The predictive power for country selection of expected returns estimated through
the residual income model is examined through analysis of 19 developed-country
indices for 1988–2005. Zero-investment strategies based on a ranking or
optimization methodology—expected returns and conditional country risk
estimates—posted significant positive performance over various holding
periods. Risk-adjusted returns remained significant after control for four world
risk factors—market, size, the book-to-market ratio, and
momentum—constructed through a country stratification methodology based on
stock constituents. The results were robust to various long-term growth
estimates and to different country-universe subsamples and remained robust after
transaction costs were taken into account.