Tag Archives: stocktalk

Country CAPE Ratios (Part 2): Local Currency Returns

Summary In a previous article, we found that CAPE ratios did an excellent job of predicting country returns in 2013 but did a lousy job in 2014. Several commentators raised the point the analysis should have taken into account currency fluctuations. This article conducts the same analysis as before but uses local currency returns to evaluate the performance of CAPE in 2013 and 2014. Introduction The cyclically-adjusted price-to-earnings [CAPE] ratio is a commonly-used measure of valuation that has had some success in predicting long-term returns. In a chart from recent article by Hussman Funds entitled ” Does the CAPE still work? “, CAPE was found to be a reliable predictor (> 90% accuracy) of actual 10-year returns of S&P 500. The major deviations between the expected and actual 10-year returns occurred when the U.S. markets became very overvalued or very undervalued. In my previous article entitled ” Country CAPE Ratios: Wizard In 2013, Dunce In 2014? “, I mentioned the Cambria Global Value ETF (NYSEARCA: GVAL ), a fund launched in March 2014 by Mebane Faber and Cambria Investments that uses CAPE-like methodologies to invest in the cheapest markets worldwide. The timing of GVAL’s launch coincided nicely with CAPE’s fantastic performance at predicting 2013 country returns. In his “Meb Faber Research” blog , Faber presented data showing that the 5 cheapest and 10 cheapest countries posted average gains of 20.74% and 21.11%, respectively, while the 5 most-expensive and 10 most-expensive countries averaged -17.81% and -5.39%, respectively. This represents a differential of 38.59% for the 5 cheapest versus the 5 most-expensive, and 26.5% for the 10 cheapest versus the 10 most-expensive, a remarkable outperformance. Unfortunately, CAPE did a lousy job in 2014. The data showed a surprising positive correlation between CAPE and 2014 returns, meaning that the more expensive countries actually did better than the cheaper countries. I even ribbed on Faber for keeping quiet about CAPE’s performance throughout 2014, even though in 2013 Faber had enthusiastically proclaimed ” CAPE Country Returns YTD, the Ball Don’t Lie! ” a month before year-end. Perhaps Faber read my article, because he dutifully provided a CAPE update on New Year’s Day, 2015, even joking that the new edition of his book would be entitled “Global More Value.” Both Faber and my own performance data quoted USD returns. However, several astute commentators on my last article suggested that the true way to gauge CAPE should have been to use local currency returns. Therefore, this article seeks to evaluate local currency stock market performances to see if CAPE did any better in 2014 (or any worse in 2013). For the interest of consistency I will be using the same set of countries I did my previous article, even though Faber provided a more comprehensive list of country CAPE numbers in his update, which was posted after my article. 2013 Country CAPE evaluation The following table shows the 2013 return performances the various countries in both local currency [LC] and US dollar [USD] terms. Local currency returns were obtained from stock exchange performance data from the Wall Street Journal while USD returns are based on the ETFs and were obtained form Morningstar . Note that the country ETFs (often based on MSCI or FTSE indices) do not necessarily correspond to their respective stock exchanges. Country ETF CAPE at end-2012 2013LC % 2013USD % Greece GREK 2.6 28.06 24.91 Ireland EIRL 5 33.64 45.58 Argentina ARGT 5.2 88.87 15.04 Russia ERUS 7.2 -5.55 -0.88 Italy EWI 7.4 16.56 19.07 Austria EWO 8.4 4.24 11.48 Spain EWP 8.5 21.42 31.91 Portugal PGAL 9.5 15.60 – Belgium EWK 10.3 18.10 24.6 Israel EIS 11.1 15.12 18.3 Canada EWC 18.3 9.55 5.31 South Africa EZA 18.5 17.85 -7.47 India INDY 19.3 8.98 -3.99 Malaysia EWM 20.1 10.54 7.84 USA SPY 21.1 29.60 33.45 Chile ECH 21.2 -14.00 -23.9 Mexico EWW 21.2 -2.24 -1.58 Indonesia EIDO 24.7 -0.98 -23.14 Colombia GXG 33.5 -11.18 -15.01 Peru EPU 33.7 -23.63 -25.42 I compiled the total return performances into a bar chart. Countries are sorted from left to right, in order of increasing CAPE values. Local currency returns are shown as blue bars whereas USD returns are shown as orange bars. (click to enlarge) The data is also shown as a scatterplot, showing the relationship between CAPE at end-2012 and local currency returns in 2013. As with the 2013 USD returns, we see a negative relationship between CAPE at end-2012 and 2013 LC returns. The R-squared value of 0.3845 is less than the R-squared value for 2013 USD returns presented in the previous article, which was 0.5365. Nevertheless, the correlation was still significant (p-value = 0.0046). 2014 Country CAPE evaluation The following table shows CAPE values for selected countries at end-2013 and their 2014 LC and USD returns. Again, I am using the same countries as I did in my previous article. Country ETF CAPE at end-2013 2014LC % 2014USD % Greece GREK 3.8 -28.9 -38.2 Russia RSX 7.0 -12.1 -45.0 Ireland EIRL 7.3 15.1 1.9 Argentina ARGT 7.4 59.1 2.9 Jordan 8.6 Italy EWI 8.6 0.2 -9.9 Hungary 8.6 Austria EWO 9.0 -15.2 -20.1 Croatia 9.8 Lebanon 10.0 Israel ESI 10.3 10.5 0.7 Spain EWP 10.3 3.7 -4.7 Singapore EWS 11.8 6.2 2.9 Belgium EWK 12.3 12.4 1.8 Norway NORW 13.1 2.8 -22.8 Netherlands EWN 13.4 5.6 -4.7 United Kingdom EWU 13.6 -2.7 -5.9 France EWQ 14.0 -0.5 -9.9 Australia EWA 15.4 0.7 -3.8 Hong Kong EWH 16.3 1.3 4.6 Germany EWG 16.4 2.7 -10.5 Switzerland EWL 18.9 9.5 -0.8 Canada EWC 19.1 7.4 1.4 Japan EWJ 21.1 7.1 -4.4 USA SPY 25.4 11.4 11.4 And as a bar chart: (click to enlarge) We can see that for most of the countries, the 2014 local currency returns (blue bars) are higher than the 2014 USD returns (orange bar). This is likely due to the rising strength of the US dollar throughout 2014. The data are also presented as a scatterplot: As with the 2014 USD returns, we see a counter-intuitive positive relationship between CAPE values and 2014 local currency returns, but this time the correlation is much weaker (R-squared = 0.0192 compared to R-squared = 0.2664). Unlike 2014 USD returns, this correlation was not significant (p-value = 0.55). The difference between the 2014 USD and 2014 local currency results is probably due to currencies such as the Russian rouble and the Argentine peso, which fell off the cliff in 2014. Hence, local Argentine investors would have been ecstatic at their country’s 59.1% performance in 2014, whereas USD investors would be stuck with a measly 2.9% return. While this might seem like an endorsement for foreign currency hedging (particularly when it seems that every analyst and their brother is forecasting the U.S. dollar to continue to rise throughout 2015), keep in mind that predicting foreign currency movements is notoriously difficult, and that the expected value of excess returns on currencies in the long-term is basically zero. Faber himself says that it does not matter whether or not you hedge, as long as you do it fully one way or the other, as to not take a directional view on any one currency. Summary CAPE’s track record in 2014 does not look so bad once currency fluctuations are taken into account. Instead of predicting the opposite trend (more expensive countries did better on a USD basis in 2014), CAPE had no predictive power at all in 2014 for local currency returns. Nevertheless, it should be stressed that CAPE is a long-term measure of valuation, and deviations from the predicted trend should be expected as part of the natural volatility of the markets. In fact, true value investors should embrace these deviations as they might be able to buy the cheapest markets at an even cheaper price.

