Stocks and Shares

Why I am buying Russia and selling the USA

When buying anything, it’s a self evident truth that paying less is better than paying more, assuming quality is the same. It could be a car, or a house, or a coat, or an investment. Everything has a value. We make a good purchase when the price is lower than that value. So how do we decide if stocks are good value? There’s no single easy answer, but by looking at a range of measures we can significantly improve our chances of making good choices.

A business is an organisation that owns productive assets, such as factories, brands, buildings, machinery and stocks of finished products. The people working for a business use those assets to make a profit. They produce a good or service for sale, and once they’ve paid the suppliers, wages, debt interest and taxes what’s left belongs to the owners – the shareholders.

We can’t know with any certainty exactly how much profit any one company or group of companies will make in future years. But we do know how the current price of a company’s shares compares with its recent finances.

Using financial analysis is a great place to start when deciding whether now is the time to buy something, or indeed the time to sell. Whilst this kind of analysis will never give us certain outcomes, it does give us important information about the chances of generating significant investment profit in future, whether it comes in the form of capital gains (rising share price between purchase and sale) or income (cash dividends received during ownership).

Financial analysis largely uses a range of ratios that compare one measure with another to give us some clues as to where things stand in relative terms. That is, relative to other potential investments or relative to historical levels for the measure at hand.

Probably the most commonly used ratio is the price-to-earnings ratio, which simply compares the market price of the share to the earnings per share (EPS). EPS is simply the net profit (earnings) of the company divided by the total number of shares that the company has issued.

So if the share price is $20 and the EPS is $2 then the P/E is 10 (or 10 times, or 10x). Put another way, if profits don’t grow it would take the company 10 years to generate $1 of profit for every $1 of capital invested in the shares, at current market prices. The higher the P/E the longer it would take, and vice versa.

…any single measure can be misleading at times. So it’s best that we look at other ratios as well, not just the P/E.

But any single measure can be misleading at times. So it’s best that we look at other ratios as well, not just the P/E. There are many ways to do this, and some are very complex. However there are also a handful that are easy to understand. I always looks at much more than one measure when deciding whether to buy something. So let me take you through three other common yardsticks that I like to look at.

Dividend yield is one such measure. This looks at the dividend per share (DPS) divided by the share price. DPS is how much cash the company pays to the owner of each share each year. If that sounds a bit complicated it isn’t really. Dividend yield just tells you how much income, as a percentage, your investment is likely to earn you at the current price.

Let’s say the DPS last year was $0.50 and the share price is $20, then the dividend yield is 2.5%. In general terms, the higher the dividend yield, the more attractive the investment. High yield also usually goes hand in hand with low P/E, but not always.

We can use these two measures together to get a quick snapshot of what’s cheap in the world, especially at the country index level. The chart below compares P/E and dividend yield for selected stock markets at the end of December 2014, using information from Star Capital.


In short, anything in the top left is “cheap” by these measures, with a low P/E and high dividend yield. On the other hand, anything in the bottom right is “expensive”, with high P/E and low yield. As a rule of thumb, at the country index level, I consider a P/E of around 15 to be “average”. (At the individual stock level it depends on the industry. Some industries routinely trade in the 20s, others in the low double digits.) Anything below 10 is very cheap and anything above 20 is expensive.

When it comes to dividend yield, around 3% is average. Above 4% indicates cheapness, and below 2% indicates that the index is on the pricey side.

When it comes to dividend yield, around 3% is average. Above 4% indicates cheapness, and below 2% indicates that the index is on the pricey side.

Measured by P/E this indicates that Russia (P/E 6.7), Italy (8.5), China (10.1) and Greece (8.1) are cheapest and Spain (22.3), Portugal (20.6), Canada (20.6), Switzerland (20.6) and the USA (20.3) are the most expensive.

Using dividend yield the bargains appear to be Russia (5.7%), Brazil (4.8%), Spain (4.6%) and Portugal (4.3%), and the worst yields are available in Greece (0.7%), Japan (1.7%), India (1.5%) and the USA (1.8%).

This is both helpful information, but also potentially confusing. Russia looks cheap on both measures, and the USA looks expensive on both measures.

That gives a clear buy signal for Russia and a clear sell signal for the USA, as long term investments (we never know what prices may do in the short term).

But there are conflicting signals as well. Greece has the second lowest P/E ratio (good), but the absolute lowest dividend yield (bad). Both Spain and Portugal have high P/Es (bad) but also high yields (good).

So what we need is to look at more measures to see if we can shed more light.

The next measure is the price-to-book ratio (P/B). This compares the price with the “book value” of the companies in the index. Book value is another term for net assets, which is also known as shareholders’ equity in a company balance sheet.

Book value adds up the value of all the things a company owns (assets) less all the money it owes (liabilities) to give a net asset value. This can be thought of as the liquidation value of the company.

This is because, in theory, you could buy the whole company, sell all assets, pay off all debts, and the book value is the cash amount that you’d be left with. (In practice at the individual company level this depends on accounting policies, and I don’t want to get into too much detail here. But at the stock market level it’s a good proxy for liquidation value.)

