A Dogs of the World strategy that beats the benchmarks

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There's an old expression, "Opportunities abound; you just have to know where to find them."

If only it was that simple when it comes to investing. Well, maybe there is a way to find them, but you'd have to be willing to take a deep dive into poorly performing international stock markets at seemingly terrible times.

I'm talking about a Dogs of the World. It exists. I discovered it during my hunt to build an international contrarian stock market strategy. Historical data backs up the approach.

The stock market in Brazil was up an eye-popping 66 percent in 2016, according to MSCI. Peru was up 59 percent, according to MSCI. Mind you, the news coming out of these economies was terrible. So what's the catch?

There's no catch. I simply isolated 50 single-country stock market indices since the beginning of 2011 and back-tested how I would have done if I invested in the bottom countries (either worst 10, five, three or one) in every year since then.

"This is a gutsy way to go international, but it's what I'll do. ... It's often best to go where others have left."

I was pleasantly surprised. The results would've outperformed the MSCI EAFE and MSCI Emerging Markets index handily. The way it works is, if you invested in the bottom annual performers from the previous year, every year since going back to 2011, the process was repeatable and delivered alpha over the two standard international stock benchmarks.

In fact, if you had invested in only the second-to-worst country starting in 2011 — rather than the five worst — a $100,000 investment would turn into $294,000, (assuming reinvestment of the full amount each year over a five-year period through 2015). That was the biggest winner of all among potential Dogs of the World strategy options.

In the end I decided to create a portfolio of the bottom five single countries. The bottom five outperformed the bottom 10, and one country or even three countries just isn't enough for my taste when it comes to international diversification. To be clear, this research did not include every single-country stock market in existence, but the 50 markets I chose do cover most of the globe, with a few exceptions — for example, Nigeria and Egypt.

The world's worst markets in 2016

2016 total return
3-year total return
Year-to-date return
Mexico (-10.11) (-30.77) 1.1
Italy (-9.4) (-15) 2.77
Turkey (-8.28) (-27) 1.1
Denmark (-8.04) 18.7 3.1
Ireland (-6.96) 12.88 2.7

(Source: iShares 1-year and 3-year ETF total return data through 12/31/16; Google Finance year-to-date return data through 1/24/2016.)

Creating a portfolio of 2016's bottom five international stock markets takes us globe-trotting to domiciles that are as controversial as ever.

Here are a few important things to consider about the bottom five, starting with the worst:

  1. Mexico: Potential trade war with United States, President-elect Trump's favorite country to threaten. The wall is another point of contention.
  2. Italy: Its banking sector is very weak; the government had to bail out the country's third-largest bank, and more bank bailouts may be necessary.
  3. Turkey: This is perhaps the most controversial pick. A failed coup, terrorism, war in Syria and with its Kurdish minority, cold relationship with its NATO partners, warmer relationship with Russia, a weak economy and a prime minister (Erdogan) who is less interested in a secular government.
  4. Denmark: As with many other countries, it has a very high dependence on trade, and it's facing an aging demographic.
  5. Ireland: Ireland is in decent shape. However, investors are concerned that if U.S. companies no longer do inversions (relocate to Ireland to lower their corporate tax), that could hurt its economy. Also, Brexit looms large, as Great Britain is a major trading partner of Ireland.

These five country stock markets have turned positive in the past month. Two have done well when viewed over a three-year time horizon. The worst, Mexico, remains mired in a big multi-year slump, but Mexico didn't even make the bottom five among the world's worst in 2014 or 2015.

A few things to keep in mind: This is based on back-testing. We all know — or should know — the classic investment performance caveat: Past performance is no guarantee of future results.

This strategy is deeply contrarian. This is for investors who have a high-risk tolerance or for those who allocate only a small portion of their portfolio to it.

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I think it works because investors sold their holdings in these markets when the news was bad, which translates into potential upside when investors realize these countries are probably not going to disappear. In other words, this is a gutsy way to go international, but it's what I'll do because I trust my work and because I feel it's often best to go where others have left.

By Mitch Goldberg, president of investing firm ClientFirst Strategy.

Read more from Mitch.