In The growth illusion, an article appearing in the most recent Buttonwood’s notebook column of The Economist, Buttonwood argues that valuation, rather than economic growth, determines investment returns at the country level. In support of this thesis, Buttonwood highlights research undertaken by Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School, which suggests that chasing growth economies is akin to chasing growth stocks, and generates similarly disappointing results. Buttonwood explains Dimson, Marsh and Staunton’s findings thus:
Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting. In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintle of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year’s GDP growth rate and the next year’s investment returns.
Buttonwood posits several possible explanations for the phenomenon:
One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses. The third factor may be that growth is siphoned off by insiders – executives and the like – at the expense of shareholders.
In even simpler terms, just as growth stocks have lower returns than value stocks, so do growth nations have lower returns than value nations—and they similarly get overbought by the rubes.
Buttonwood discusses other research supporting Dimson, Marsh and Staunton’s findings:
Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.
Buttonwood concludes that higher valuations – determined on an earnings, rather than asset basis – lead to lower returns:
What does work? Over the long run (but not the short), it is valuation; the higher the starting price-earnings ratio when you buy a market, the lower the return over the next 10 years. That is why buying shares back in 1999 and 2000 has provided to be such a bad deal.
It raises an interesting question for us: Can relative price-to-asset values be used to determine which countries are likely to provide the best investment returns? If anyone is aware of such research, please leave a comment or contact us at greenbackd [at] gmail [dot] com.