Countries whose stocks are out of favor often outperform he investment case for buying Greek equities does not rest on the hope that its economy will outperform the world’s much stronger economies, such as the U.S. Instead, the reason you might want to bet on Greece or any of the other basket cases in southern Europe relies on the much safer assumption that they will do better than what investors are currently expecting. That’s hardly a long shot, since those expectations are already about as low as you can possibly imagine. In fact, you could very well end up making more money over the long term with the stocks of basket cases than you would by investing in countries on which investors are currently placing very high expectations — such as the U.S. Imagine a racetrack that allows you to bet on any of the finishers in a 10-horse race: One of those horses is a crowd favorite who is widely expected to win, while the other is widely expected to come in dead last. Imagine further that the crowd-pleaser ends up finishing second, while the unpopular horse ends up coming in seventh. In such a case, believe it or not, you would most likely end up making more money by betting on the horse than came in seventh than the one that came in second. This isn’t just idle speculation on my part. Consider a study conducted by Mebane Faber, a portfolio manager at Cambria Investment Management. He went back through history to find those few instances in which a country’s stock market was almost unimaginably out of favor. He did this by calculating, for each country at the end of every year for which data were available, its cyclically-adjusted price/earnings ratio — the so-called CAPE that has been championed by Yale University professor Robert Shiller and last year’s Nobel Prize winner. When counting each country’s CAPE at a particular year-end as one observation, Faber’s database through year-end 2011 contained around 850 data points. In just nine of them — 1.1% — were a CAPE reading below 5: “The U.S. in 1920, the U.K. in 1974, the Netherlands in 1981, South Korea in 1984, 1985, and 1997, Thailand in 2000, Ireland in 2008, and Greece in 2011.” It would be a gross understatement to say that investors on those occasions were shunning those countries’ equities. And, yet, Faber found that you’d have performed very well indeed by nevertheless holding your nose and investing in them. As you can see from the above chart, the inflation-adjusted returns in these nine cases were impressive: 35% over the subsequent year, for example. The outperformance was a long-term phenomenon as well: Over the subsequent 10 years, on average, these countries’ stock markets outperformed inflation by an average of 12% a year — far higher than the norm. More video from this series: Which are the cheapest countries now, as judged by their CAPEs? Not surprisingly, southern Europe dominates: Greece’s CAPE is the cheapest, according to Faber, with a year-end CAPE of 2.8. Hungary, Austria, Portugal and Italy are in not much better shape, with CAPEs of 5.9, 7.3, 7.7 and 9.6, respectively. To put these numbers in context, the U.S.’ CAPE currently is 27.9, according to data posted at Shiller’s website. The only other times in U.S. history when the CAPE was higher were before the 1929 Crash and the bursting of the Internet bubble in 2000. Bear in mind, however, that you should be focusing on the long term when considering a contrarian strategy of buying countries’ equities when their CAPEs are below 5. As is evident in Greece’s current CAPE below 3, a country whose stocks are out of favor can become even more out of favor. By the same token, a country whose stocks are in favor, such as the U.S. market has been in recent years, can remain in favor for several years and can become even more favored. In the go-go years of the late 1990s, for example, the CAPE rose to current levels in early 1997. Needless to say, the market continued higher for three more years before succumbing to gravity. As this illustrates, valuations eventually regress to the mean. So don’t be too quick to dismiss the idea of investing a portion of your equities in Greece and other weak economies in southern Europe. marketwatch