Mebane Faber by ValueConferences

Mebane Faber Chief Investment Officer, Cambria Investment Management

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Exclusive Session Transcript (lightly edited, may contain errors) Mebane Faber, Chief Investment Officer, Cambria Investment Management “Building Trading Models with the 10 Year CAPE” Best Ideas 2013, January 8-9, 2013 Host:

It’s a great pleasure to have with us Meb Faber, Co-Founder and Chief Investment Officer of Cambria Investment Management based in California. Meb will also be familiar to many of you through his wonderful writings on investment strategy and he’s got a new book coming out titled Shareholder Yield which is especially timely given the debate around taxes in the US and how taxes will affect investment returns in the future, so very much looking forward to that. Today, Meb will discuss his investment approach and where he’s finding the best equity ideas currently. So without further ado, Meb please go ahead.

Faber:

Great, great. Thanks for having me. A quick intro, again my firm is Cambria, there’s a short disclaimer you can feel free to read at your leisure. But you can find a lot of our research and writing through two different books, the first being The Ivy Portfolio we published back in 2009, again, The Shareholder Yield coming out this January. But we do a lot of white papers. We’ve done about a dozen in the Cambria Quantitative Research series and the focus of today’s talk is based on one of these papers and so you can find a printout on the Best Ideas 2013 conference website.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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But the title of this topic is called “Global Value, Building Trading Models with a Ten-Year CAPE.” We’ll get into more about what that means here in a minute. But this isn’t a hypothetical exercise. We’ve been managing money since 2006. You can find more information on our blog Mebane Faber, as well as the Cambria website which is CambriaInvestments.com, both of those archive a lot of the research. So let’s get started. When a lot of people are talking about investing, they have very distinct opinions. There are people who are value people or trend followers, or Vanguard bobblehead indexers, and often when presented with new ideas, it’s like talking about politics or religion and people tend to throw out the logic, and focus really on their ingrained beliefs. So hopefully with this presentation as well as with any investment approach, you’re going to have an open mind and hopefully pick up a few ideas and possibly learn something, and think about the world in a little different way. This good looking guy right here, for those who don’t recognize him is Sir Isaac Newton, one of the most famous scientists that’s ever lived. And why are we even beginning to talk about him? Well, there’s a chart of a stock in the 18th century and this is a Marc Faber chart from his Gloom Boom & Doom newsletter and what this is demonstrating is two things, it’s kind of a leadin to this presentation. One, and this is a stock that we actually expanded some research in another white paper called Learning to Love Investment Bubbles. We’re going to show that there have been bubbles throughout history. It’s not something that’s particularly © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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new but it’s been going on for many years. And so this was a speculative stock in the early 18th century and it goes to show that there are massive run-ups and mania as well as crash but also shows the second thing which is some behavioral biases that people have. And Newton was an early investor in this stock, sold some, made a lot of money but then saw a lot of his friends continuing to trade and speculate in this stock. And like many of us have probably experienced whether it’s the late 1990s internet or real estate, flipping houses in 2007, it’s very difficult when everyone else is making money to be able to not participate. And so, Newton reentered and then again lost all of his money after the stock declined, and never really reached levels of the peak. Then he’s famous for a great quote and he says “I can calculate the motion of heavenly bodies but not the madness of men.” And so this may feel closely familiar to a number of us with the 2008-2009 bear market, which wasn’t a market that many people have really ever experienced in their lifetimes because the last time in the US especially, that there was a market like this was in the 1930s where there was this massive debt deleveraging and many asset classes declined at the same time. There was really only one safe haven and that being long term government bonds. But this just goes to show there are these huge losses and max drawdowns on a monthly basis, which is the peaked to trough loss, for many of these markets, it was in the order of 50% to 70%. If you look at every G8 country in the world, a 60-40 allocation which is typically seen as a very safe allocation has declined by at least two-thirds at some point. So the lesson © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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here is the markets have always been volatile, they’ve always had really large drawdowns and if you can think about that as not necessarily a bad thing but an opportunity, then it becomes a little more interesting as well. So let’s start to get to the meat of the topic of the presentation now and here’s another two good-looking fellows. If you don’t know who they are, on the left is Benjamin Graham, often known as the father of security analysis, and on the right is Robert Shiller, Professor from Yale. And their ideas form the basis for what we’re going to talk about today. Benjamin Graham, along with David Dodd, in 1934 proposed in the book Security Analysis examining a security but smoothing earnings over a period of years. In this case they were talking about an ideal period being somewhere around five to seven years. As a way to smooth out the business cycle and to show that earnings have a long term perspective on earnings that might not necessarily be exposed to expansions and contractions, and be able to assess a security’s value relative to this longer term earning power. Over seventy years later, this is almost sixty years when Shiller put out the book. He published the paper and then his famous Irrational Exuberance book that developed a metric which is simply called the ten-year cyclically adjusted price to earnings ratio (CAPE) is based on some of the work that these guys did. But he basically made a huge name for himself by predicting the equity market bubble in the United States, saying that markets were expensive and of course there’s been a very low return ever since.