Technology, Value Investing

Cheap Beats Expensive

Buying the most expensive stock markets can be a recipe for disaster for your portfolio. Buying the cheapest markets is a far better idea, as I’ll show you. But what’s the best way to figure out which is which?

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What’s cheap… and what’s expensive?

Whether a stock market is “cheap” or “expensive” depends on its valuation. One common approach to valuation is to look at the price-to-earnings (P/E) ratio. For an individual stock, computing the P/E ratio involves dividing a company’s share price by its earnings per share.

For example, a company whose shares trade at US$100 and that earns US$5 per share has a P/E ratio of 20. In a sense, that means that you’d be “paid back” for your investment in 20 years.

So if the share price of a stock goes up while its earnings stay the same, the P/E ratio goes up… and if the earnings go up but the share price stays the same, the P/E ratio goes down. A lower P/E ratio means a stock is cheaper.

For an entire stock market, calculating the P/E ratio involves calculating the weighted average P/E of all the stocks that make up a stock market index. So a large company’s P/E ratio is going to count for more in the overall market’s valuation than a small company’s P/E ratio because it has a bigger weighting in the index.

There are a lot of ways to value a stock, or a stock market, besides the P/E ratio. You can also compare the share price of a company to its book value (the value of a company’s assets minus the value of its liabilities) per share. This is (not surprisingly) called the price-to-book value ratio (P/BV).

One of the problems with measures like P/E and P/BV is that they’re just a snapshot. Factors like the economic cycle can affect company, market and earnings in any given year. A big company, with a heavy weighting in the market, might have a bad earnings year, throwing off the whole market’s P/E ratio. The weather could hurt some companies’ earnings, and pull down the earnings of the market as a whole. The commodities cycle can have a large effect on commodity companies… and on it goes. So, the P/E ratio is helpful – but it can be deceptive, too.

Rather than using just the P/E ratio alone, it’s better to adjust earnings for these kinds of cycles. One way to do this is to take the average for ten years of earnings (rather than just one year, like with the P/E ratio), and adjust them for inflation – to calculate the cyclically adjusted P/E ratio (CAPE). This smoothens the cyclicality of a single year P/E. It’s more difficult to calculate, but it’s a more complete valuation measure than the normal P/E ratio.


How cheap beats expensive

Investing in markets that have a low CAPE, on average, results in much better returns than buying stock markets with high CAPEs. (Of course, this is the same for stocks… all else being equal (and it rarely is, but anyway), your odds of making money improve when you buy a stock that’s cheap, rather than a stock that’s expensive.)

Stock market returns for 2017 illustrate this. We looked at CAPE valuations of the world’s markets at the end of 2016, and then calculated the returns of these markets over the course of 2017. We did the same thing for the 10 most expensive markets (again, at the end of 2016).

As shown in the graph below, the 10 cheapest markets (up 29.5 percent last year) performed a lot better than the 10 most expensive markets (up 23.4 percent). (As it happens, a broad global index – the MSCI World Index – underperformed the 10 cheapest markets, partly because the U.S. market, which comprises more than half of the index, was up a still-strong, but weaker, 20.7 percent). (All returns are expressed in U.S. dollars.)

What were those 10 cheapest markets, on a valuation basis, by the end of 2016 – which went on to perform so well? As shown below, Poland – more often in the news for political shocks than for raging stock market performance – was the best-performing of the cheap markets, up 51.1 percent in 2017. It was followed by Turkey, where the stock market rose 47.5 percent. Egypt and Russia – the cheapest markets – pulled up the rear, rising 4.4 and 3 percent, respectively.

By comparison, the most expensive markets recorded an average return of 23.4 percent. Denmark (the most expensive market based on CAPE), Belgium and the Philippines beat the group’s average and posted the highest returns – 34.2 percent, 29 percent and 24 percent, respectively. Mexico was the worst performing expensive market, returning 15.5 percent. While expensive markets in 2017 performed well, on average they lagged the cheaper markets by a big margin.

These results – cheap outperforms expensive – reflects those of the previous year. In 2016, the 10 cheapest markets (on a CAPE basis, measured at the end of 2015) returned an average of 19 percent. Over the same time period, the 10 most expensive markets returned an average of negative 1 percent..

Cheap can stay cheap

Just because a market is cheap (that is, it has a low CAPE) doesn’t mean that it won’t stay cheap, or get even cheaper – or that the market will move up. (Some markets, or stocks, are value traps. Similarly, just because a market is expensive (high CAPE), it doesn’t mean it won’t get more expensive, or that shares won’t appreciate.

Valuation is just one factor to consider when buying shares or a market. But year after year, it’s shown to be a good place to start.

(In a few days, we’ll tell you which markets – both developed and emerging – are cheap right now on a CAPE basis.)

Good investing,