Cinderella markets

Buttonwood

Feb 15th 2005
From The Economist Global Agenda

If ever there was a time to shun glamour and look for inner beauty, this is it

WHEN Buttonwood went through outstandingly plain phases as a youthette, her mother—now, alas, of sainted memory—used to raise the quotient of references to Inner Beauty and its superiority to the flashy outward stuff. How those memories come back these days, with fund managers touting as never before the fragrant charms of fast-growing foreign markets. As April nears and those last bits of tax-favoured retirement income look for a home, investors are listening. Last week’s net inflows into emerging-market equity funds were the largest one-week numbers in over a decade. So far this year, investors have put $4.64 billion into non-American equity funds and pulled $1.58 billion out of American equity funds. The figures come from Emerging Portfolio Fund Research, a firm in Cambridge, Massachusetts.

The attractions are obvious. Though there are certainly lemons among them, developing economies as a group are likely to grow twice as fast as developed ones this year, the IMF reckons. Their shares are far cheaper, trading on trailing price/earnings ratios about a third lower than in developed countries and at a larger-still discount if predicted future earnings are factored in instead. So emerging-market shares, which were hot in the 1990s but cooled off later in the decade, have been making a comeback.

Investors think they are betting that these countries will continue to outpace the developed world in economic growth. But they are also—unconsciously—making a lot of other bets: among them, that corporate profits will grow in line with the countries’ economies; and that shareholders in existing companies will have a corresponding share of these profits.

But does past economic growth in fact imply greater future stockmarket returns? Not on your nellie, say Elroy Dimson, Paul Marsh and Mike Staunton from London Business School (LBS), in an annual study of global investment returns sponsored by ABN AMRO, a Dutch bank, that was published last week. Though this finding is not entirely new, the LBS team brings to the analysis an unrivalled set of data going back 105 years for 17 developed countries and substantial periods for another 36 countries.

They identified three elements in the total return on shares—dividend yield (price divided by previous dividend), dividend growth and changes to the price/dividend multiple. They found that, over the long haul, economies with slower GDP per capita growth produced better real returns on shares than faster-growing ones, and vice versa. The star performer over more than a century, by the way, was Australia, followed by Sweden, South Africa, America, Canada and Britain.

Messrs Dimson, Marsh and Staunton then tested this finding in a different way, using a share-trading rule based explicitly on economic growth. They classified all their countries into quintiles according to how quickly GDP had grown in each over the previous five years. Equal sums were invested in each quintile, and dividends were reinvested. The countries were re-ranked each year, the quintiles were re-based and fresh investments were made. At the end of 2004, the total return from buying shares in slowest growing countries was 12% a year, compared with a 6% return on shares in the fastest-growing countries.

What might account for this perverse relationship between economic growth and stockmarket performance? The easiest thing to say is that by the time a country comes to be recognised by the global investment community as “fast-growing”, its share prices have probably been bid up too high for newcomers to make much money out of it. Another explanation is that insiders cream off profits before they hit the bottom line. Also, growth may be fuelled by thousands of small entrepreneurial companies that never come to market and thus do not recompense shareholders in existing firms.

More broadly, economies tend to grow when they get bigger inputs of labour, capital and technology. The benefits of growth may be felt by those who supply the labour (local workers), the capital (including local savers and investors) and the technology (eg, Cisco Systems)—or by none of the above, such as consumers. Shareholders will probably get a look-in, but there is nothing to say how big.

Jay Ritter, who teaches finance at the University of Florida, takes the argument further. In a paper that will be published soon in the Pacific-Basin Finance Journal, he maintains that not only is past economic growth no guarantee of future stockmarket returns, but even future economic growth (could we but know it) is no guarantee of contemporaneous stockmarket returns except in the most transitory way. A rough-and-ready empirical example of that truth, looking only at share prices: in 2004, and for the second year running, China was the worst performing stockmarket tracked by The Economist, falling 15% despite the country’s rapid growth. Mr Ritter reckons that current earnings yields are the best guide—but earnings need to be massaged over ten years or so to remove the distorting effects of specific moments of the business cycle.

So is the moral of the story to forget high-flying Thailand? Not quite. Emerging markets may not produce the outsized returns investors expect but they are still a good way to diversity portfolios. As the developed world’s markets become more highly correlated, emerging markets, refreshingly, continue to go their own way. The point is not to expect Thailand to produce greater-than-average returns on its shares—and to keep a sharp eye out for transaction costs, which are often higher in emerging markets.

If this argument about economic growth and stockmarket returns feels faintly familiar, it’s because it is. Here we have, on a bigger scale, a favourite debate of stockmarket strategists over whether growth stocks or value stocks give the bigger return. Are investors better off buying a stock with a high price/earnings ratio because they think its prospects for growth justify a higher multiple? Or do they get better returns from buying a cheaper, higher-yielding share? In the short term, either investment style can produce consistently good returns: growth stocks predominated in the 1990s, value stocks have done better in the past five years and there are those who think the tide is about to turn back now. In the long run, however, according to the LBS team and many others, value stocks—like Cinderella countries with unglamorous growth rates—are more likely to provide higher returns.

There is something so counter-intuitive about this line of reasoning that Buttonwood doubts investors will be able to resist the lure of fast women, fast cars and fast economies—any more than she really believed her mother about the superiority of Inner Beauty. But just in case reason lurks out there somewhere among the irrational exuberance, the accompanying table groups countries, as the LBS team did, according to how quickly they have grown in the past five years. On “value investing” criteria, the countries in the lowest-growth category are no worse a bet—even perhaps a better bet—than the countries under highest growth. Anyone for Denmark?

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