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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And let’s get into a little bit of what this looks like. This chart is a picture of, we’ll call it the CAPE, the cyclically adjusted price to earnings ratio since the late 1880s. And Shiller has all this data on his website, so you can go to his website at Yale and be able to download the Excel spreadsheet that has all this and play around with it. But what you can see from this is it gives you a very broad perspective of markets. And you can see that, on average, the median and average CAPE is around sixteen, seventeen. However, there are peaks and troughs that are wildly away from that. So you can see a number of times in the U.S. that it hit a low of five in the early 1920s, again a generational bottom in the 1980s, but also these massive peaks in the late 1920s, when the roaring 1920s bull market peaked out. And then, of course, you can see it again in the nifty 1950s and early 1960s. And then the mother of all bubbles in the U.S. hit a peak of 45, and you guessed it, December 1999. And what this shows, and one of the biggest things is, that if you look, it’s taken over twelve years for the U.S. to even get back to kind of this median, normal valuation of this pre-bubble period, it could be an enormous headwind. And the price in this tends to be much more volatile than the earnings series of course. The earnings for the most part aren’t anywhere as near as the price, but that’s the great opportunity. And so how does that work? It actually works great if you’re looking at ten-year forward compound returns for U.S. stocks, these are real returns so net of inflation, based on the various CAPE buckets, you have at the very low end, the zero to five bucket and then the five to ten, all the way out to the forty to © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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fifty. And you see this really nice stair step that shows, if you buy the equity market when it’s trading at low valuations, you have great returns for the next ten years. And if you pay too much, which is just very simple value investing, it’s kind of “Investing 101,“ don’t overpay, then your future returns tend to be fairly meager. The red column is where we are right now. It’s about 21, which historically has been about 25% overvalued in the U.S. It’s not terrible, it’s not 1999 but it’s certainly a headwind and it’s certainly not super undervalued. If you look at the ten-year CAPE and you flip the axis and then you compare it to the forward ten-year real CAGR, you see that lines up pretty nicely. In the early part of the century, there are a couple of gyrations, but ever since it’s been almost spot on, on being able to predict the future returns for the equity markets. One thing that people don’t look as much into is the macro environment, how that relates to the CAPE. Rob Arnott at Research Affiliates has done some great research here. I think the title of the paper was King of the Mountain where he was looking at price earnings ratios relative to inflation. And what this chart shows is that when there’s mild inflation which is kind of what you want, what the Fed would love to have, somewhere in this 1% to 3% perhaps up to 4% area, you get rewarded with the highest price to earnings ratio. People are willing to pay a higher multiple on earnings for low inflation rates and consistent inflation rates. However, if you go above 4%, or below 1% and kind of tethering into deflation area, the multiple contracts. And so you can very easily have, if you start to get just moderately high, © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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say 5% to 6% inflation in the U.S., you can have a compression in P/E from this level of above twenty down to fifteen which will be a 25% compression or down to even ten, that’s a 50% loss just in prices based on the prevailing inflation rate. And so one of the things that we did, that we haven’t been able to find anywhere else is, we said, this is interesting, can we construct this for all the foreign markets? And, of course, finding data for earnings in foreign markets tends to be a bit challenging, but there are a few places you can go that have been able to construct this for a number of decades. So, starting in the 1970s you can come up with maybe ten countries, in the 1980s perhaps twenty and today of course you can come up with thirty, forty , fifty, if not more. But we said, we want to look at countries we have available, these ten-year ratios and does this work elsewhere? So we were able to compile a database and basically what we found is pretty similar, is that most countries spend a majority of their time in this kind of nice little bucket of fifteen to twenty, ten to fifteen, they spend a decent amount of time there but that’s the undervalued side, twenty to 25 on the high side. But what we also found is many more instances of bubbles and busts. And that shouldn’t be surprising because a lot of these markets, emerging markets tend to be incredibly volatile and much more exposed to what’s going on in the macro world as well as internal sovereign issues than the U.S., which is a much bigger country. And so you find the nice stair step all the way from one year up to ten years is that you buy when it’s cheap, you get rewarded with nice returns. And if you pay for something expensive, you’re going to get hit with future bad returns. © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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And so one fun thing we did, we said alright, let’s look at the bloodiest of the bloody markets, the same as attributed to Rothschild’s quote, “buy when there’s blood on the streets.” We said, let’s take a look when the CAPE’s below five, which is incredibly rare. Out of roughly almost a thousand market years we’ve looked at, it’s only happened probably I think just around eight, ten times. In the U.S. we talked about earlier it happened in the 1920s, the U.K. in the 1970s, South Korea a little bit in the 1980s, Thailand in 2000 when they were going through their issues, Ireland in 2008 if we can remember that. And, of course, right now the more interesting and timely is Greece in 2011. But what we show here is, had you bought these on a yearly basis, just at the end of the year you say, so I’m just going to buy any of these markets below five, you see the outsized returns are incredibly favorable to the investor, the one year, three-year returns at north of 30%, even in five-year up to 20%, and ten-year still nice returns at 12%. Likewise, if you’re paying bubble valuations over fifty, which in the U.S. it has never crossed, it got to the high forties in 1999, but in other countries it’s certainly passed that. Malaysia, it’s happened in the early 1990s. Japan if you remember the kind of bubble of all bubbles in the late 1980s. It hit a CAPE in the nineties, that’s twice as bad as the U.S. was. And it’s taken Japan over twenty years to even get back to this median valuation. Just now is Japan getting back to a kind of normal valuation, and so that headwind, we’ll expand more on this later, but that headwind of investing in a country that is this overvalued, sure there’s 50%, 100% rallies along the way, but it takes that long to work off this overvaluation. © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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And