The Benefits And Costs Of Socially Responsible Investing

By Alex Bryan In 1970, Milton Friedman famously wrote, “There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” While that may seem like an extreme view, Friedman does have a point. As the owners of a firm, shareholders hire managers to act as their agents. When managers focus on profit maximization, they also tend to maximize shareholder wealth. If they choose, shareholders can then donate part of that wealth to social causes that are important to them. To the extent that managers pursue objectives other than profit maximization, they may reduce shareholders’ wealth and effectively substitute shareholders’ priorities with their own. Profit maximization also tends to promote efficiency and accountability. In the pursuit of their self-interest, firms usually allocate scarce resources to their most productive uses. The trouble is that firms do not always bear the full social costs of their actions. Economists call these phenomena negative externalities. For example, a coal power plant that expels its waste into the atmosphere could increase the prevalence of acid rain and make the surrounding area less desirable to live in, potentially hurting property values. Because the power generating firm does not directly bear these costs (in the absence of regulation), it may produce more electricity from coal than is socially optimal. So a narrow focus on profit maximization does not always lead to the most efficient social outcome. There is also an argument that this focus can result in an unfair distribution of resources. Perceptions about fairness are very subjective, but they can have a big impact on a firm’s image, and ultimately its profitability. For example, Nike (NYSE: NKE ) faced consumer boycotts in the 1990s for its suppliers’ use of sweatshop labor. Even though the suppliers paid market wages in the developing countries where they operated, the conditions those workers toiled in and the compensation they received seemed unfair to many Western consumers, who used their purchasing power to express their discontent. In order to mitigate these potential problems, many corporations have defined their corporate social responsibility more broadly than Friedman to include taking responsibility for their impact on the environment and social welfare even when there is no legal requirement to do so. While that is certainly laudable from a social perspective, an expansive view of corporate social responsibility may also be consistent with long-term profit maximization. In getting out ahead of environmental and social problems that their operations may create, companies may be able to stave off potentially onerous regulations and reduce political risk. A proactive approach can also reduce the risk of conflicts with nongovernment organizations and other advocacy groups that can hurt sales and damage the value of a brand. Mindful of this risk, Starbucks (NASDAQ: SBUX ) developed standards for ethically sourced coffee in partnership with Conservation International in the early 2000s. In accordance with these standards, it now sources most of its coffee from producers with independently verified environmentally friendly practices. Many companies have actually built strong brands and competitive advantages with their corporate social responsibility programs. For example, Whole Foods Market (NASDAQ: WFM ) caters to environmentally and health-conscious consumers and commands premium prices for its organic products. Whole Foods’ environmental stewardship is an integral part of its brand identity and contributes to its pricing power. Similarly, Ben & Jerry’s (part of Unilever (NYSE: UL ) ) environmentally conscious production processes and image as a socially responsible firm help it differentiate its products. To a large extent, the firm uses ingredients that have been Fairtrade certified, which offers farmers in developing countries above-market prices for their goods in order to promote better standards of living. Many consumers are willing to pay more for these products because they feel better about the way they were made. Because corporate social responsibility can influence how consumers perceive a brand and their purchasing decisions, the pursuit of social and environmental goals can serve a similar role to advertising. In some cases, pursing these goals may also help reduce costs. For instance, by improving the energy efficiency of its manufacturing processes, Dow Chemical (NYSE: DOW ) has saved about $400 million from 2005 through 2013. It doesn’t always work out that way. Firms must balance the costs of implementing these programs against their benefits. A strong reputation for social responsibility may help firms attract and retain better talent, which could further sharpen their edge. It’s attractive to many people to be part of an organization they can be proud of and to feel that their work is making a difference. Merck’s (NYSE: MRK ) program to end river blindness may have allowed it to attract scientists who would not have otherwise been available, according to a paper by