Investors should be wary of basing investment decisions on economic data

Investors should be wary of basing investment decisions too heavily on the plethora of economic data they are exposed to on a daily basis, such as GDP growth rates, inflation data, manufacturing and production numbers, various confidence indexes, rating a

Razeen Dinath, investment analyst at RE:CM, says research has disproved the existence of a positive relationship between real economic growth and stock market returns.

“Research by Dimson, Marsh and Staunton, academics at the London School of Business, analysed the relationship between real GDP growth per capita and real stock returns of 83 countries from 1972 to 2009. Investors in emerging stock markets are most frequently guided by the alluring prospect of rapid economic growth leading to higher corporate earnings and associate this with higher stock returns. The study however refuted the existence of a positive relationship between GDP growth and stock returns and found that the correlation was negative, except for the highest growth countries.

“The reason for this is that when the market anticipates a high economic growth rate, the price paid by the market for those earnings and increase in book value is usually high. Growth is an important component of the return equation, but a more important aspect is the re-rating of the stock market from cheap to fair value which then usually progresses to expensive territory.”

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Dinath argues that while profitable investment opportunities may exist in emerging markets, investors should not use economic growth as their sole premise when making an investment decision. “A more important consideration is the starting valuation. Emerging market investors benefitted greatly in the early 2000’s, not necessarily from high economic growth, but mainly due to equity valuations of emerging markets being vastly undervalued.”

He says that China has had the fastest GDP growth in the last decade at 10.7%, while an investment in the Chinese stock market delivered a total return of 19.7% per annum. “Inflation averaged 2.8% over this period, with the Price to Book multiple expanding from 0.9 to 1.5, adding 5.4% to the return equation. China’s outperformance of developed markets over the last decade is due to China achieving extremely high growth and starting off at a cheap valuation.”

Dinath explains that the 50 year GDP growth rate for the world is around 3.5%. “Given this context China’s growth over the last decade has been phenomenal. To highlight the impact that starting valuation has on the total return, China once again provides us with compelling evidence. On 1 January 2008 China’s P/B ratio was 3.1, and has subsequently reverted to the long run average of 1.6. Over the same period China GDP has grown by an average of 9.8% per annum, with inflation of 3.5% per annum. The total return from an investment in the Chinese stock market over this period was -2.6% p.a. China’s growth rate was still very good, but investing at a time when the market was expensive resulted in subsequent poor returns. The de-rating of the price to book ratio resulted in a negative 11.5% p.a. impact on the return, which could not be offset by Chinas superior growth.”

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His views are consistent with RE:CM’s tried and tested investment philosophy that an investment return is determined by the price paid for the investment. “We look to invest in companies at a discount to our estimate of fair value, which provides us with a margin of safety and the expectations of high investment returns. We also focus on quality companies who earn returns higher than their cost of capital, which causes the business to grow its intrinsic value over time. This investment philosophy aims to improve investment returns while lowering investment risk, which we define as the risk of losing our client’s capital.”

RE:CM’s investment outlook on the South African market is that South African equity is priced around fair value to expensive. “There are some pockets of attractive investment, specifically in the platinum industry and gaming sector in companies such as Amplats, Lonmin, Sun International and Tsogo Sun.

“On a global front, RE:CM believes that the market has undervalued high quality companies in the U.S, Europe and Japan. We believe we have uncovered value in these markets and have invested in quality companies that are priced well below their estimated fair value,” concludes Dinath.