High-growth countries don't always provide better returns.
The assumption that high-growth countries naturally produce high investment returns is beginning to sound more and more like a syllogism. (Like 'All cats have four legs. My dog has four legs. Therefore my dog is a cat.')
None of us want to invest using this brand of logic, so it deserves some more thought.
When I began researching this article, I quickly found that several commentators from other publications had the same idea in the past week and have covered a great deal more than I was expecting to say. Rather than starting afresh, I think it would be useful to compile the best bits into this piece.
No correlation between growth and returns
To begin with, I'll start with Faith is strong in the emerging markets, by Steve Johnson, writing for the Financial Times. As you might guess from its title, much of the article brings out many of the statistics used for why we should invest in emerging markets, so if you haven't read those 100 times already then take a look.
The bit that caught my attention though is that some exceptional researchers, Professors Dimson, Marsh and Staunton, of the ABN AMRO/CSFB annual equity-study fame, think fast-growing economies reap lower investment rewards.
Thing is, they admit the data on that is not statistically significant, which effectively means we must ignore it. However it did encourage me to do some more digging. I found in their original, 108-year study that they're convinced there is at best no correlation between rapidly-growing economies and high investment returns (and at worst a negative one). The data on this was much more conclusive.
It is also supported by Larry Swedoe's article on CBS Moneywatch, What does a good economy really mean for your portfolio? He calls markets 'highly efficient', which many of you might dispute, but he draws together separate research from Professor Ritter of Florida University and Professor Siegel of Pennsylvania University that concurs with the study by Dimson et al.
Investors rewarded less than workers
Dimson et al speculate two possible reasons for the lack of correlation. Firstly, it's possible that the profits aren't distributed to investors in equal share, with entrepreneurs, directors and employees benefiting more. I would suggest that you could take this further. In countries growing rapidly, which normally means emerging markets, there is typically worse corporate governance, which means more money could easily end up in the employees' and directors hands -- and probably others.
Their report found that long-term dividend growth did not keep up with per capita GDP growth. As dividends typically play a key part in investors' returns, this could support their theory. Ritter found the same with dividends. He also pointed out: 'If increases in capital and labour inputs go into new corporations, these do not boost the present value of dividends on existing corporations.'
Value investing wins again
The second reason that Dimson et al proposed was that growth countries, like growth stocks, don't do as well as value stocks, and for the same reasons. Growth cases attract lots of investment too soon and build their values out of proportion. Above average growth -- and possibly more -- may be built into the price already.
Also writing for the Financial Times is David Oakley, who pens Big shift benefits emerging markets. He says there have been record outflows from developed-world equity markets of $75bn this year already, and record inflows to emerging markets of $63bn (which is already higher than the record in the whole of 2007 of $53bn.
If the exodus gets any bigger, value investors should probably be looking harder at developed markets for bargains.
Age matters
In Investment gains in China lag economic growth for Reuters, Wei Gu claims that Asian emerging stock markets trail the growth of their economies, with the exception of India. It also notes that India's is the only seasoned stock market (over a century old) of the lot, hinting at more possible reasons for the success of developed markets over emerging ones.
Taking China as its example, the article argues that the stock market is too small to reflect its economy. This may apply to the stock markets of other high-growth countries too (although again not India). If a stock market doesn't reflect the economy, it's not likely to take part in the same growth as it either.
The article inspires more possible reasons. Heavy-handed or poor regulation in some markets and markets dominated by largely state-owned companies (which will be inefficient) could add to the reason the overall returns don't match economic growth. The impact on markets of a stream of accounting scandals likely contributes too.
I think we'll see winners and losers when investing in high-growth economies. Just make sure you don't try to improve your battered portfolio by investing in them based on the politician's syllogism:
I must do something.
This is something.
Therefore I must do it!
More recent Fool comment on emerging markets:
