Going Global: Evaluating Foreign Investments With CAPE

While investors remain understandably leery about the economic environment in the new year, many are looking to various corners of the market for more meaningful and stable returns. Mebane Faber, PortfolioManagerat Cambria InvestmentManagementand co-founder of AlphaClone, recently took the time to discuss which trends investors are likely to see developing in 2013 and how the innovative CAPE ratio can help investors pick more promising investments. ETF Databse (ETFdb): Looking further in 2013, what are the two or three most compelling macroeconomic themes that you see developing?

Mebane Faber (MF): We have spent a lot of time thinking about how investors approach the equity markets. Many investors come from a market capitalization standpoint or have a home country bias, which causes these investors to overweight the biggest countries or their home country. We started searching for a better way of building an index of countries. By applying the Shiller cyclically adjusted 10-year price-to-earnings ratio (CAPE) to over 40 countries we did find a way to gain exposure to countries based on valuation, instead of pure market cap weighting .

ETFdb: Can you just give a brief explanation of the CAPE ratio and why you follow it?

MF: The concept of smoothing earnings over multiple years is nearly 70 years old and goes back to Graham and Dodd. Robert Shiller popularized the theory with a paper and his book Irrational Exuberance in the 1990s, where he focused on smoothing earnings over 10 years and then adjusting for inflation. This helps to smooth out the peaks and valleys that normally happen over the course of a full business cycle. The typical CAPE ratio is between 15 and 20, with bubbles occurring around 30 and bottoming out around seven.

ETFdb: From a risk-reward perspective, should risk tolerant investors focus in on domestic equities or foreign ones?

MF: From a traditional standpoint of the U.S. investor there are a number of factors to consider. The U.S. market, by most standards, is trading at an overvalued level featuring a CAPE ratio of 21, which is on the more expensive side. But if you look to foreign countries, many are trading at lower levels, for example, Greece, Ireland, Italy and many other European nations that are recovering from economic slumps are trading at record low levels and could offer great potential returns for U.S. investors .

ETFdb: In your opinion, which regions or countries offer the most lucrative investment cases and why? Are there specific ETFs that you prefer for accessing these?

MF: We always recommend buying a basket of countries to even out your risks and returns. But at the country level both Greece and Ireland are trading at CAPE ratios below five, which has historically led to very strong returns for the next five to even 10 years. There are also countries like Russia, Austria, Italy and Belgium that are trading at CAPE ratios under 10, which makes now a great time to invest.

ETFdb: What are the noteworthy risks surrounding the opportunities highlighted above?

MF: Greece is a perfect example, because at one point it was trading at a CAPE ratio of 10, and an investor could have called that the bottom, but they would have lost when the ratio fell to two. Value investing takes on the behavioral biases of people selling assets when they are down. You can lose a lot of money trying to catch the bottoms, which is partly why we recommend a basket of countries instead of just one. Investors also need to look out for P/E ratio compression because of high inflation rates, because these funds might look appealing but in a rising inflation environment they are not. We also follow trends, set maximum P/E ratios, and use other practical tools when forming a portfolio .

Bottom Line: When choosing where to park your investments, whether it be domestically or abroad, a great tool to use is the CAPE ratio, as it places an emphasis on valuation instead of traditional cap-weighting. Investors should, however, be mindful of the level of diversification that foreign equity ETFs offer, as this will play a big role in the risk/return profile of the investment.