Sam Lee: Hi, I'm Samuel Lee, a strategist with Morningstar.
I'm here at the Morningstar ETF Conference 2014. Joining me today is Mebane Faber of Cambria Investment Management. He is the chief investment officer and co-founder.
Thank you for being here.
Mebane Faber: Great to be here.
Lee: Over the past couple of years, you've launched a series of value-oriented ETFs. First, you started with the Shareholder Yield ETFs. Could you explain a bit about shareholder yield and why you think it's a new and useful addition to the market?
Faber: Our strategy for launching ETFs is, first, funds that we would want to invest in, and no copycat funds. We want the funds to either be different or better in some regard. Shareholder yield is a very noticeable omission in the ETF space. A vast amount of income funds focus on dividends. That's only part of what a company can do with its cash flows. They can also distribute the cash as buybacks. To only look at one or the other … if you're a dividend investor and ignoring buybacks, you're ignoring half of the way companies distribute their cash. And the same thing with buybacks; if you're only doing buybacks, you're ignoring half of what the dividend world is doing.
So historically, sorting companies' stocks based on what we call "shareholder yield"--or "net payout yield" the academics like to say--has done a much better job of performance than dividend yield alone.
We screen the companies for this high yield, so it ends up having roughly a high-teen return: a net buyback yield of around 6%-7%, a dividend yield maybe around 2%. But what you find is investors care more about the aggregate amount that's getting paid out, and they don't really care how you distribute it, but just the absolute amount that gets distributed to them as shareholders.
Lee: Historically dividend strategies have outperformed the broad market. And you're saying that net shareholder yield outperforms dividend strategy. Could you describe in the ballpark range what the historical returns have been?
Faber: What's an important question for investors, and really in any profession, is to ask, is this time different? Dividend yield investing has worked fantastic in the U.S. It has worked abroad. It has worked across countries. But one of the things that changed in the early 1980s, a structural change, is that the U.S. government made it easy for companies to buy back their own stock.
So buybacks have grown from a really small part of what companies do with their cash flow to often exceeding dividends in any given year. To ignore that is a big mistake. Sorting companies based on this metric has worked fantastic all the way back to the '20s. It's worked even better since the '80s, since this started happening, and you come up with a much better portfolio, particularly right now where dividend yield is really expensive.
Historically high-dividend-yielding stocks have traded at about a 20% discount to the overall market. Right now, for the first time ever, it's trading at a premium. But that's not true with the shareholder yield companies. They're actually trading still at a discount to the overall market.
But regardless of your approach, we think it's important to have a valuation framework. You want companies that are cheap, paying out dividends, but also cheap in buying back their stock for 80 cents on the dollar, or even less.
Lee: Switching gears a little bit, you recently launched the Global Value ETF. It doesn't quite target dividends, but it does have a similar philosophical framework. Could you describe that strategy?
Faber: The basic is value, of course. There are 45 investable countries in the world in the developed and emerging-market indexes. There's no reason to focus on the U.S. alone. And this is most investors' first basic mistake. The U.S. is only half of world's market cap. Most investors have a home-country bias and put 70%-80% of their portfolio in the U.S. At a minimum, they should have 50%.
But more importantly, take the next step, and ask, what about valuation? If you look at the U.S. on any long-term valuation metric--we prefer one called CAPE, which is a cyclically adjusted price-to-earnings ratio, which is a 10 year P/E--the U.S. is one of the most expensive countries in the world. It's not terrible. It's not a bubble. It's trading around a value of 25-26. It's hit a peak of 45, but it's also traded in the low-single digits. That's the bad news: We expect returns in the U.S. to be about 4% going forward.
But what this ETF does, it says we want to buy the 11 cheapest countries in the world, and those countries right now have a single-digit P/E ratio. But the problem is, like any value strategy, it's hard. You're investing in Russia, Greece, Brazil, a lot of Eastern Europe. But when you have a deep-value strategy like this, it's important to only rebalance once a year, allow the countries time to rebound. We think the foreign markets' broad indexes can do still 10%, and then the cheapest countries within those can get into the midteens.
Lee: But you are taking substantial levels of risk. You are investing in countries like Russia, where there are good reasons why the market has discounted these countries.
Faber: Let's talk about risk for a second. A high correlation with value is simply how much those markets have already declined. So they're cheap because they've gone down a lot already. If you look at Russia, if you look at a lot of these countries, they are down from their peaks often 50%. So you're buying what's already declined. Most of that news flow is in the rearview mirror.
When you think about risk, historically, if you look at the U.S., and this is same abroad, the higher you pay for stocks, the higher valuation multiple, the larger the chances that you have a big drawdown in the next three to five years. If you think about it, if you buy stocks in 1999, the chances are higher--it's not guaranteed--that you're going to have a big loss in the ensuing three to five years.
The opposite happens when it's cheap. You have a much lower probability that stocks will continue to decline, simply because they already have.
So often when we think about risk, we actually think it's the opposite. We think buying Russian stocks, or a basket [of stocks]--it's important to buy a basket; you never want to just go and buy Greece, for example, but to buy a basket of these countries--we think is much, much less risky than buying U.S. stocks right now.
Lee: Thanks for being here.
Faber: Thanks for having me.