dragging down overall returns.
Disclaimer: This review is based on the book, “Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market” by Mebane (Meb) Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Global Value: Valuation Extremes and Buy-Sell Signals
- Global Value: CAPE Ratio Valuations at Home and Abroad
- Global Value: The CAPE Ratio, Inflation and Criticisms
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