U.S. stocks are expensive, and buybacks are at record levels, but nothing is as concerning as the appetite and the underwhelming performance of dividend-yield ETFs this year.
Meb Faber, a widely respected quant analyst who is also head of Cambria, the ETF issuer behind funds such as the Cambria Shareholder Yield ETF (SYLD | B-44) and the Cambria Global Value ETF (GVAL | F-25), tells ETF.com that investors better steer clear of dividend ETFs, focus on value in the buyback space and, above all, keep their portfolios heavily allocated to foreign stocks—cheap foreign stocks.
ETF.com:What’s your latest take on U.S. stock valuations?
Meb Faber: The U.S. market is a little bit expensive. And one of the challenges of the valuation is that people want to fall into one of two camps. They either want to believe that things are cheap (“It’s screaming buy!”) or that things are expensive (“It’s going to crash!”). People think in very binary terms, and they hate thinking in terms of it being a spectrum of future probabilities.
It’s boring to hear, but the more the market goes up, the fewer future returns there are going to be over the next, say, 10 years. The more it goes down, the higher the returns will be. We expect future returns to be in the 4 to 5 percent nominal range going forward.
It’s not horrific. It's better than bonds. But you run into some problems as the market gets more expensive. The higher it gets, the higher the chance you have of a large drawdown.
There’s a study out now that tracked the median stock valuation for the S'P 500, and on a price-to-sales basis, going back to 1960s, it’s the highest it’s ever been—ever!
The good news is most of the rest of the world is really cheap, and in some places, it’s exceptionally cheap. In our global value fund [the Cambria Global Value ETF (GVAL | F-25)], we look at the bottom quartile of developed and emerging countries, and that bucket is the cheapest it’s been since the bottom in 2009, the bottom of 2003 and the early 1980s. And if you wondered what the three best times to invest in our lifetime are, those are pretty good starting points.
ETF.com:Yes, but GVAL is actually down more than 2.5 percent year-to-date. Are those value traps, or have these value opportunities not materialized yet?
Faber: In any active strategy you would expect it to outperform in the majority of years, maybe 60 percent of the time. And we expect it to outperform the global index by quite a bit. But any active strategy—because it’s so different from the global market-cap portfolio—could have a year, two years, three years of relative underperformance. Over time, we think it’s going to be much better. And we actually think right now is a particularly great time.
But what happens in the irony of these markets is that when you buy the basket of cheap countries, you usually get a pretty diversified lot:We have Russia and Brazil in there and then a lot of Europe. If you were to ask people what the best-performing countries in that fund were and what were the worst, they would be surprised, but Russia's the second-best-performing, and it’s had the worst headlines since launch in March.
The best performer is Brazil, but it’s just been lights out. Europe is struggling with potential deflation, but I've been putting more of my own money into it. When the stories start to fade away, when things start to get better, I think you're going to have really, really explosive returns. Obviously, I'm biased, but the valuation levels are exceptional right now.
ETF.com:What’s the story with buybacks in the U.S.? I read recently that they are at record levels this year. Does it make sense for companies to be buying so much of their own shares if their prices are overvalued?
Faber: On aggregate, no. And on aggregate, CEOs are terrible at timing buybacks. Buybacks largely are cyclical and follow the stock market. If you look at how companies use cash, the two most volatile are M'A and buybacks. Typically they tend to move together. M'A hasn’t really been that cyclical yet, but it’s starting to catch up, but not at levels that you saw in 2007 and the 1990s.
When times are good, and they have cash sitting around, is when they typically do buybacks and acquisitions. It’s the exact opposite of when they should be doing it, which is when the market’s down 50 percent and in general their equities are cheap—like in ’08 and ’09. But if you look back, there were no companies doing buybacks. They were actually issuing shares.
However, that should never really matter to the individual stock picker. You need to pick the companies that are cheap that are buying back their stock, because dividends and buybacks are the exact same thing if the stock’s trading at intrinsic value. If it’s below intrinsic value, it’s a transfer of wealth from the seller to the buyer. You're buying a dollar for 80 cents, 60 cents, whatever.
You have to have a valuation-screening criteria to buy cheap companies buying back their stock. The last thing you want is expensive companies buying their stock. This is one of the biggest problems with dividends right now.
ETF.com:You recently tweeted that dividend ETFs have lower dividend yields than the broad market. Are dividend-yield ETFs overpriced or what?
Faber: This is the problem:As billions of dollars have rushed into dividends in the search for yield over the past decade, it has changed the asset class. If enough money goes into something, it can change the characteristics of a factor. Factors aren’t static.
With dividend factors, for example, when you buy dividends, historically, you're buying value. And dividend stocks historically have traded at 20 percent discount to the broad market. That's why they work, they're cheap.
Typically, they're not great companies, they're overleveraged, have a lot of debt and in many cases are not doing that great. Again, you have to have a valuation filter. Back in ’99, dividends were a fat pitch. They were at the biggest discount to the market they've ever been, but no one wanted dividends in ’99. People were talking tech, dot-com, biotech.
Fast-forward to ’08, as interest rates have come down, and no one wants bonds, investors went searching for yields into dividends. Dividends have done great. In ’08 they got hit, but for the first time ever, they're trading at a valuation premium to the S'P 500.
Dividends not only are not at a 20 percent discount, they're more expensive than the S'P 500. That’s the last place you want to be—buying these companies that have high leverage that are more expensive than the S'P. That’s the reason dividends, and dividend funds, have underperformed so much, unless they have a valuation framework.
ETF.com:How do buybacks fit into this?
Faber: These funds still ignore buybacks, which makes no sense. And the same problem happens with the buyback stocks and ETFs—they ignore dividends. It’s the most nonsensical thing on the planet.
But the reason the buyback funds are doing so much better than the dividend funds is that, right now, they are yielding a lot more. If you look at the yield on high-dividend funds, it’s around 3 percent, maybe 4, while the top buyback yield is around 6 percent.
Investors don’t care where they get the yield, it’s just the aggregate amount that they care about. So, the buyback funds are doing better because they have a higher yield, cash flow yield, than the dividend funds. Shareholder yield’s doing better than both because they combine the two.
And here’s something I keep saying:If you look at a lot of the dividend funds, many of the stocks are actually net issuers. Many of the dividend stocks that are above 4 percent in the Russell, for example, actually have a negative yield because they're issuing more than 4 percent of shares.
You think you're getting paid 4 percent but the company’s actually diluting you by more than 4 percent a year. It’s a net loss on the yield. But it’s hard for people to compute it.
ETF.com:So are you better off just owning an S'P 500 fund versus a dividend-yield ETF, or a buyback ETF? What should an investor do?
Faber: No, you're better off owning SYLD [the Cambria Shareholder Yield ETF (SYLD | B-44)]. First, focus on the holistic yield. And, if you're including buybacks, which you should, you want the cheap companies.
It doesn't matter what sort of valuation framework you use, but to be able to at least quantitatively or objectively select or remove the expensive ones is key. Remember that the vast majority of stocks are twice as expensive as they have been historically.
Or, you're better off staying away from dividend yields, moving out of the U.S. and getting away from U.S. small-caps. Small-caps are the most expensive they’ve ever been relative to large-caps. Move to foreign.