Monday, April 5, 2010

Kotok and Sciarretta, Invest in Europe Now!

There are books that stretch my brain and those that don’t. It is often not a function of the books themselves but rather of the breadth of my knowledge. I received three books from Wiley to review and they span the spectrum. I decided to start with the fastest read, Invest in Europe Now! Why Europe’s Markets Will Outperform the U.S. in the Coming Years by David R. Kotok and Vincenzo Sciarretta (Wiley, 2010). The book’s 215 pages of text are divided into three parts: macro issues, stock-specific strategies, and guru chapters. The third part, which comprises almost half the text, is a series of interviews that Sciarretta did with ten experts on the European markets.

I am not a macro investor nor do I consider myself a seer. Moreover, to me the word “now” means a period much shorter than the time it takes to write and publish a book. So instead of writing a real review, I’m going to use this opportunity to explore two topics—what investment strategies have worked in European equities and what I would have written had I been considered a guru on investing in Hungary (and given only a paragraph’s worth of space).

There has been extensive research in recent years on building multifactor portfolios. I wrote about a fairly new research paper, "Diversification Across Characteristics," a couple of weeks ago. Kotok and Sciarretta’s book provides data from the European markets.

The Eurozone, the authors admit, does not offer the American investor much diversification when it comes to trading strategies; generally speaking, what works in U.S. equities works in European equities. Using the EURO STOXX index as their database, an Italian firm designed and analyzed several 10-stock portfolios (both single factor and multifactor) over a ten-year period—December 31, 1998 through December 31, 2008. The portfolios were rebalanced every three years, leaving the fateful 2008 period to stand alone.

Over the course of the first nine years the best single-factor strategy was low enterprise-value-to-sales stocks with relative strength coming in second. EV/sales returned 16.2%, relative strength 14.4%, and the DJ EURO STOXX 3.7%. Once 2008 was added to the previous nine years performance sagged, but EV/sales was still the best overall at 8.1% and relative strength second best at 6.8%. The index lost 2.9%.

The three multifactor portfolios combined value and previous-year momentum. The winner used as its value component a price-to-cash-flow ratio below 10 and a dividend yield greater than 2%. This multifactor portfolio outperformed all single factor portfolios over both the nine-year and ten-year time horizons—19.4% and 11.1% respectively.

To move beyond the contents of this book, if the authors urge us to invest in Europe now, what about Eastern Europe, more specifically Hungary? (I know more about Hungarian politics than anyone without an ounce of Hungarian blood in her should, so now might be an appropriate time to share a couple of observations.) Hungary has been digging itself out of its financial hole with the help of IMF and EU loans and a stringent austerity program. So far so good. The problem is that national elections are coming up very soon (April 11 is the first round) and the prediction is that the opposition party will win, some say by a landslide. To a Western investor this might sound like good news: a right-of-center party will replace the socialists. The problem is that in Hungary things are topsy-turvy: the socialists have been the advocates of democracy, capitalism, and foreign investment while their opponents have a checkered record in areas normally considered investor friendly. For instance, they have illegally broken contracts with foreign companies. In general they are less democratic, less capitalistic, and more nationalistic. I am, of course, making neither a political nor an investment recommendation, just urging due diligence before investing in a country that has already outperformed most world markets. As of April 1 the BUX ETF, registered in Hungary and a tracker of the BUX Index, has a one-year return of 108.82% and has gained 14.55% year to date.

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