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The One Thing That Doesn’t Change In Investing

Ser Jing - Three Facts About The Straits Times Index To Put Market Ups-and-Downs Into Perspective (pic)

There’s some strong evidence in the USA that buying shares when they’re cheap and holding them for the long-term gives investors there a great chance of doing well. But, does the relationship hold in other international markets?

Differences in cultures, level of acceptable-disclosure for public companies, and the breadth and depth of the stock markets among different countries could possibly mean very different outcomes for an investor who bought cheap and held for long.

But as it turns out, buying shares with cheap valuations does work even outside the West.

Investing cheaply works

Investment manager Mebane Faber did research into how valuations – based on the cyclically adjusted price earnings ratio (CAPE) – could affect investment returns for 32 international markets around the world from 1980 to 2011.

The table below shows part of his research results for the average real (i.e. inflation-adjusted) returns for the 32 stock markets around the world, including those of Singapore. Notice how the returns trend downwards as the CAPE increases.

Average CAPE 10 Year Real Compounded Annualised Growth Rate
<10 10.9%
10 to 15 9.6%
15 to 20 8%
20 to 25 5.7%
25 to 30 3.3%
30 to 40 2.1%
40 to 50 -0.2%
>50 -3.1%

Faber also dug into the data to examine the real returns of stock markets that exhibited a CAPE that was below 5. He found nine such instances: USA in 1920; UK in 1974; Netherlands in 1981; South Korea in 1984, 1985, and 1997; Thailand in 2000; Ireland in 2008; and Greece in 2011.

An investor who invested in those markets would have had the returns shown below:

Holding Period Average Annualised Real Returns
1 year 35%
3 years 30%
5 years 20%
10 years 12%

Contrast that with subsequent returns for markets that carried CAPEs of above 50 shown in the table below. Faber found 13 examples of a country’s market sporting a CAPE higher than 50: Austria in 1991; Malaysia in 1993; Japan in 1986-1990, 1999, 2005, and 2006; Italy in 2000; India in 2007; and China in 2007.

Holding Period Average Annualised Real Returns
1 year -15%
3 years -9%
5 years -6%
10 years -3%

These were different international markets (American, European, and Asian) that sported different valuations at different times. But yet the trend is clear: Internationally, cheap stocks are likely to do better than expensive stocks – it’s not just an American or Western phenomenon.

The common thread that binds us all

But why is that? I can’t know for sure, but I highly suspect it has something to do with the universality of human emotions such as Greed and Fear, a view (link goes to a video: watch from 43:00min to 45min) shared by behavioural investing expert Carl Richards.

Greed causes investors to chase rising prices without regard for fundamentals, eventually leading to situations such as a country’s market sporting sky-high CAPEs of more than 50. Without strong support from earnings or assets, those prices eventually collapsed on their own weight, leading to poor subsequent returns as Faber has shown.

On the other hand, fear causes investors to sell indiscriminately, often causing prices to be much lower than what economic reality might dictate to be the real value of shares, leading to instances of CAPEs falling below 5. When people start to see through the fog of fear, optimism starts to be built in again and prices start rising.

Will greed and fear ever stop haunting us?

This of course, leads to another interesting question: will the cycle of greed and fear ever stop? For investors like Howard Marks, co-founder of the US-based asset management firm Oaktree Capital, the answer is never.

Marks once said thatMoments like 2008 [referring to the Great Financial Crisis of 2007-2009] will continue to present great opportunities for as long as emotion rules the markets. In other words, forever.”

His firm was frenetically investing during the crisis, putting US$6b to work buying up distressed loans in American companies like Clear Channel Communications and Freescale Semiconductor in the space of three short months from Sep 2008 till the end of that year. Those trades, and more, eventually racked up US$6b in gains for Oaktree’s investors.

What about Singapore? Our stock market barometer Straits Times Index (SGX: ^STI) has more than doubled from its 10 March 2009 low at 1,455 points and investors in the index, through the SPDR Straits Times Index ETF (SGX: ES3), could have gotten even better returns if dividends are accounted for.

It seems that greed and fear – and by extension, wildly optimistic and overly pessimistic prices – are here to stay. And it’s the same, everywhere.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.