The Twelve Days of Christmas: The Max Value Strategy

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(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/25/2013

Editor's note: Over the past year, S&A's quantitative analyst, Ian Davis, has developed an idiot-proof investment strategy that nearly guarantees a substantial outperformance of the stock market. For the full story on this unique, statistically proven model of investing, read on...

The Max Value Strategy: A Simple Way to Beat the Market

 Originally published in the April 13 edition of Quant Trader

What would you do if you were told your property rights were going to be taken away in 15 years?

This was the question that faced Hong Kong citizens in the early 1980s, when it was widely known that Britain's "lease of the new territories" was expiring in 1997. At the expiration of this lease, Hong Kong was going to be handed back to the People's Republic of China, a country that didn't guarantee property rights.

The future of Hong Kong looked grim. Investors were predicting mass emigration from Hong Kong, a flight of foreign capital, and a subsequent economic downturn. It's no wonder that between 1983 and 1985, Hong Kong was the cheapest country in the world relative to its historic valuations.

Then, in December 1984, Margaret Thatcher and Deng Xiaoping, the then-leaders of Great Britain and China, respectively, signed the Sino-British Joint Declaration. Under the agreement, the way of life in Hong Kong would remain unchanged for a period of 50 years.

With the signing of the declaration, came an end to uncertainty, and Hong Kong recovered to more normal valuations. But what if you had invested between 1983 and 1985, when Hong Kong was the cheapest country in the world?

During that two-year stretch, the DataStream Hong Kong index increased by 76.5%.

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Last week, I recommended that you buy another country under China's watchful eye, Taiwan. Like Hong Kong in the early '80s, Taiwan is the cheapest country in the world relative to its historic valuations.

The Max Value strategy is simply the strategy of buying the country indexes with the best value each year and holding them for a set period of time.

Let's take a look at why this strategy works and how it has performed over the last 29 years.

Why Max Value Works

Today, I'm going to show you how the simple strategy of buying the cheapest countries in the world and holding them for long periods of time can lead to enormous gains.

But first, why do I think such a simple strategy can beat the market by more than 10% annually when hundreds of money managers struggle to eke out even an extra percentage point each quarter?

It's because of the time frame.

Most money managers on Wall Street are trying to earn more than the market each quarter. Their jobs, by and large, depend on these quarterly returns. Their quarterly figures are widely published and reviewed by potential investors. Good quarterly figures mean more money for their funds.

Also, if a mutual fund's returns are significantly different from the market's return (even if it is above that return), then the fund's management and the amount of risk it is taking come under scrutiny. All of this leads to money managers who are like sheep, trying simply to match market returns most of the time.

Consequently, some very simple strategies can produce fantastic returns over the long run, if you are willing to endure short- to medium-term periods of volatility.

Simple Strategy, Amazing Returns

The idea behind this strategy is that valuation levels should be mean-reverting over long periods of time. Thus, when countries are significantly undervalued, they will perform better than their peers over the coming years in order to return to their normal valuation levels.

For this study, I used the median levels of the country's valuations. I used medians instead of means since, when dealing with valuations, the median is almost always a better measure of center than the mean.

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Also, for this study, "cheap" will be defined as the countries whose valuations are the farthest below their median levels. Conversely, "expensive" will be defined as the countries whose valuations are farthest above their median levels.

For every year between 1978 and today, I ranked each of the 51 countries indexed by Thomson DataStream from cheapest to most expensive relative to their median valuations.

Then I calculated the annual returns you would have achieved by investing in the cheapest countries and holding them for a set, multiyear, period of time. The following table lists the annualized returns you would have achieved by investing in between one and four of these cheap country indexes, and turning over your portfolio every one, two, three, or four years. These returns do not include taxes or fees, so they are a better representation of the returns that could be achieved by investing in a retirement account.

All of these returns significantly beat the 10.4% annualized return achieved from buying and holding DataStream's world index. The best two returns were achieved by holding one fund for four years at a time, or two funds for two years at a time. The following two charts show the growth of $10,000 when invested in these trading strategies, compared to $10,000 invested in the DataStream world index.

So Which Strategy Is Best?

As you can see from the charts above, the first strategy would have turned $10,000 into $49.2 million, and the second strategy would have turned $10,000 into $24.7 million.

Although the first strategy achieved better overall returns, the second strategy had a more consistent growth rate. Between the middle of 1999 and 2000, for example, the first trading strategy suffered a fall of 58.8%, but the second strategy suffered a more modest 32.7% fall.

Also, investing in two funds rather than one achieved greater returns for all turnover periods except a four-year turnover period. For these reasons, I believe investing in two funds and holding them for two years – before reinvesting in two new countries – is the best strategy to take advantage of this study's findings.

Good investing,

Ian Davis

P.S. The Quant Trader is a weekly trading service available to members of the S&A Alliance. For more on the Alliance, please call Michael Cottet and his team at 888-863-9356.

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