that’s not just relevant to people that are investing in individual countries, but it’s also relevant to indexers. The Japanese index, being one of the largest economies in the world, has a very heavy weighting historically in the Morgan Stanley EAFE, in a lot of the investable products. And so this supplies the product designers probably with a lot better ways of designing country indexes than simply doing it based on market cap weighted. So, we’ll extrapolate this later, but there are a couple other countries that traded above fifty. Italy in the bubble year 2000, but if you guys remember the BRICs, India and China in 2007 were trading above fifty when everyone was rushing into India and China and then they’ve had the terrible bear market after that. But what you can see is, it’s the opposite of the really cheap markets. If you buy these really expensive, you’re getting negative returns for the next five to ten years on average which is really, really tough for investors. So, it’s something that you want to avoid as well as take advantage of if you can. One of the things that we want to do is say, being a trader, being a fund is how do I put this into a portfolio context? How can I make this systematic? So, we said, alright and the paper has more statistics, we said what if we just invest each year in the cheapest 25%, what if we invest in the most expensive 25%, and then what if we just equal weight all countries? And what we found is that you get these nice returns just from the buy and hold equal weight, I think it was right around 9%. But what you also get in the cheapest markets is returns almost up to 14%. So you’re adding those 4% to 5% in alpha just by buying the cheapest markets.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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Now, you have the same amount of volatility of course and the same amount of drawdowns. You have a 50%, 60% drawdown, whatever these markets had, but you capture about 4% to 5% outperformance. And then on the downside, if you’re just investing in the most expensive, you’re down around 4%. So it rewards you to buy the cheapest markets to form an index, value-weighted rather than market cap-weighted, as well as to avoid the expensive ones. And then one other idea is, you say, well that makes sense. On a relative basis we were sorting these countries but how do I stay away from, when everything’s overvalued like the late 1990s when there was a bubble in everything equity. So there’s a great Buffett quote: “The first rule is not to lose. The second rule is not to forget the first rule.” So, we ought to be able to step aside when all markets are expensive because there are times this happened. And the picture of the mouse, he’s trying to get the cheese, trying to get the reward but being smart about it, trying to protect himself as well. And then the Arthur Ashe quote: “Either you understand your risk or you don’t play the game.” So, what we did in the paper is, we said there’s a very simple rule. We’ll buy these countries, the cheapest quartile only if they’re trading below a CAPE of fifteen. And this is just a once a year decision that takes five minutes a year to be able to update this and we say alright, if they’re trading below fifteen, they’re in. But if they’re not trading below fifteen, if there are countries that make it into this, we’re just going to put their portion of the portfolio in cash. So the portfolio can be in cash.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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So, what you see is it gets roughly the same return, it outperforms by around 100 to 200 basis points, but you soften the blow from some of these bear markets like in the late 1990s. And I think it cuts the drawdown at least in half and the worst year in this portfolio was about half that of buy and hold. So where do we stand now? What is today’s snapshot of the world? And we track over forty countries but this is currently the top ten and bottom ten that we track. And it should be no surprise, but a lot of beleaguered Europe is shown in the undervalued category. Certainly the winner being Greece at one of the lowest CAPE ratios we’ve ever seen. But also Ireland is in that special under five bucket, but plenty of undervalued, Russia, Italy, Portugal, Austria, Spain are all in this undervalued bucket. And on the opposite side, and for most of the spectrum it’s roughly fair valuation for the world right now, which is one of the reasons we tend to be fairly bullish on equities. That having been said, if you look at the U.S., which accounts for a great part of market cap as well as for GDP, they’re one of the more expensive countries, actually in the top five most expensive. Colombia, which I’m traveling to for the first time next month, is one of the most expensive or the most expensive we track at thirty-two, up there with Peru and Indonesia. But this gives you a snapshot of what the world looks like. Both the EAFE and emerging markets Morgan Stanley indexes are at reasonable valuations that I think it’s around thirteen to fifteen. So pretty good, not terribly undervalued, but there are certainly markets out there that are pretty cheap.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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And then in the paper we say, like many approaches especially in the value world, a lot of the indicators line up on the same direction when the security or the market has been pushed far enough away from fair value. So if you look at probably almost any valuation indicator of Cisco [CSCO] in the late 1990s it would say the same thing, whereas if you’re looking at a lot of the valuation indicators for Greece or Italy or Russia, they’re probably going to say the same thing right now. And so there’s a French-Fama dataset that’s free online and we reference it in the paper, and there’s a good article by Samuel Lee of Morningstar on this topic as well. They had countries we can sort on other factors such as price to book, price to earnings, price to cash flow as well as dividends. And this is a very similar test, but it sorts countries back to the 1970s based on these metrics. It takes the top third of the universe or top quarter, and you can see a similar outperformance of 2% to 4% depending on the metric. And so there’s a lot of value to be had in looking at these. A lot of people would take an ensemble approach where you’re saying, we’re going to take the top 20% based on all of these factors rather than just one, and they all tend to work well. And if you really want it to get exciting and get down to say, the top 10% of the universe, you can certainly get the most outsized performance. But we like to say a lot of the information is in the tails and you can do that but often it tends to be pretty volatile. Before we finish up, there are a couple of other ideas and comments we wanted to make on this type of investing. Shiller has actually just put out a lot of research partnered with Barclays on sectors in the U.S., and we’ve verified this © BeyondProxy LLC

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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research, but he built the CAPE with U.S. sectors. And then it takes the top five sectors by CAPE relative to their twenty-year history which is a pretty interesting way to do it, I think for sectors, I don’t know if that applies so much to countries like Japan, you could be in this consistent bear market from having started with such a massive overvaluation. But it’s certainly the way they do it and it takes the top five sectors and then drops the worst momentum of the five so they end up having four sectors, and it shows nice outperformance for the past decade or two. They’ve launched an ETN based on that. But sectors is another example, we talked briefly about this on the last slide where an ensemble model of value factors works better. And then for those that are familiar with us, they know we’re big proponents of both momentum and trend, or other factors that may complement value factors. Most value factors line up on the same side, but if you can take markets and one of the biggest, from a trader, a real money manager standpoint is, I don’t want to be investing in a lot of these countries as they’re falling knives. So at some point Greece was a fifteen CAPE, then a ten, then an eight, then a five and now it’s two because it’s had a drawdown of over 90%. And you don’t want to be investing all the way down. So there are some things that you can do with trend and momentum to try and alleviate that catching or falling knife problem. We’re not going to get into it here because we don’t have time but we publish some of these things on a kind of rolling basis. But we think it makes a lot of sense to combine value and momentum, as well as other factors.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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And with that, I will wrap up. Here’s some ways to feel free to get in contact with us through my website, blog, my email as well as phone number. And if we have time, I’ll be happy to do a little bit of Q&A. Host:

Thank you so much for this very insightful presentation. Anyone who has questions for Meb, I’d like to refer you to our online Q&A area where you can write in a question and I’m sure Meb will be happy to answer it, or you may also contact Meb directly. I have a few questions myself, just wondering on that chart where you showed the CAPEs for the various countries, can you give us a sense of how you then look at this as an investor. For example, Russia is up there or Greece? What goes through your mind when you see those very nice CAPE values? What’s the next step there before you pull the trigger as an investor?

Faber:

Well, one of the things that’s important that people need to look at is an index is nothing more than a just a group of stocks. And you have to be careful when you’re dealing with a lot of these countries because a lot of these indexes don’t contain a whole heck of a lot of stocks. Some of them are in single digits number of stocks and so then you’re simply investing in a couple of stocks. So it’s a little bit of buyer beware, but in general, you want to make sure that the index that you’re calculating these values for represents the indexable product. So it could be an instance where you say, look I calculated that Russia’s, whatever they may be, an eight CAPE and then go buy a mutual fund or an ETF that may be a completely different composition of stocks. So an investor on a practical level has to be really careful that they match up what they’re investing in.

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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But in general when you see these low valuations, it’s time to get excited, it’s time to be interested in what’s going on. But that behaviorally is the hardest part as an investor. You’re buying Greece, you’re buying Spain, you’re buying Italy and that doesn’t work out, you’re going to get fired. It’s a lot of career risk in buying things that are in the news for negative reasons that continue to do poorly. So that’s one of, we think, the reasons for the alpha, is the ability to step in front of this train and say, okay, I can have a clear mind, it’s not the end of the world necessarily. And then also, we promote that investors shouldn’t just focus on one or two countries but rather to try and buy a basket so it smoothes out the risk of any one of them falling into the ocean. Host:

When it comes to Greece, for example then, we also hear by talking to other investors a lot of these types of comments where people say, well yes, Greece is cheap, but when we look at the individual names we actually struggle to find any obvious value. And do you even contemplate that or do you not even engage in that sort of thinking but stick to your approach?

Faber:

There’s other ways one can approach this. Once you come up with the broad theory of why this works, you can then drill down in a number of ways. So, a fund may say, look we realize all the value is broadly in Europe right now, so we’re going to go hunting in Europe and focus on these countries and try to buy stocks that fit our criteria whatever they may be, and I think that’s fine. Some people use this as an initial screen just to get a kind of blueprint for where we stand right now in the world. And these aren’t short term trading indicators, these work out over the

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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course of years. But when you kind of look at some of these countries and, again they’re just nothing but baskets of stocks, it gives great perspective. One of the things we hear a lot about Greece or certain of these countries in Europe is, because they don’t have their own currency, the markets can’t get back to equilibrium the way that they normally would if they had their own currency and it may be true and it may be this time is different. But the valuations are so cheap that it’s hard to ignore. Host:

I guess one of the countries that sticks out to me when I look at this chart is, for example, Belgium or Austria. What do you make of this? I guess one could say that well Russia, it may be obvious that it’s cheap on a quantitative basis. One immediately perhaps thinks of the corporate governance issues. With Greece, of course, there are other issues around the Euro exit for example or with some of the other European countries there. But with Belgium, Austria do they stick out to you as well or how do you interpret that?

