Hat tip to reader Henry Cobb.
The Economist reports an intersting conclusion in how we measure the equation more growth=more profits for investors.
None of this is to deny the importance of emerging economies. The booms in India and China will have enormous effects on everything from the wages of unskilled labour to the price of commodities. But the simple equation that more growth equals more profits for investors is simply not borne out by history.
FASTER economic growth means higher returns for investors. That is a big part of the rationale for investing in emerging markets.
The problem with this argument is that it is not true. Research by the London Business School looked at 17 countries over 108 years. The countries with the slowest-growing economies (as measured by GDP growth over five-year periods) returned 8% a year; the markets in the fastest-growing economies, by contrast, returned just 5% a year.
When a broader group of 53 economies, including many emerging markets, were examined, the tortoises beat the hares by a wider margin—12% to 6-7%. James Montier of Société Générale found that the slowest-growing emerging markets have delivered higher returns than the fastest growers over the past 20 years.
An earlier study by Jay Ritter of the University of Florida tried to explain a key LBS finding—a negative correlation between real stock returns and real per capita GDP growth over more than a century. Why should this be?
Mr Ritter points out that an economy can grow quickly by applying more capital and more labour, in which case owners of capital will not earn higher returns. What matters for stock returns, he says, is how much of an economy’s growth comes from the reinvestment of earnings into investments with net positive value in publicly traded companies.
But in emerging markets a lot of wealth is being created in private unquoted companies (or, in some cases, by companies owned by the government). In neither case do investors in existing quoted companies benefit.
Investors also need to be wary of the argument that, as emerging economies become more important in global GDP, so emerging markets will take a bigger weight in global stockmarket capitalisation. This may be true, but much depends on how the emerging markets become more important.
One way is for share prices to rise; another is for more shares to be issued. In the latter case, existing investors are simply getting a smaller share of a bigger pie. Société Générale found this “dilution effect” worked out at 2% per year in developed markets, but a staggering 13% per annum in emerging ones.
Worse still, the expectation that higher growth will lead to higher returns actually works against the investor. That is because markets assign a high price-earnings ratio (and low dividend-yield) to countries and companies where future growth is expected to be strong. But there is a negative correlation between high valuations and future returns.
That may create a particular problem for those investing in emerging markets at the moment. According to Mr Montier, emerging markets are trading on a trailing price-earnings ratio of 22 and a price-to-book ratio of more than 3, both substantial premia to developed markets.
On a cyclically-adjusted p/e basis (averaging the earnings over 10 years), emerging markets are trading on a multiple of 40, close to their highest ever and around the level that developed markets achieved at the height of the dotcom bubble. They are also trading around two standard deviations over their trend level, a measure that marked out previous bubbles such as Japan in the 1980s.
And how do hedge funds fit in as money makes money?