Growth in China, India and Brazil Might Not Mean Great Investment Returns

(MoneyWatch)  As you may know, one of my favorite hobbies is debunking the "conventional wisdom" of investing. Another piece of conventional wisdom I keep hearing is how investing in companies with high expected growth rates in earnings leads to high stock returns. Historically, this has simply not been the case.

From 1927 through 2008, value stocks (with relatively poor earnings) have outperformed growth stocks by an annual average of 5 percent a year. Investors make the same mistake when it comes to investing in countries.

One of the most frequent questions I get relates to the desire to capture the stunningly high growth of developing countries such as China, India and Brazil. A few months ago, I showed that there's a negative correlation between country growth rates and stock returns. The post also provided the economic reasons why this is true.

As London School of Business professor Elroy Dimson notes: "People have hopelessly got the wrong end of the story." Based on decades of data from 53 countries, Dimson found that economies with the highest growth produce the lowest stock returns. Stocks in countries with the highest economic growth have earned an annual average return of 6 percent, while those in the slowest-growing nations have gained an average of 12 percent.

Dimson notes that investors chasing returns in rapidly growing countries are "paying a price that reflects the growth that everybody can see." The same can be said of investors chasing the returns of rapidly growing companies.

A second point lost on investors is that markets price risk, not growth. It's the discount rate (reflecting risk) applied to expected earnings that determines the expected return, not the rate of growth.
Think of it this way: The benefits of technological change don't necessarily go to the owners of capital. Those benefits can instead mean higher wages for workers and lower prices for consumers. The same is true of the benefits of rapid economic growth.

There certainly can be a role for emerging markets in equity portfolios. However, that role shouldn't be based on expectations of high rates of economic growth. Instead, it should be based on their returns not being highly correlated with the returns of either U.S. stocks or the stocks of other developed nations -- thus, providing the benefits of diversification.