I’m finishing my tour around risk, diversification and portfolio construction with my last home truth today. The last idea is perhaps the most counter-intuitive – it suggests that there is, in fact, no relationship between top-line GDP growth of regions such as the emerging markets and bottom line equity returns. Again, we’re back with the discussion of behavioral economics – and our preference for shiny, sexy, new things that are growing fast. The core idea here though is that an asset that is growing fast – probably measured by something like profits – is a better bet. This last statement sounds eminently sensible. Buy an asset where the cashflows are growing. What’s not to like about this idea? In fact, quite a lot as it happens. Fast earnings growth is NOT necessarily a good guide to future capital gains. In sum, don’t be seduced by ‘good looks’ and a fast growth rate – focus on the fundamentals!
The graphic below is from Paul Marson who a few years ago was chief investment officer at Swiss Bank Lombard Odier and it looks at the relationship (correlation) between two sets of variables – the horizontal axis looks at GDP growth for a combined group of developed and emerging economies (as measured by the IMF) whilst the vertical axis looks at investor returns. The straight line plots the relationship between GDP growth and investor returns – it shows that as GPD growth rates increase, returns to investors actually start to DECLINE. Paul Marson’s analysis is backed up by a legion of academic research, all of which agrees on the idea that there is, in fact, a negative correlation between GDP growth and investor returns. For Marson and others, the moral of the story is that investors should ignore sexy, growth economies such as China and instead embrace boring, slower growth economies such as Belgium.
What makes low growth attractive? Two factors would seem to be at work, both related to the fundamental measures mentioned earlier. The first is that faster-growing economies do see an increase in the value of their local stockmarkets, especially as investors chase up PE ratios. But this mania inevitably results in speculative bubbles, and massive volatility in local share prices – most investors fail to get into local markets when they are cheap but buy as those PE multiples hit their highs. The other key factor is the boring dividend cheque. Companies in fast-growing countries tend to ignore boring dividends in favor of reinvesting profits back into business expansion and new capacity – the slight hitch is that the law of diminishing returns, which suggests that over time those returns from each extra dollar of new investment will diminish. In the cutthroat world of emerging market businesses, price competition eats into net margins – eventually, it becomes obvious to all and sundry that a better alternative is to hand the money back to shareholders via dividends, rather like those boring Belgians! Sadly, in the meantime, a vast amount of money has been wasted on unwise new investments, money which could have been handed back to shareholders to produce a greater total return.
For investor’s a number of strategic ideas emerge from this important home truth. The first is that rather than modishly chase after global regions such as ‘emerging markets’ investors should actually focus on individual national markets and only buy those countries where the ‘fundamentals’ look strong. The next idea is that investors should look to invest in faster-growing markets, but look to take advantage of those swings in market sentiment and thus multiples. In simple terms, investors can buy faster-growing assets when they are cheap. Last but by no means least, investors should also stay focused on that dividend income, especially from emerging markets.