SAFT ON WEALTH-Should you fire your economists?

Wed Feb 19, 2014 4:12pm EST

By James Saft

Feb 19 (Reuters) - Rather than waste time and money making doubtful predictions about economic growth, you might just do better by buying stock in countries which have recently had hard times.

A new study finds a rather puzzling outperformance of equities in countries which, if you looked at the economic rates of growth, would appear to be struggling.

This adds to earlier findings by the authors, Elroy Dimson, Paul March and Mike Staunton of the London Business School, which found a lack of correlation between economic growth and investment returns.

That study found a negative correlation, of -0.39, between per capita GDP growth and returns in a study of 21 countries between 1900 and 2013. In other words, stocks from the lower-growth economies tended to outperform the higher-growth ones. Shift the analysis to aggregate GDP growth, rather than per-capita, and you get a rather weak positive correlation of 0.51.

But what happens if you put this into practice?

"There is no evidence of outperformance by economies that have had high growth in the past," according to the authors, who carried out the new research as part of an annual review of investment returns by Credit Suisse. (here)

"Over the period covered by this exhibit, the total return from buying stocks in low-growth countries in fact surpassed the return from buying stocks in the high-growth economies."

For the purposes of the study the authors looked at returns between 1972 and 2013 for 85 countries. Divide that universe into five parts ranked by aggregate economic growth over the preceding five years and you get a striking outperformance among the basket cases. The bottom fifth produced annualized returns of nearly 25 percent, as compared to just 14.5 percent from the top fifth. The middle three cohorts are tightly grouped between 14.4 percent and 16.5 percent.

While I might suggest, in something approaching earnestness, that you fire your economists based on these results, the study did look at how you would do if you could accurately forecast future economic growth over the coming five years. Get that right and there is a massive difference in returns, ranging from just 4.2 percent for the bottom fifth to 28.8 percent annually for the top growing fifth.

But to capture those returns you'll need to get your predicting correct, putting the right countries into the right baskets. That, as we have seen time and again, is hard to do.

GROWTH VS RETURNS

So why is there a weak to negative correlation between growth and investor returns?

For one thing all economic growth does not flow to investors. It is particularly true that growth creates a need for new capital, which in turn leads to the issuing of shares and the dilution of the equity portion belonging to existing shareholders.

Growth also usually implies the application of new technology, which itself can tend to make existing investment, sunk costs, return less.

Amazon is a good illustration of this at the company level. Though it has grown at a tremendous rate, Amazon has never recorded a profit because its business model requires it to make new and ever larger investments in technology. That's driven Amazon stock prices higher, at least so far, but suppressed those of its competitors.

William Bernstein, of investment advisory firm Efficient Frontier Advisors, has described what he called the "Paradox of Wealth," a tendency for economic growth to give rise to low returns.

Under this theory, as economies grow, returns tend to suffer, in part because the investment in technology rises as a share of GDP. That costs money, leads to dilution of shareholders and suppresses returns.

Dimson, March and Staunton make more conventional arguments, noting that equity prices as they are today factor in anticipated changes in business conditions.

They also note that when you buy shares in a company in an improving economy, you are buying an asset that is theoretically becoming less risky. All else being equal, you should get a lower return for taking on less risk.

It also strikes me that the competition to invest in "hot" markets with high levels of growth may cause equity owners to lose out on a portion of the fruit of their investment that they can capture in more staid, slow-growing developed economies.

Think of all the foreign companies which have plowed money into China in hopes of cashing in on its former double-digit growth. A lot of people got rich, but perhaps a higher percentage of them were intermediaries rather than shareholders.

Of course this may all simply be a value investment story. Buy that which is unpopular, unglamorous and beaten down and you are usually well on your way to outperforming.

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