Buying value is an investment philosophy that works. To benefit from a value strategy, investors have to decide on a definition for value.
There are numerous ways to decide when a stock offers value, and many of these methods work well as long as they are applied with discipline. For deciding when a stock market in general offers value, we prefer to use the CAPE ratio defined by Robert Shiller.
The CAPE ratio -- which stands for cyclically adjusted price-to-earnings (P/E) -- is calculated with inflation-adjusted earnings over the past 10 years. This smoothes out the sudden spikes in earnings seen in recessions and at the beginning of an economic expansion, and provides a way to judge a market's value based on a full economic cycle.
In the past, when the CAPE ratio has been high, stock prices have delivered below-average returns over the next few years. Low CAPE ratios highlight long-term buying opportunities.
Shiller's CAPE can be applied to any stock market in the world. Investors looking at CAPE to make investment decisions a year ago may have bought stocks in Greece where the CAPE ratio was 2.6, the lowest of any global stock market. Investors willing to buy Greek stocks have been well rewarded. Global X FTSE Greece 20 ETF (NYSE: GREK) is up about 23% since the beginning of the year.
Irish stocks were also cheap with a CAPE ratio of 5 in December 2012. The iShares MSCI Ireland Capped (NYSE: EIRL) ETF is up nearly 40% year to date.
Other ETFs that would have been buys based on low CAPE ratios are Global X FTSE Argentina 20 ETF (NYSE: ARGT) and iShares MSCI Italy Capped (NYSE: EWI), which both started the year with CAPE ratios below 8 and have delivered double-digit gains. Market Vectors Russia ETF (NYSE: RSX) is the only one of the nine countries with the lowest CAPE ratios and a tradable ETF that shows a loss in 2013.
Looking ahead to next year, several of the countries with low CAPE ratios cannot be bought with ETFs. We have listed the lowest country CAPEs below and noted an ETF when it is available.
There is some overlap between last year's list and this year's. That is to be expected because it takes time for an undervalued market to recover.
Rather than buying all available ETFs, we found two investments that provide broad exposure to the most undervalued regions.
First is a closed-end fund, Central Europe, Russia and Turkey (NYSE: CEE). Closed-end funds (CEFs) trade like ETFs but have a fixed number of shares issued. ETFs increase or decrease the number of shares when money is added to or withdrawn from the fund. Because CEFs have a fixed number of shares, they can trade at a discount or premium to their asset value. CEE is trading at a more than 10% discount to its value, offering investors a chance to buy $1 worth of assets for less than $0.90. If the stocks it holds increase in value and the discount decreases, investors could see a large gain in this fund. CEE holds most of its assets in Russian stocks and also has exposure to Hungary.
The second investment we like is in the Middle East, a region that is undergoing constant change. Three of the 10 countries with low CAPEs are in that region, but Jordan and Lebanon are smaller markets and do not offer ETFs. PowerShares MENA Frontier Countries (NYSE: PMNA) is an ETF that offers exposure to the Middle East, but it has only 0.2% of its assets in Jordanian stocks and no significant investments in Lebanon.
Market Vectors Israel ETF (NYSE: ISRA) could benefit from stability in the region. The country itself has a low CAPE and is a buy. The prospects of geopolitical stability add to the attractiveness of ISRA.
Action to Take -->
-- Buy CEE and ISRA as long-term holdings
-- Set stop-loss orders 20% below the purchase price
-- Maintain these holdings as long as the CAPEs remain below 15
This article was originally published at ProfitableTrading.com:
The Top 2 International Value Funds for the New Year