Faber:

One of the things we didn’t include in the presentation was that if you look at say the bottom third of all the countries we have listed, the low valuations correlate to roughly a drawdown in the indexes of around 50%, whereas in the top highest CAPE it’s closer to like 10%, so it’s a very broad valuation correlation. The CAPE ratio is slow to react so you’re just buying markets that have gotten crushed and at the very end, the worst five or so, it’s closer to 70% to 90% drawdowns. And in general that erases a lot of your risk. But I think it was David Einhorn that mentioned the other day, what do you call a stock that’s down 90%? It’s one that was down 80% and then

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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got cut in half. So the mathematics still work out really tough, for good and bad. Greece, for example, is already up probably 50% or so from this past summer, so there’s a lot of room for upside. But what we do, and we run a strategy called global value and momentum, is that we pair a lot of the worst performing countries, but want to own them as they’re starting to increase in value. So, we’re not trying to pick the bottom, rather we’ll wait for them to bottom and may give up the first slight run off the bottom, but try to invest in it when the trends are positive. And that’s kind of a way that we hopefully try to mitigate some of the loss from trying to catch a falling knife. Host:

Just to step back a bit, based on your experience, can you share with our audience some of the ins and outs of using ETFs to invest and play these sort of themes on a practical level? What are some of the pitfalls there? Is there anything that you can share with our audience?

Faber:

Yes. I mean like trading any sort of listed security, you want to be careful with execution, and this is simple, but trying to market in orders for securities is in general not the best approach. We like ETFs because of the structural benefits, the fee benefits as well the tax benefits, but I’m totally okay with investing in mutual funds etc. as long as you’re finding the ones that pass all your criteria. But in general the structural way of trading ETFs, a lot of the smaller ones may not have the volume, they have the liquidity, but you just got to be a little careful. But a lot of what we talked about today is very long term time horizons, so it’s nothing you need to be able to day trade or get in today or even tomorrow,

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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or even next week or next month. That’s something you’re probably going to want to be able to trade and hold for years as opposed to just the next few weeks. Host:

Are there any other instruments that one could employ when it comes to these sort of strategies? Are ETFs just your preferred method?

Faber:

They are preferred because of again the tax benefits. Most people still don’t appreciate that ETFs should rarely, if ever, pay capital gains distributions because of their structure, whereas mutual funds do, which is an enormous negative that I still think is not appreciated. But if you look at, for example, the SPDRs since the late 1990s haven’t ever paid a meaningful distribution and that’s a very, very real tax benefit, whereas most of the mutual funds, because the money comes in and out, are trading these securities and they have to. So that’s one, and then the fees in most ETFs tend to be a lot cheaper than mutual funds. But here’s another interesting opportunity. When markets are getting bombed out so 2008, 2009, those are a perfect example, it just tends to be more when it’s across the board. But if equity markets in general are in drawdown, a great place to look are closed-end funds because they can trade away from their net asset value. And so often you can buy a fund that focuses on a certain part of the world or country that will trade at 15%, 20%, 30% discount to net asset value. So not only are you buying the portfolio cheap based on the CAPE ratio, you’re getting it for 70 cents on the dollar. The challenge of a lot of those funds, of course, is they’re often expensive, some of them charge 1.5%, 2% so you don’t want to

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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hold them for years because it will eat away at the benefit of having the discount, but there are a number of them that have reasonable fees. That’s another area of opportunity. And then, of course, people can trade other stuff such as futures and options if they’re comfortable and familiar with those. Host:

How do you deal with currency? Can you just give us a sense of how your approach deals with that?

Faber:

Currencies are an interesting topic and it’s probably too short time we have here to be able to really get into it the way we wanted to. Many investors especially in the U.S. don’t view currencies as an asset class. They view currencies as something that may be a good or bad thing when they invest abroad and depending on what the dollar does relative to the currency, they rarely hedge out the foreign returns. And because they don’t have an approach, they don’t really see it as a way to generate any alpha. They see it as a zero sum over time. And frankly, most people in the U.S. see it as, are steaks inexpensive in Argentina right now or is it cheap to go skiing or travel in Europe? But everything is a currency trade, what you do every day with your money or your investments. And there are a lot of factors we think that make sense on their own for currencies such as value, such as momentum and trend, and carry, which is the most famous one, but we think the worst to diversify our portfolio. So we come up with currency views on our own and we think it’s a tradable asset class as a standalone strategy. It gets a little difficult mixing in what’s going on with the currency/equity/fixed income markets and so we don’t want to

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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get too complicated on the valuation side but in general it’s something we think about that can be a benefit to investors if they spend some time with it. Host:

Now we are here at the Best Ideas conference and just based on your comments I’m curious, if you could just summarize for us what are then your best ideas when you’re looking to invest for 2013 and beyond?

Faber:

We think that from a U.S. investor’s standpoint who’s looking at the world especially it’s a really challenging opportunity set in the U.S. So, U.S. stocks are slightly overvalued, there have very high margins right now which tend to revert over time, so those are headwinds. But they’re not terrible, it’s not as bad as it was in the late 1990s but not super exciting and we’re coming off a great year. And then bonds are kind of universally understood as one of the worst opportunities. You have negative real returns there likely for the coming years. So an investor has to be global first of all. So, the equities in many foreign markets, especially Europe, but we love buying a basket of these cheap, low CAPE, under ten valued markets which has you buying Greece, Italy and Spain, and Russia which is difficult for many people but we think rewarding as well over time. And then, real assets we think are important too for a part of the portfolio. Exposure to commodities, exposure to real estate, both domestic and abroad. But one of the things we’re most excited about is these low valuation countries, especially in Europe.

Host:

And I guess as U.S. investors when we look at the next year, a lot of people are worried about what the government will do and

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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Exclusive Session Transcript (lightly edited, may contain errors) CONFIDENTIAL – do not redistribute

the tax picture. You’ve got a great book coming up, Shareholder Yield, can you tell our audience a little bit about the book and give us a bit of a preview about the themes there? Faber:

Sure. We think that most income investors that are focusing on dividends are taking the wrong approach. Not to be too harsh, but the SEC passed a rule in the early 1980s, 10b-18, that gave U.S. companies safe harbor for buying back their own stock. And there are five ways that companies can use cash flows – dividends, buyback stock, pay down debt, reinvest in the company, as well as mergers and acquisitions. And what you’ve seen since the early 1980s is a big shift in the way companies distribute cash to their shareholders and that’s largely dependent on tax rates in the U.S. And there are academic papers that show this happens all over the world. But when you’re taxing dividends at an inferior rate to long term capital gains, it makes no sense for a company to be paying out dividends when they could be buying back stock. Now, there are some other caveats that make more sense for companies to have a process for buying back their stock when it’s undervalued on an objective measure. But so what you do is if you take this more holistic approach to cash flows which we call shareholder yield, and then you screen for companies based on this level of yield, you end up coming up with a portfolio that beats dividend indices by about 2% a year, one and a half to 2%, and beats the S&P by about 4% a year back to the 1980s. And then O'Shaughnessy has taken the research all the way back to the 1920s and found similar results. So we think it’s a big opportunity for investors especially with the tax code

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Mebane Faber Chief Investment Officer, Cambria Investment Management

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changing in the way that it is and all this money rushing into dividend stocks for the past few years. We think it’s a great time to rethink the approach and take a more holistic view of cash flows and their distributions. Host:

Great. Well, we certainly look forward to reading more about that in your book Shareholder Yield coming out soon. Meb thank you so much for your time today, and sharing all your insights with our audience.

Mebane Faber is a co-founder and the Chief Investment Officer of Cambria Investment Management. Faber is the manager of Cambria’s Global Tactical ETF (GTAA), separate accounts and private investment funds for accredited investors. Mr. Faber is also the co-founder of AlphaClone, an investing research website, the author of the World Beta blog, and the coauthor of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. He is a frequent speaker and writer on investment strategies and has been featured in Barron’s, The New York Times, and The New Yorker. Mr. Faber graduated from the University of Virginia with a double major in Engineering Science and Biology. He is a Chartered Alternative Investment Analyst, and Chartered Market Technician.

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