Poking holes in the celebration of classic diversification strategies

Diversification is a wonderful thing, but so is performance, and sometimes it is necessary to step outside one’s…

Diversification is a wonderful thing, but so is performance, and sometimes it is necessary to step outside one’s comfort zone to take advantage of what the market is offering.

“The best opportunities have always been found when there is blood in the streets, like with biotech stocks in 2002 or homebuilders in 2009,” said Mebane Faber, portfolio manager at Cambria Investment Management LP.

Although his allusion is theatrical, he merely is promoting the renowned strategy of zigging when everyone else is zagging. And Mr. Faber is doing it by translating risk into value.

By embracing the philosophies of such noted investors as Rob Arnott, John Hussman and Robert Shiller, Mr. Faber finds it easy to poke holes in the celebration of classic diversification strategies.

“The conventional efficient-market theory is that markets are not predictable and cannot be forecast,” Mr. Faber said. “Value has no place in the efficient-market ivory tower, but does it seem reasonable for an investor, perhaps a retiree, to have allocated the same amount of a portfolio to stocks in December 1999 [when the S&P 500 was at 1,457] versus 1982 [when the S&P was at 122]?”

With traditional diversification, that is exactly what happens.

Consider, for example, the MSCI EAFE Index of 22 countries representing Europe, Australia, Asia and the Far East.

From 1990 until recently, Japan was the largest weighting in the market-capitalization-weighted EAFE. At 20% of the index, Japan now is second, behind the United Kingdom at 22%.

So-so returns

And no other country in the index has a weighting of more than 10%.

Diversification purists will shrug this off as a reality of cap-weighted indexing.

But the cost of such diversification can be illustrated by the mediocre 10-year annualized returns of 3.4% in Japan and 4.5% in the United Kingdom.

Meanwhile, smaller EAFE components such as Australia, Denmark, Hong Kong, Norway and Sweden had a 10-year annualized returns ranging from 9.9% to 14.6%.

“If the highest-cap-weighted countries were the most undervalued, then market cap weighting would be wonderful,” Mr. Faber said. “No one ever said you have to invest only in the biggest countries.”

To that end, Mr. Faber applies time-tested quantitative analysis, looking at cyclically adjusted price-earnings ratios to identify the most undervalued global markets.

From there, he builds separate-account portfolios of market index exchange-traded funds representing the dozen or so most undervalued single-country markets.

It is gutsy stuff, to be sure, because, based on the latest analysis, the portfolio would be equally weighted in Austria, Belgium, France, Greece, Ireland, Italy, the Netherlands, Portugal, Russia and Spain.

Each of these local stock markets has fallen from its most recent peak by between 32% and 92%.

For perspective, the S&P 500, measured on the same scale, is down 2% from its recent peak.

But the S&P 500 also is a lot less attractive, according to the CAPE value scale, which factors in the past 10 years of inflation-adjusted P/Es.

On that scale, the S&P 500 is at a CAPE level of 20.9, making it the fifth-most expensive of 36 major global equity markets.

It compares to a CAPE level range of between 2.4 and 11.3 for the 10 least expensive markets.

As one might expect, buying value and embracing risk has its advantages.

Cape levels and returns

Using only the U.S. equity markets, the average 10-year annualized return of investments made at the 10 lowest CAPE levels between 1881 and 2011 was 16.1%, on an average CAPE level of 10.9.

On the other end of the scale, the average 10-year annualized return of investments made at the 10 highest CAPE levels over the same period was a decline of 3.3%, on an average cape level of 23.3%.

Calculated another way, over the same 130-year period, investing in the U.S. equity market whenever the CAPE value was below 5, which happened 0.8% of the time, would have produced a 10-year compound annualized growth rate of 15.8%.

But investing whenever the market’s CAPE level was above 40, which also happened 0.8% of the time, would have produced a 10-year compound annualized decline of 3.5%.

Although long-term CAPE-level analysis is popular for its ability to smooth out volatile cycles, it is only one of a number of valuation measures that can be applied, including straightforward price-to-book, cash flow or dividends.