The price you pay for growth is the key to higher returns.
Emerging markets are big news. Many doubled or more in the market rally of 2009, which has encouraged legions of investors to take a closer look at these more exotic regions.
Yet we saw in 'The Emerging Market Growth Trap' Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School found there is no correlation between long-term GDP growth and real equity returns. This undermines one leg of the case for investing in emerging markets on the basis of their economic growth.
Should we ignore growth completely?
Even if a country's long-term GDP growth doesn't equate to similar returns for investors in its companies, that doesn't mean that economic growth is irrelevant for equity returns. Clearly, companies operate in the economy and have more opportunity to make money when the economy is growing.
In their contribution to the Credit Suisse Yearbook for 2010, the London Business School authors do indeed find a close contemporaneous relationship between quarterly GDP and the level of the US stock market. But, as they note, such data can't be used in practice to guide investment, because GDP figures are not published until after the quarter has ended.
By that time it's too late to invest to benefit from the relationship. What's more, they are also subject to heavy revision.
What rate of growth is best?
What about basing investment decisions on GDP performance over longer time periods, rather than just a quarter?
To do this, the authors divided countries into five batches, ranging from the lowest to the highest growth economies over a prior period. They then ran the numbers for each 'quintile', making portfolio decisions based solely on knowledge of past GDP figures.
The following table shows the returns on markets ranked by past GDP growth:
GDP ranked by
5-year past growth | 19 countries
(1900-1929) | 83 countries
(1900-2009) | 83 countries
(1972-2009) |
|---|
| Lowest growth | 10.9 | 14.1 | 25.1 |
| Lower growth | 9.3 | 11.7 | 18.6 |
| Middling growth | 10.1 | 10.6 | 16.2 |
| Higher growth | 7.8 | 9.0 | 11.9 |
| Highest growth | 11.1 | 13.1 | 18.4 |
Source: Credit Suisse Yearbook 2010
As you can see, high growth economies did not go on to consistently deliver higher stock market returns in the future.
For example, over the period of 1972 to 2009, you'd have done better buying stocks in what had previously been the slowest growing economies!
Again, this doesn't mean that if economic growth is strong in the emerging markets in future that their stock markets won't benefit. It certainly doesn't prove the emerging market bulls wrong there.
What it does show is that stronger GDPs in the recent past shouldn't -- on the face of this evidence -- be a reason to invest now for further gains.
Mystic Meg makes a bundle
The reason past GDP performance isn't a killer guide to future stock market returns is that by the time you've heard about the great economic growth in Brazil, India or China, so has everyone else and his dog.
As these investors look forward to such growth continuing, they bid up the prices of shares in listed companies, and your opportunity to see a profit on any new investment diminishes -- even if the economies continue to do well.
Now, if you could discover a country's GDP figures before anyone else, that could be a very valuable strategy.
And sure enough, this research found exactly that. Their data crunching showed that an investor who managed his portfolio with foresight about next year's GDP would indeed enjoy outstanding outperformance.
What's the catch?
The snag is that we can't divine future economic growth with any confidence! We don't even know for sure what growth was over the past year, since the national bean counters often take lengthy periods to make up their minds about the final figures.
To quote the report, this inability to accurately predict future GDP growth means: "Investors [therefore] have no choice but to extrapolate economic growth into the future. This is tricky because markets already anticipate future growth, and it is challenging to beat investors' consensus growth predictions".
It's similar to the value stocks versus growth stocks debate. There's no doubt many growth companies see superior business over the years. The hard part is buying them cheap enough to profit.
Similarly to buying unloved value shares, going on the Credit Suisse research you'd do better to buy emerging markets when GDP growth has been poor and nobody expects much from the future. The markets will likely recover ahead of GDP returning to growth, and when they do your investment will rise.
In fact, the authors found that recent stock market performance was a far better guide to future GDP growth than vice-versa, as investors anticipated an imminent economic recovery and bid up shares to profit from it.
Buy the bubble
I certainly don't dismiss the idea of making emerging market investments, and nor do the authors of the Credit Suisse report -- not least for the diversification benefits.
I hold some Templeton Emerging Market Investment Trust (LSE: TEM) shares, as well as favourably placed FTSE companies like Standard Chartered (LSE: STAN).
But I'll wait for another emerging market wobble before increasing my directly-held emerging market investments, rather than piling in with the herd. This research proves yet again that the price you pay is key when it comes to profiting from an investment.
Still, if you don't want to miss the fun, an interesting way to play the emerging market mania could be to buy UK-listed fund managers who specialize in these regions.
Like this you'll hopefully profit both from a rise in the markets lifting their underlying funds, as well as from the flood of new money coming from investors seeking out better returns abroad, and boosting the fund's management fees.
More from Owain Bennallack:
> Owain owns shares in Templeton Emerging Market Investment Trust and Standard Chartered.
