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samedi 26 février 2011

Don't buy economic growth

A recurring theme in the financial market relates to so-called top-down investments, whereby the principal focus of equity investors is on developments in the real economy.

It is especially popular to focus on economic growth in a particular region or country, writes portfolio manager Torkell Eide in a guest commentary in Norwegian business magazine Kapital.

The advantage of this type of investment philosophy is that it is easy to come up with a seemingly sensible analysis.

When deciding which company should be included in a portfolio, however, the disadvantage of basing one’s analysis on economic growth is that you can quickly end up with popular and relatively expensive shares. Having as your fundamental guiding principle that a country with high growth also gives high returns in the stock market is not an obvious recipe for success. If anything, the reverse is true.

In 2010 MSCI Barra published a study analysing the correlation between economic growth and stock market returns. The conclusion was unambiguous: the correlation between equity returns and GDP growth is non-existent. As an example, between 1958 and 2008, annual economic growth in Japan – the first Asian miracle – was around five percent. The return in the stock market was two percent. Switzerland had economic growth of just below 2.5 percent in the same period, while the stock market rose 3.5 percent.

As we see it, there are three important reasons why economic growth is not (necessarily) the path to economic nirvana for equity investors :

Return on equity

The most important reason has to do with return on equity. Globally customs differ as regards the capital structure of companies. In countries like Japan there has historically been less focus on capital efficiency. Capital which could have been paid out to shareholders in the form of dividends appeared on the balance sheet in the form of golf courses, cross ownership in other businesses and cash. When you realise that in the long term dividends account for around 50 percent of the return for equities, it is easy to see that an ineffective capital structure goes a long way in explaining the differences in equity returns between Japan and the US for example.

A secondary effect, which is becoming increasingly evident, is that large and strongly growing economies, like China, attract a lot of risk-willing capital. The result may be weaker returns on capital than the growth rate might indicate, with a direct impact on the share price.


The fact that stock markets in countries like Sweden and Switzerland have provided relatively good returns despite small home markets and relatively weak economic growth, is a good illustration of the effects of globalisation. Value creation in companies such as Nestlé, ABB and Atlas Copco is mainly fuelled by factors that are unrelated to economic developments in Sweden and Switzerland. For all three companies it is developments in the emerging markets that are the driving force. An example of how the reverse can be the case is Brazilian oil company Petrobras. Here the oil price and decisions regarding domestic energy policy are more important to the price development than economic developments in the emerging market country of Brazil.


The final point that distorts the correlation between growth and equity returns is the valuation of companies. Strong economic growth and general optimism around the future of a country often goes hand in hand with optimistic valuations of the stock market. Those who bought Chinese stocks in 2007 with a top-down perspective were correct about economic developments, but wrong about valuation. As a consequence they have lost almost half their money.

As a top-down investor you often pay a high price to be a shareholder in a company listed in a country in which macroeconomic prospects are exemplary. And where there are far more people analysing the economic development of a country than that of the companies in it, as is the case in India, you end up with a top-down climate which we in SKAGEN abbreviate to POO - Popular, Over-researched and Overvalued.

(Torkell Eide - Skagen - 18/02/11)

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