The growth illusion
Is it not obvious that investing in higher growth countries will yield higher returns? Not at all. This is one of the traps investors regularly fall into. Saturday’s FT has a timely reminder.
FT Money editor Matthew Vincent reports new research by Paul Marson (ex chief investment officer of Goldman Sachs Wealth Management) for Lombard Odier showing that there was no connection between emerging countries’ economic growth rates between 1976 and 2005 and the total return (capital returns including reinvested income) earned investing in representative indices for the different countries.
In “The Triumph of the Optimists”, recording a century of investment returns from 16 different countries, academics Elroy Dimson, Paul Marsh and Mike Staunton also debunk the myth that differences in economic growth in more developed economies explain differences in returns. In “No Monkey Business”, I used similar historical evidence to show that real return trends for developed markets in the post-war period are remarkably similar in spite of very different experiences of both inflation and real economic performance. I also compared two centuries of real (after-inflation) total returns for a Wilshire index for US companies in which the growth trend is essentially the same during its emergence as an economic power and after. I showed how the only period of superior returns from emerging markets came with their emergence as an investment strategy. not their economic performance. The two are not at all the same.
The growth illusion at the country level is an extension of another popular belief that high-growth companies make better investments. What gives the lie to this is the inconvenient evidence that over the last six decades value investing has generally outperformed growth investing. This is not to say that there were not periods in which the discipline of value made an investor look very pedestrian or out of touch.
Can this counter-intuitive finding about growth be easily explained to lay investors so that they might better protect themselves from wealth-reducing biases? It certainly helps if you have any business experience but it is not so difficult to understand.
Paul Marson is on the nail in pointing to the reason: financing: ‘Companies financing from externally gained funds will dilute their shareholders’. This must be true unless high-growth companies, and by extension high-growth countries, are able to sustain higher returns on equity and by a large enough margin to ensure that they are self-financing. This rarely happens.
It is rare because superior growth usually involves heavy investment that depresses returns in the short term and it is also rare because competition works quite effectively to suppress excess profit margins. Companies can appear to resist the dilution effect of raising new equity if shares are priced by investors at very high levels but this then acts as a trap for shareholders as sooner or later this overvaluation will correct. Technology stocks at the end of the 90s spring to mind but so should the ‘funny money game’ in the 70s in which many acquisitive conglomerates and asset strippers were first darlings of the stock markets and then blew up.
The growth you should be interested in is the sustainable growth in company earnings per share, which reflects profitability advantages rather than economic performance or sales growth. These will almost certainly look very different from popular perceptions. But this is not the only form of self-defence you need. As Matthew Vincent reminds FT readers, you also have to focus on valuation – the price you are being asked to pay for earnings growth potential.
The reason for the value discipline, at the country level as well as the stock level, is that changes in valuations are much greater than growth differences. Investors quite simply keep ‘getting it wrong’.
The trap was very effectively set at the end of the height of the last growth stock boom in the late 1960s, prior to which growth appeared to have the edge on value investing. It was a potent mixture of a widely-held belief system and massive capital flows, as it coincided with the democratisation of equity investing via mutual funds. At its peak, high growth was particularly prized because the US was by then looking like it was in the slow lane compared with the emerging ‘economic miracles’ in post-war Europe and Japan.
The most obvious way to participate, when international equity investing was much less well developed, was to buy the US multinational companies that were able to escape the constraints of an anaemic home market by embarking on a global land grab. It was too obvious and investors ended up grossly overpaying for the actual earnings growth. Whereas the story itself was, in large measure, true, the valuations were fanciful. The impact was that investors first suffered a bursting of the bubble and then had to wait over a decade or more for earnings to catch up with share prices.
There are many parallels today in popular beliefs about investing in Asia, also a very good story.