Geoffrey Heal. This disease affected millions in Africa who could not afford the drug Merck developed to treat it. So Merck gave it away to those who needed it, which enhanced its reputation. Because a firm’s impact on the environment and social welfare can affect its brand, risks, and ability to attract and retain talent, pursing social and environmental goals can promote sustainable and attractive profits over the long term. Companies that take a more holistic view toward corporate social responsibility may be less likely to take shortcuts to boost short-term profits at the expense of long-term opportunities than their less socially conscious counterparts. However, there is a risk that firms with an expansive view of corporate social responsibility might also have less accountability for their results. It is easy for a firm to claim it has a long-term view, but because the results do not materialize for several years, it’s difficult to hold managers accountable for their immediate actions. Firms might also justify actions that are socially suboptimal in favor of a preferred stakeholder. For instance, a firm may avoid necessary layoffs that would improve efficiency in order to support the community. But that firm may ultimately become less competitive and contribute less to society than it would have if it were more efficiently run. Good corporate governance is vital to prevent this type of waste and promote accountability. Fortunately, a few sustainable, responsible, and impact investing, or SRI, funds incorporate governance into their stock-selection criteria. Investment Options Investors looking for a core holding that targets stocks with socially responsible characteristics might consider iShares MSCI KLD 400 Social Index (NYSEARCA: DSI ) and iShares MSCI USA ESG Index (NYSEARCA: KLD ) . Both screen for stocks with strong environmental, social, and governance, or ESG, records in areas that are relevant to their industries, such as carbon emissions, labor management, and corporate governance. They exclude tobacco companies, anchor their sector weightings to the MSCI USA Investable Market Index, and charge a 0.50% expense ratio. However, the MSCI KLD 400 Social Index also excludes companies operating in the weapons, alcohol, gambling, nuclear power, adult entertainment, and genetically modified organisms industries, while the MSCI USA ESG Index could include these companies. The MSCI USA ESG Index uses an optimization approach to manage tracking error relative to the MSCI USA Investable Market Index while maximizing exposure to companies with strong ESG characteristics. In contrast, the MSCI KLD 400 Social Index applies market-cap weighting and does not explicitly manage tracking error. From its inception in 1990 through 2014, the MSCI KLD 400 Social Index outpaced the S&P 500 by 0.5% annualized with slightly greater volatility, due in part to its smaller average market cap. A returns-based regression analysis also reveals that the MSCI KLD 400 Social Index exhibited a modest tilt toward more-profitable companies. This is not enough to infer causation between social consciousness and profitability or stock market performance. It could go the other direction. More-profitable companies may be more likely to implement strong social responsibility programs because they may face greater risk for failing to do so. Highly profitable firms have also historically had better stock market performance. Ultimately, what matters is performance relative to expectations. Even if investors expect a company to have higher costs as a result of its social responsibility program and that it will not reap any benefits, they should price it accordingly so that it offers a competitive return. Aggregate shareholder wealth may be lower than it otherwise would have been, but the stock’s return could be comparable to the market’s. However, SRI index funds tend to charge higher fees than traditional index funds, which can put investors at a disadvantage. Vanguard FTSE Social Index (MUTF: VFTSX ) helps reduce this cost hurdle: It is the lowest-cost SRI fund available, with a 0.27% expense ratio. This fund tracks the FTSE4Good US Select Index, which targets stocks with strong ESG characteristics, similar to the two iShares funds. It applies similar industry exclusions to the MSCI KLD 400 Social Index, though it does not necessarily exclude companies that produce genetically modified organisms. Where SRI index funds passively screen for companies with strong ESG characteristics, their actively managed counterparts, such as Parnassus Core Equity (MUTF: PRBLX ) and Domini Social Equity (MUTF: DSEFX ) , can use their relationships with portfolio companies to advocate for positive social change. Both funds vote proxies to advance ethical business practices, such as diversity, fair pay, and environmentally friendly policies. Reference Heal, G. 2004. “Corporate Social Responsibility–An Economic and Financial Framework.” Columbia Business School, Working Paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=642762 Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.