Is GDP growth over-rated?

Research has challenged the link between economic growth and shares.

Summary: Fast-growing economies tend to be associated with fast-growing sharemarkets. But new research has found there is no correlation between a country’s economic growth and its share-price growth. The link is not only weak, but actually negative.
Key take-out: Billionaire investor Warren Buffett rarely uses macroeconomics when assessing an opportunity, but likes to track the total market cap against the total economy to get a feel for the overall position of the market.
Key beneficiaries: General investors. Category: Growth.

Asia is certainly one of the fastest-growing economic regions, far exceeding the Western world sluggishness. And on this basis, many claim that people should tactically expose themselves to this region.

It’s easy to see the allure… younger demographics, higher economic growth and lower debt levels all provide a warm comfort that cannot be found in the West. But this rationale needs to be challenged and clarified, especially given that emerging market investments carry some of the highest volatility of all investments.

Ask a simple question: Is it safe to assume that a fast growing region means fast growing share prices? You will likely find the results very surprising indeed.

Secondly, I will demonstrate that China does remain somewhat attractive, but for reasons far more relevant than the mere fact that it is growing fast.

Expand your thinking

The “fast-growing economy = fast-growing shares” theory has gained increasing publicity since it became understood that the Western world faces, at best, anaemic growth. The simplicity of this theory is soothing in our complex and challenging world.

But one needs to expand their thinking in order to realise the truth behind this assumption. Many experienced investors understand the best returns come from three sources: earnings growth, dividend payments and a momentum effect.

Using technical terms, the best returns come from investments that deliver a combination of earnings per share (EPS) growth, dividends and an expansion in the price/earnings ratio (P/E). Stay with me for a moment while I clarify.

Firstly, we must agree that when you are buying a business you are buying its profits. This will be explained in a moment, but needs to be understood as EPS rather than raw earnings growth. If the EPS grows, the value of that investment should also grow in line with this, but only on the provision that it’s priced fairly to begin with. This is “Investing 101” and legendary investors like Warren Buffett have reiterated this for years.

So if we use a current investment as an example, we can source that the iShares China25 Index has a current EPS of $2.70 and the P/E ratio is 13.06 times, creating a current price of $35.30 ($2.70 x 13.06 = $35.30). Mathematically, the price can only rise if either EPS grows and/or the P/E ratio expands. If we assume the normalised P/E ratio is 15 times in the long term, which could be considered reasonable, then a patient investor can expect the price to rise to $40.50 ($2.70 x 15 = $40.50). This equates to a tidy return of 14.7% plus any dividends. If earnings growth also expands, then the returns could multiply.

The real evidence

This is where the emerging market theory breaks down. Some heavy hitting research by Boston-based money manager Grantham Mayo van Otterloo (GMO) challenges the link between shares and economic growth (GDP). Known as one of the leading experts at asset allocation, GMO make a very compelling case that the link is not only weak, but actually negative. The chart below shows a scattered outcome, which is completely different to the positive correlation that was expected if the theory was true.

In fact, GMO tested over 100 years of data across 16 countries and found absolutely no correlation between a country’s economic growth and its share-price growth. Once again, the relationship was found to be slightly negative. Most interestingly, the negative relationship exists in the Emerging world too. On this basis, a rational investor could question why everyone insists on predicting economic growth. Why bother chasing shadows that are found to have minimal or no effect on your actual investments?

Regardless, I am acutely aware that the predictions are unlikely to subside despite the body of evidence. As GMO says: “Equities are an ugly asset class – one that is more likely than almost any other to lose investors a significant amount of money at those times when they can least afford it. That is, in a way, their charm”.

Can shares sustainably outperform the economy?

Critics of this research would point out that corporate profits, GDP and market cap (the total equity value) all track similarly in the very long term. Historical evidence from the US suggests all of them achieve approximately 3.3%-3.6% real growth per year.

