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A list of Dan Richards’ previous articles appears at the end of this article.
Historically, people invested in emerging markets for two reasons – for higher returns and diversification.
Last week’s column examined some new research, suggesting that while there were some diversification benefits to adding emerging markets to a developed market portfolio, those benefits have shrunk over the past while.
Recent research also explores the return payoff of investing in emerging markets such as Brazil, Russia, India and China. Contrary to popular beliefs, investing in high-growth emerging markets has produced inferior returns to those obtained from slower growth economies.
Historically, many practices in fields such as medicine, teaching and investing were articles of faith – things were done because they made sense on the surface and because they’d “always been done that way.”
In the past forty years, those fields have seen an accelerating shift to an “evidence-based” approach, looking at hard data to evaluate the conventional thinking on which decisions were historically made.
The father of evidence-based thinking in medicine is Archie Cochrane, a Scottish doctor who first wrote about this concept in the early 1970s – and evidence-based decision making is among the elements of the new Obama health care program that hopes to reduce spending by eliminating low-payoff treatments.
Economic growth and emerging markets
Fueled by access to better information and the explosion of processing power, the evidence-based approach has spread into investing, replacing anecdotal observations with careful examination of data.
In 2002, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School published Triumph of the Optimists: 101 years of Global Investment Returns. Looking at a century of returns, the book provided an in depth analysis of 16 countries, all but one of them in the developed world – the exception was South Africa.
The authors analyzed total returns and the long-term equity risk premium and showed that some historical indexes overstate long-term performance because they are contaminated by survivorship bias and that long-term returns for most countries are seriously overestimated due to a focus on periods that with hindsight are known to have been successful.
In 2005, the three turned their attention to whether faster growing economies translate into superior returns for investors.
They first examined the connection between high growth economies and emerging markets, looking at the rate of economic growth in 53 countries and ranking these countries from the fastest growing to the slowest growing.
They confirmed that emerging markets tend to be faster growing. Of the 11 fastest growing economies at the end of 2004, all but one were emerging market countries. Of the 11 lowest growth economies eight were more mature developed markets.
Growth rate and investor returns
The authors then looked at the connection between faster growing economies and investor returns – and here reached some surprising conclusions.
Each year, countries were ranked based on the growth of their economy over the past five years in “real terms,” after inflation.
They first looked at the 17 countries for which their data goes back 105 years and compared the pace of growth with stock market returns.
Going back 105 years, there was a negative correlation between the fastest growing economies and the returns they provided to investors – in other words, the slowest growing countries provided the best returns, the fastest growing the worst.
The returns for the slowest growing economies averaged just under 8% and the returns for the fastest growing economies averaged about 5%. (Remember that the countries in the fastest and slowest growing categories changed every year, depending on growth in the previous five years.)
The authors also looked at their full sample of 59 countries, for which data doesn’t go back as far – and here the results were even more striking.
The slowest growing economies averaged stock market returns of over 10% - compared to between 5% and 6% for the rest of the sample.
And the economies with the very worst stock market returns? Those that had just experienced the fastest economic growth.
Implications for investors
The study authors concluded: “It is clear that the total return from buying stocks in low-growth countries has historically exceeded the return from buying stocks in high-growth economies. National equity markets have behaved rather like stocks within a market: low-growth (‘value’) markets have performed better than high-growth (‘glamour’) markets.”
The authors identified a number of possible reasons for this. Countries with faster growing economies tend to have higher beginning stock market valuations, as future growth has already been priced into share values. Valuations in these economies may be overstating the good news from expected future growth. And since emerging markets generally have less developed capital markets, the best investment opportunities might be in private companies that are unavailable to investors.
The research by the London Business School professors mirrors the research into the U.S. market by Jeremy Siegel of Wharton. In his 2005 book “The future for investors: Why the tried and the true outperforms the bold and the new,” he demonstrated the disappointing experience from investing in stocks of the fastest growing U.S. companies, simply because their beginning valuations reflected this growth and were too high as a result.
None of this means that investing in faster growing emerging markets can’t provide good returns for investors – there are clearly some great companies that will be terrific investments.
It suggests, however, that investors need to be very selective about the companies they buy in emerging markets – based on historical experience, buying these markets as a whole has high odds of a disappointing outcome.
* Dan Richards conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries and to reach him, go to www.clientinsights.ca.
