Buy cheap. This is a motto many live by, not only in their daily lives but also in their investment philosophy. Historically, “buying cheap” stocks was a good idea (i.e., the so-called “value” premium). But how might valuation matter when it comes to country allocations? In other words, given valuations, how much money should I allocate to U.S. equity and how much should I allocate to International equity? There is no right or wrong answer here. Some, such as Warren Buffet, recommends ~100% U.S. exposure (as of 2017). However, as we have discussed here, the high U.S. equity returns may be anomalous. So given current valuation information, and knowing that diversification is the so-called “free lunch” of investing, how can one approach the U.S./International allocation decision? Two simple solutions are generally offered:
- Allocate according to overall market-cap of the respective markets. This is currently around 52% U.S. and 48% Developed International.
- Split the assets evenly — 50% U.S. and 50% International.
The ResultsThe paper begins by reviewing the different measures used in the literature to split firms into value and growth. The authors split firms based on a “yield” measure, using seven variables as the numerator and two variables as the denominator: Below are the seven numerator variables:
- Book Value
- Cash Flow
- Gross Profits
- Market Capitalization
- Total Enterprise Value
ConclusionsAs is shown in the cumulative returns graphs above, country valuation based-timing strategies have not worked for some time now! Any advisor 4 who advocates a decent international exposure knows that the U.S., while more expensive than other markets, has been on a great 9-year run now, trouncing developed and emerging equities. 5 So is Warren Buffet right–should we put 100% in the U.S.? I would still advocate against such an approach and prefer a ~50/50 allocation, but as with anything investing, nothing works all the time. For those really interested in this topic, I recommend you read some more of the Research Affiliates articles, such as here, here, and here. In addition, they have a great tool that allows investors to investigate projected future returns for multiple asset classes (with assumptions and different models). 6 Let us know what you think …
And the Winner is … A Comparison of Valuation Measures for Country Asset Allocation
- Adam Zaremba and Jan Jakub Szczygielski
- A version of the paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.
The authors evaluate and compare the usefulness of various valuation ratios for country selection. To this end, the performance of 73 national equity indices is investigated for the period 1996 to 2017. The EBITDA-to-EV multiple is the best predictor of performance and outperforms other metrics. An equalweighted portfolio that is long (short) in the tertile of countries with the highest (lowest) EBITDA-to-EV ratio produces a mean monthly return of 0.69% and a Sharpe ratio of 0.81. These are more than double the Sharpe ratios obtained from using traditional metrics such as the book-to-market ratio or dividend yield. Two major drawbacks of inter-country value strategies are identified: 1) payoffs are derived predominantly from emerging and frontier markets and 2) profitability has significantly declined in the last decade.
- To be fair, only including those four links is only a small amount of research that has been examined on the topic. Nevertheless, I include them as references worth reading. ↩
- The list of the countries can be found here:↩
- Panel B then examines the 4-factor Alphas, and one can argue that there is more “alpha” for the TEV portfolios. ↩
- Including us!! ↩
- 2017 was a change, but who knows how long that will last. ↩
- Note: predicting asset class returns is hard. ↩