Wednesday, July 25, 2012

Stock Returns & GDP Growth: Why There's Little Correlation

A follow up to this post:

Why Growth Matters Less Than Investors Think

Below is a specific example of higher GDP growth not leading to higher stock returns. This article by Brett Arends that I mentioned in the prior post points out the following:

Real GDP growth from 1958 to 2008
- Japan 4.5%
- Sweden 3%

There was much more growth in Japan over that time horizon, but it was the Swedish investors that enjoyed the better returns. In fact, returns were three percentage points higher on average each year over those fifty years. Naturally, with compounding effects, three percent ends up being quite a lot more money over fifty years. It also makes quite an impact over a somewhat shorter time horizon. Let's say over the next quarter century what you've saved as of today ends up growing to $ 1 million by achieving the Japan-like returns. With the same amount of money at risk, the Sweden-like returns would instead grow to more like ~ $ 2 million as a result of the extra three percent per year. So the real cost of that 3% gap left to compound would be $ 1 million in gains.

So in the case of Japan and Sweden, growth in GDP told you little about potential equity returns. The article by Arends points out that research firm MSCI Barra looked at many major markets over the same period of time. The firm found no major correlation between GDP growth and stock market performance among them.

Professor Jay Ritter at the University of Florida also found that the correlation between the GDP growth and stock returns was actually negative for the twentieth century.

So what's at least some of the reasons?

- Investors often overpay for the fast-growers. A good investment at one price becomes a lousy one at another. Where there's excitement, stocks that sell for high multiples of earnings (paying too much for promise) usually follow. It's tough to do well long-term paying more per share than something is intrinsically worth. Also, depending on just how pricey the shares are, buybacks are anywhere from less effective to downright dumb as far as continuing shareholder returns are concerned. Shares that sell consistently below intrinsic value, if bought back when cheap, can juice long-term returns substantially even in a modest economic growth environment.
- Booming economies and industries attract lots of capital that leads to more competition. This usually lowers return on capital at least until a clear leader emerges. Return on capital is all-important and, in the case of Japan, their great companies have not exactly been known for being focused upon achieving high returns for shareholders. Also, high growth sometimes requires more capital than a business might have at its disposal leading to capital raising and share dilution. Well, it's per share increases to earnings that matter for an investor...not just absolute increases.
- Many enterprises are global and derive much of their value creation from outside their home country. So high GDP growth inside their home country, even for a sustained period of time, means little to these companies.

When you buy shares of anything, it's ultimately a proportional claim on its future cash flows. It may or may not be an exciting growth story. That's of little relevance. I opened the prior post with this Buffett quote that's relevant here:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

The primary drivers of long-term returns is the price that's paid relative to intrinsic value, return on capital (having the highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise), and whether real durable advantages exist. 

A good business needs little capital, can return excess capital to shareholders or use it to finance opportunities at an attractive long-term return, yet can maintain (better yet...grow) the size and strength of its economic moat. It also requires business leaders who do not choose growth for its own sake over returns for its shareholders. 

To be fair, sometimes the pursuit of market share and a willingness to endure pain in the early stages is quite necessary and smart. It helps if one already has a truly unassailable and profitable franchise well-established in a different market. Many of the great global brands have such a situation. They can afford to invest long-term. The key difference is they are usually operating with huge advantages and predicting that they will have a successful future outcome is less difficult to do. It's more about patience. In these cases deferring profitability in order to build a durable leadership position in a new market is wise.

Otherwise, lots of competing capital tends to show up (financial and human) in a high growth country or industry with difficult to predict outcomes. In this kind of environment there will no shortage excitement, innovation, and rapid change. All that capital formation tends to fund and create capable competition. There will be big winners, big losers and, at least before the fact, it won't always be easy to distinguish between them.* Enough capital for a sustained period of time ends up producing lots of new competitors with unpredictable long-term economics. A business can go from having what seemed to be an unassailable moat to having none at all in a relatively short amount of time. 

Once favorable economics for owners are no more. 

Just keep in mind that certain companies, often the great global brands with difficult to replicate distribution**, earn consistently above average return on capital. These great franchises can remain persistently profitable without engaging in anti-competitive behavior. The simplistic idea that high profitability will attract capital (and vice versa) that leads to less profitability (the supposed inevitable closing of the profits gap) doesn't always work in the real world. That model of how competitive forces will generally play out among competitors over time is flawed or, at least, limited in scope. It is not difficult to provide real world examples.

The formation of new innovative companies is good for civilization but may or may not be good for shareholders. Sometimes it will be. Sometimes not. One has little to do with the other. Airlines are incredibly important but rarely have been good for shareholders. When high returns are expected it often invites capital that creates lots of tough competitors. Pricing power and/or cost advantages are either non-existent or transitory. They do not prove durable. Sometimes, growth is pursued in lieu of returns. With the best intentions market share is pursued with the idea that profits will comes later. Sometimes it even works out. Still, more often than not, you get lots of growth but a low return on capital affair for owners. Not good if the best possible risk-adjusted returns is what you are after.

Those able to consistently pick the big winners (some are very good at that sort of thing) in these kind of dynamic situations may even do very well. To be successful, that style of investor also had better be very good at not allowing the big losses to occur. Big winners and big losers often reside in the same neighborhood and the houses aren't easy to tell apart. It's amazing how much getting above average returns comes down to just avoiding losses. Well, the big losses are often the flip side of going after home runs.

Otherwise, that's why the boring stable modest growth industries can be a more attractive investment approach. They attract little in the way of new capital formation, offer less excitement, but future outcomes are easier to predict. 
(Again, returns can turn out rather well in the long run if you just mitigate the possibility of big losses.)

Finally, as I mentioned above, just because a stock happens to be listed on a particular exchange, doesn't mean its future cash flows are tied to that country. There is no shortage of great franchises that derive a large proportion of their economics a great distance from the country of origin or listing.

Adam

Related posts:
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

Think search engines in the late 1990s. Anyone that truly could see Google (GOOG) was going to be the winner before it all played out the way it did deserves huge rewards. I say "truly" because I'm guessing at least some early investors in Google thought the young company had a great chance to succeed but did not really know it would work out so well. 
** Though there are certainly other ways to create an enduring moat.
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