Therefore, these same critics would question the sustainability of a sharemarket that is outperforming the economy. Surely it is not possible for this to continue forever, right?

Well, not necessarily. Ben Inker from GMO offered further evidence on how it is possible for shares to sustainably outperform the economy.

In part it relates to the growth paradox, whereby “companies in fast growing countries generally exhibit both low dividend payout ratios and high rates of dilution of shareholders, both of which hurt shareholder returns enough to more than counteract the higher aggregate profit growth associated with fast growth.” In other words, raw corporate profits tell us very little about the actual return to shareholders.

If you are interested in finding out more there is a white paper labelled , “Reports of the death of equities have been exaggerated” which is available on the GMO.com website. But be warned, the numbers are sure to make you spin about as much as attempting to learn Mandarin.

Humans really are irrational sometimes

The bottom line is simple: there is sound reasoning for shares to sustainably outperform the economy and for Western world shares to match (or even beat) emerging market shares.

So if economic growth is of inconclusive or negative value, what can investors rely on?

As an investor, one needs to decide whether they are truly long-term focused (e.g. Warren Buffett, in which case EPS growth has a greater impact) or likely to succumb to sentiment changes.

A simple way of looking at this would be to reflect on one’s actions during times of economic distress; i.e. did you contemplate selling during the Eurozone crisis or the GFC? If the answer is yes, a dramatic re-think is required.

We must also stem our worst habits – the obsession with predicting the future and the huge tendency to follow the herd, both of which are proven destroyers of investment returns.

Keep in mind that the Chinese symbol for crisis holds two characters, one resembling danger and the other opportunity.

The unfortunate reality is that very few of us have a tolerance level longer than a few years, which is why economic sentiment seems to matter so much. But instead of panicking, investors should seek the opportunities by obtaining a rounded view of the fundamentals.

What does Warren Buffett make of economic growth?

It is always good practice to cross-check your thoughts against the world’s best. This is where Warren Buffett’s time-tested methods have great appeal. Buffett rarely uses macroeconomics when assessing an opportunity, and evidence such as the above justifies this action (or lack of action to be more precise).

However, Buffett does like to track the total market cap against the total economy to get a feel for the overall position of the market.

But be clear: he uses these for comparative purposes and not growth prospects (remember that the growth becomes diluted to actual shareholders). In other words, he looks for gaps between the total economy and the sharemarket to understand whether people are being overly fearful or greedy.

Re-considering the emerging markets

Coming back to the emerging markets, the above evidence means that the fast-growth story has received a harsh knock.

But just because the fast-growth assumption has been confronted, it does not mean it makes a bad investment case.

From a P/E ratio perspective, the emerging region’s investable assets comprise a range from 13.06 times – 20.81 times according to iShares. It is not at all safe to assume that they all should revert to 15 times, but the evidence would favour the lower-ranked P/E ratio countries such as China (code IZZ), rather than the expensive Taiwan (code ITW). Similarly, the price-to-book value ratio range is 1.62 times to 2.95 times and it would be prudent to favour the lower P/BV countries including China at 2 times.

These simple tactics are not a guaranteed source of returns, but they do have a track record of pushing the odds in your favour.

However, looking at the real return prospects of the emerging market basket as a collective whole, it looks pretty mixed on face-value fundamentals. According to iShares, the P/E ratio currently stands at 17.88 times and the P/BV at 2.95 times, both largely in line with global metrics but not glaringly attractive.

Long story, short – forget about the headline economic statistics because there is no evidence to support its practice. Instead, persist with the fundamentals.


Editor’s note: Lachlan Partners recommends exercising caution when using ETFs to gain exposure into emerging markets, and our preference is to use active managers that have the knowledge and expertise to pick stocks that are priced attractively. Source: iShares by Blackrock

This article first appeared in “The Investing Times” newsletter, published by Lachlan Partners, and to which Scott Dixon is a regular contributor.