The Weird Way to Big Returns

Recently I was able to sit down to dinner with a group of astute investors and analysts who I consider some of the sharpest minds in the industry.

As we talked over steaks the size of a catcher’s mitt and some of my favorite bourbon, an interesting conversation came up about the relative attractiveness of global stocks as opposed to U.S. stocks, and it’s had my wheels turning ever since.

The Cyclically Adjusted PE (CAPE) Ratio measures price to 10-year average earnings, and if you take a look at it, you can see that the U.S. markets are expensive with a CAPE of 30. That’s high, but it isn’t bubble magnitude just yet.

What did look particularly attractive to the group were emerging markets.

Most of those in attendance at dinner were actively looking for exposure outside the U.S., and at least one was all-in on emerging markets.

Now it may take some time for these foreign markets to catch up with, or potentially pass the United States, but history tells us that buying into those nations markets with lower CAPE ratios is a solid strategy for long-term investing.

Let me show you …

An Unconventional Idea Taken Seriously

The consensus that evening was that the best way to take advantage of the cheaper foreign markets was by buying those exchange-traded funds (ETFs) that invested in indexes of those markets.

That might work out okay for some, but by now, you’ve probably figured out that I don’t like paying full price for anything.

If I can find a way to buy these already bargain markets at a discount to what others are paying, that’s how I want to structure the trade.

Thanks to closed-end funds, I can do precisely that. I can buy funds that specialize in equity investing in Central and Eastern Europe, Ireland, Switzerland, and Asian markets.

I can also buy broader-based global funds that owns stocks from all over the world.

If I’m going for the biggest bang for my buck, I can buy emerging market and emerging market value funds that trade at the lowest multiple of price to cash flow and asset value.

Now if you’re a conventional thinker, you might have a hard time making the Global CAPE strategy work for you.

The lowest CAPE ratios are usually found in some ugly places.

Right now, the list includes countries like The Czech Republic, Russia, Poland, Portugal, Spain, and other economic and political hot spots around the world.

As Baron Rothschild once put it – you’re buying when there is “blood in the streets.”

You’re going to own things that will get you strange looks from friends and family. There may even be talk of needing to see a psychiatrist for doing something so strange with your cash…

But while the topic may be unnerving on its surface, I’ve crunched the numbers and Global CAPE Investing – buying markets with the lowest CAPE Ratios – beats buying and holding a U.S. index fund over time.

Here are a couple of ideas you might want to add to your long-term portfolio in place of the overly large S&P 500 index position to boost overall long-term returns…

You better get yourself a big safe (here’s why)

Eastern Bloc Value

Central and Eastern Europe Fund Inc. (NYSE:CEE) invests, surprisingly enough, in companies in Central and Eastern Europe.

Russia is the biggest holding, followed by Poland, and Hungary.

Performance over the last decade has not been good, but again, research shows that a lousy decade for emerging markets is usually followed by a great decade, so that’s the bet with this fund.

CEE is currently trading at a 13% discount to the net asset value.

When these markets come back into favor, the discount will narrow and may even go to a premium to NAV.

The Early Adopter

If we’re going to go tromping around in emerging markets, we should include the Templeton Emerging Markets Fund (NYSE:EMF).

Sir John Templeton was one of the first to apply the principles of value-oriented investing with a global approach.

The Templeton Emerging Markets Fund had its IPO back in 1987 and has a solid track record of success.

Today the fund is invested in China, Taiwan, Brazil, Russia (again), South Korea, India, and other emerging markets.

The fund is trading at a discount of 11.9% and has a distribution yield of over 5%.

The holdings of this fund are a little less obscure than those if the Central European Fund as it holds companies like Alibaba Group Holding Ltd. (NYSE:BABA), Taiwan Semiconductor Manufacturing Co. (NYSE:TSM), Tencent Music Entertainment Group (NYSE:TME), and Samsung that may be more familiar to US investors.

The discount of this fund has gone to a premium at several points during its 32-year history when emerging markets heated up, and it could do so in the future as well.

Emerging markets are growing faster than developed markets, and their valuations are markedly lower, but it won’t stay that way forever.

Using the Cap Ratio to invest around the world can leave you with a portfolio that your friends and family may think are weird.

However, as the late, great Hunter Thompson once pointed out, “When the going gets tough, the weird turn pro.”

Emerging markets have underperformed badly for the last decade, but economic common sense and history tell us that this could be about to change in a big way.

To the Max,

Tim Melvin

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