One proven route to market-beating returns is to invest in cheap stocks. But it’s a lot harder than it looks.
If you want to beat the market, you can’t just track the index – you have to do something different. One strategy that has made outsized returns in the past (yes, the past is no guide to the future, but it’s all we’ve got) is to buy assets when they’re cheap. This goes for entire markets as well as individual stocks. One ratio that we’ve always liked for valuing markets is the cyclically-adjusted price/earnings (or Cape) ratio. It’s defined below, but put simply, if you invest when the Cape is low (and the market is cheap), subsequent returns are higher than if you buy when the Cape is high. A recent review by The Brandes Institute notes that if you’d bought the US market on a Cape of less than seven in July 1982, you’d have made an annualised return of 14.3% for the next ten years. If you’d bought in December 1999, when the Cape was above 44, you lost 2.5% a year for the next decade.
You can’t use the Cape to time the market – the US is expensive right now (above 30) and has been for a long time. But value investing is about patience. Let the expensive markets do what they will – we’re interested in the cheap ones. The good news is that, while the US has been most heavily studied by researchers, Cape appears to work across global markets too. You can monitor Cape and other market valuation measures at StarCapital’s website.
So what looks cheap today? The top ten includes Russia, Turkey, Hungary, Singapore and Spain. I know what you’re thinking. “Invest in Turkey? Russia? But look at the state of them!” This is true. And, of course, it’s the reason these markets are as cheap as they are – you don’t get opportunities when people feel comfortable. To bag a bargain, you have to invest in assets that no one else wants to buy.
The good thing about buying an entire stock- market is that you’re not exposed to individual company risk. But clearly it’s still not risk free. Prices can keep going down, but there are bigger risks too. Politics can take a radical turn for the worse. As emerging markets expert Mark Mobius points out, state appropriation of assets – meaning you can’t rely on property rights, which underpin the value of any equity – is a bad sign.
This is why you have to diversify – don’t just buy one cheap market. Mebane Faber of Cambria Investment Management suggests that a strategy of buying the cheapest 25% of global markets (which amounts to about ten to 12 indices) is best. And if you still can’t bring yourself to invest in far-flung, high-risk markets, the good news is that right now the UK is among the cheapest options out there – on a Cape of just under 16, it’s currently ranked twelfth-cheapest market in the world by StarCapital.
The Cape ratio explained
Investors often use the price/earnings (p/e) ratio to judge whether a stock is cheap or not. It’s easy to calculate (hence its popularity) – you simply divide the share price by earnings per share. A low number (below ten, say) suggests that you aren’t paying much for each £1 of earnings, while a high number indicates that a stock may be expensive, or that it is growing rapidly.
However, the basic p/e is highly flawed. Using just one year of profits means a stock – particularly one in a cyclical business, such as mining or house building – can look cheap because profits happen to be peaking at that point, and are set to plunge when business turns back down in line with the economic cycle. So in the 1930s value investors Benjamin Graham and David Dodd suggested that analysts should instead take the average of earnings over five to ten years. This smooths out the data over the economic cycle.
John Young Campbell of Princeton and Robert Shiller of Yale University revived Graham and Dodd’s suggestion in a 1988 paper. This suggested that the ratio of prices to ten-year average earnings was strongly correlated with returns over the next 20 years. Shiller promoted the idea of a ten-year cyclically-adjusted p/e ratio (aka Cape) in his book Irrational Exuberance, and hence it is sometimes known as the Shiller Cape. Some of the Cape’s most notable successes have included indicating that the US stockmarket was extremely expensive ahead of the tech-bubble crash in the late 1990s, and also that it was unusually cheap after the 2008-2009 financial crisis (although it never plumbed the depths of prior troughs).
The Cape has been shown to work with other global markets too. Currently the US market is particularly expensive compared with its long-term average on a Cape basis and has been for some time – although in 1999 the S&P was even more overvalued than it is today.