So, long story short, a low P/B indicates a better bargain than a high P/B. And a P/B less than one means you’re buying something for less than liquidation value. That’s an extreme bargain for the collection of profitable and often essential businesses that make up a stock index.

Here’s the chart comparing P/B with dividend yield.


By this measure both Greece and Russia are trading below liquidation value, both with P/Bs of 0.7. Put another way, at the end of December there was 43% upside to liquidation value in both markets (1 divided by 0.7 equals 1.43, or 143%). That indicates an extreme bargain in both cases. Earnings can swing around from year to year, but book values are much more stable.

At the other end of the scale, the most expensive markets on this measure are Indonesia, India, the USA and Switzerland, all with P/Bs above 2.5. In fact in Indonesia’s case it’s up at a massive 3.8.

The final measure I’ll look at today is the P/E10, also known as the Cyclically Adjusted P/E ratio (CAPE) and Shiller P/E. This is like the P/E ratio with a clever twist. Instead of just using last year’s earnings for the “E” it takes an average of the past 10 years, with each year adjusted for cumulative price inflation. The idea is to provide a smoothed average of historical returns, but expressed in the value of today’s money.

Here’s the chart of P/E10 and dividend yield.


Again we’re looking to the top left for the best bargains and bottom right for the most expensive markets.

By this measure there are four “cheap” markets with P/E10s less than 10. Those are Russia (4.6), Brazil (8.8), Portugal (6.3) and Greece (2.4). At the expensive end, over 20, we find India (20.3), Switzerland (23.1), Japan (25.9), Indonesia (26.6), the USA (27.8) and Italy (29.6).

We’ve now looked at four measures of relative pricing. For some countries they all point in the same direction, but for others they give conflicting signals. Let’s summarise so we can make sense of it all.

The boundaries I’ve chosen for a market to be cheap are P/E less than 10, dividend yield greater than 3%, P/B less than 1.5 and P/E10 less than 10. There’s no hard and fast rule here. But the further we move these to the extremes the greater confidence we can have in our conclusions.

Only one country looks cheap on all measures, and that’s Russia. Brazil, Portugal, Italy and Greece are cheap on three measures, and China narrowly misses being cheap on two measures (it has a P/E of 10.1, just a tiny bit over my threshold).

At the other end of the scale are the expensive markets. The boundaries I’ve chosen are P/E greater than 20, dividend yield less than 2%, P/B greater than 2.5 and P/E10 greater than 20.

Only one country is expensive on all measures: the USA.

Only one country is expensive on all measures: the USA. Switzerland and India are expensive on three measures and Indonesia and Japan on two measures.

Of course each country has its specific circumstances at the moment. And we can come up with all sorts of reasons to try to explain some of the apparent discrepancies. For example China has a relatively low P/E at 10.1, but fairly high P/E10 at 17.5. To me this is most likely just a product of fast growing earnings in a fast growing economy.

Put another way, Chinese profits have grown at a much faster rate than inflation, meaning that the profit average used in the P/E10 is probably understated. On the other hand it could mean that profits in China are temporarily and unsustainably high. I think it’s more likely to be the former than the latter. But there are certainly concerns surrounding high corporate debt levels in China, which could slow down future growth.

On the other hand both Portugal and Spain have high P/Es but low P/E10s. This indicates that earnings have collapsed, which is logical given the hard recessions (or depressions) that both countries have been experiencing since the global financial crisis in 2008. The question is whether that collapse of earnings is temporary or for the long term. I suspect the latter given those countries deep seated problems, set within a financially troubled continent.

Country indices such as those require more analysis before drawing firm conclusions. But for now a couple of things are clear. Based on a range of valuation measures you’re most likely to make healthy medium to long term profits from investing in underpriced Russian stocks, and least likely to have a good result in the overpriced USA.

That’s not to say, in the short term, that I’m predicting an imminent crash in US stocks (although it wouldn’t surprise me) or that Russia will keep recovering from the 2014 lows (up 15% in US dollar terms so far in 2015). However, based on their valuation extremes on a range of measures, over five to ten years the Russian bear is likely to significantly outperform the American eagle.

That said, there is clearly the risk of escalation in the confrontation between NATO countries and Russia in Ukraine and Europe. So far it’s mainly been economic (sanctions) and verbal (political rhetoric) in nature. But there seem to be plenty of people in the US and elsewhere bent on sending weapons into the region (the US has recently been parading tanks in the Baltics, close to the Russian border).

Only time will tell, but these risks look to already be in the price. Under most scenarios Russian stocks are the bargain of the decade.

You can easily get exposure to Russian shares via the Market Vectors Russia ETF (NYSE:RSX). At the end of February this fund owned shares in 48 Russian companies with an average P/E of 6.1, P/B of 0.65 and dividend yield over 4%. Just remember to stay diversified at all times. Anything can happen in the short run.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.