When growth goes nowhere, do stocks soar?

By Felix Salmon
July 27, 2009

Jason Zweig has some eye-popping results from Elroy Dimson:

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns — by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

Is this a published result? Can anybody point me to the paper where Dimon finds this?

Zweig’s first explanation for the phenomenon makes no sense:

When you buy into emerging markets, you get better economic growth — but, at least for now, you don’t get in at a better price…

In other words, economic growth is high, but stock valuations are even higher… At year end, emerging-markets stocks traded at a 38% discount to U.S. shares, as measured by the ratio of price to earnings. Now that both markets have bounced back, emerging markets are at only a 21% discount. And make no mistake: They should be much cheaper than U.S. stocks, because they are far riskier.

It seems to me that if you get higher growth at a 21% discount, that clearly counts as “a better price”. Yes, emerging-market stocks are more volatile. But the impact of volatility on a market’s (or even an individual stock’s) p/e ratio is far from obvious.

Zweig does then come up with a better reason why high-growth economies might have lower returns: essentially, the future growth is coming from companies which either don’t yet exist or haven’t yet listed. But before I start trying to work out what’s really going on here, I would very much like to take a closer look at Dimson’s results. Because they seem improbable to me: which slow-growing countries can boast a long-run 12% annual return on stocks?

Comments
10 comments so far

How could you have all that growth without the money not going to shareholders? What is this mysterious other entity? Let’s see, there’s capital, and, umm, what’s that other thing? Oh yeah, labor! I think Zweig mentions that in passing. If EM workers are capturing the profits that Zweig thinks ought to be going to shareholders then woo-hoo for the workers (and boo for me — I’m overweight EM). There’s corruption and the usually family-owned business leeching too, which I think is more common in EM countries.

Here’s a paper from a few years ago that lays it out: “Economic Growth and Equity Returns.”

“It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.”

Looks like the author cites Dimson et al. Hmm.

This is consistent with the well-known observation that value stocks have outperformed growth stocks.

The source of investor returns is RISK, pure and simple. If you take more risk you get a higher return (usually, not always of course). Growth isn’t a source of return.

Note that risk is multi-dimensional and can’t be boiled down to a single number like volatility.

Posted by Max | Report as abusive

A basic point – markets operate on feedback. High returns in one period lead to more investment and lower yields, which lowers returns in the next period. So high returns can’t be sustained regardless of growth rate.

Posted by Max | Report as abusive

(I posted the chart on my blog http://chrismealy.blogspot.com/2009/07/i -cant-find-my-money.html)

Max, I love your definition of risk: not volatility, and more of it gives you more return except when it doesn’t. No really. There are worse definitions.

Elroy et al. published a book (http://press.princeton.edu/titles/7239. html) some years ago that covers 101 years of returns. Could be in there somewhere.

Posted by Tim | Report as abusive

Felix: One source, perhaps more recently updated, is the 2005 Global Investment Returns Yearbook.

If I may, since Zweig is wrong, here are the dynamics involved for the observed outcome. Nations with low levels of real economic growth tend to grow more slowly because of constraints placed upon their economies by their governments. Those same governments also tend to favor certain players within their economies, acting to protect them from wider competition than they might see in nation’s with greater economic freedom.

This institutionalized favoritism then leads the favored companies in these nations to faster profit growth than would be seen in companies within nations with greater economic freedom.

Since those profits are then distributed to the favored companies’ shareholders through dividends, the comparatively faster rate of growth of those dividends per share lead to the faster growth rate of share prices. And that is why stock market returns in these nations outpace those with greater rates of economic growth.

In simpler terms, it’s because the fix is in.

completely worthless article; this sort of information often appears after a rally has been taken place
disclose: not short the market yet at this point

So Chris Mealy had just posted his sentiment that we all review the academic paper titled, “Economic Growth and Equity Returns.” by Jay R. Ritter, University of Florida.

The summary of the paper is below:
“It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.”

The regression analysis is with merit and should warrant your attention.

So my problem is why does IRonman go off on some rant about undue Governmental control.

Posted by Shaw | Report as abusive

One very prominent example over the last 20 years:

Brazil, with very modest growth, has had terrific stock returns. China, with incredible growth, has had modest stock returns.

Posted by Dan | Report as abusive

If I had to venture a guess, I might suggest that it comes down to cost of capital. Cost of capital is surely linked closely with the cost to form new companies.

In countries where cost of capital is high, growth is slow, and existing companies which can generate their own capital to invest are favored. This is good for shareholders in existing companies. New companies do not form or grow easily in this climate and competition is less.

In countries where cost of capital is low, growth is fast, and at the same new companies are constantly forming and challenging the profitability of existing firms.

Bureaucratic or political resistance to new businesses (corruption…) is surely another factor. Carlos Slim in Mexico realised stock market wealth on par with Buffett due in no small part to a convenient lack of competition in Latin American business. His stocks grew terrifically, but the surrounding economies barely did.

Posted by Dan | Report as abusive
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