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Invested in emerging markets because of high economic growth? There is a better way…

Are you invested in emerging markets or is considering it because of the weak economic growth in Europe and the USA?

If so this article will give you pointers on how to maximise your gains.

I am sure you have seen and heard the argument that you should invest in emerging markets because the higher economic growth will equal higher stock market returns.

It’s an interesting idea and it makes for a nice story but does the argument hold?

I can just say from past research I have seen the relationship may not be that strong.

Here is some good research I have found.

The Brandes Institute part of Brandes Investment Partners, a fund manager I greatly respect, in December 2010 published an excellent paper on exactly this subject called New Insights into the case for Emerging Market Equities.

They referred to a really long term study done by the London Business School and Credit Suisse to see if there is a link between GDP growth and investment returns.

The study uses four different definitions of GDP including nominal and real (adjusted for inflation) but the findings were nearly all the same.

And used data for 83 countries as far back as they could find. For some countries back to 1900.

Each year countries were sorted into 10 groups based on real GDP growth over the past five years. Equal investments were than made in each country and investments held for one year with dividends invested at the end of the year.

They did this for as far back as they had data up to the end of 2009.

No relationship

And what did they find?

From 1900 to 2009, over 109 years, there was no relationship between GDP growth and investment returns.

Contrary to what you may have been thinking the returns from the countries with the lowest GDP growth was the highest.

In a lot of countries the relationship was negative. This means in spite of GDP increases the stock market had negative returns.

How can you find attractive emerging markets?

As GDP growth did not work the Brandis Institute did further research to determine if here are other measures investors can use to find attractive emerging markets to invest in.

To do this they went back to the Value v Glamour research they did in the past. (I wrote about it in Value vs. Glamour stocks – Value wins hands down)

They took the largest 50% of all companies in emerging market countries and divided them into 10 groups using a simple price to book ratio. So on the one end of the 10 groups you would have the lowest price to book companies (the Value companies) and the other end the highest price to book value companies (the Glamour companies).

They then tracked the performance of each group over the next five years. Doing this each year from June 1980 to June 2010 – for 30 years.

What they found was remarkable.

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Glamour or high price to book value companies had an average annual return of 4,4% over the five year period, and Value companies (low price to book value) had an average annual five year return of 20,8%. Value thus had an average annual outperformance of 16,4%.

I am sure you will agree a 16,5% outperformance per year for five years is significant.

And this from a simple strategy of buying the lowest price to book value companies, not even considering the amount of debt the companies had or any other factors.

The research report goes on to give the following advice to emerging market investors:

  • Emerging market companies with low valuations have outperformed those with high valuations
  • Emerging markets do not move along with the US markets and my thus offer US investors some diversification benefit
  • Emerging markets are more volatile than the US markets. This is however not a bad thing as patient investors looking at individual companies can make use of the volatility to invest in mispriced companies.
  • The real advantage of investing in emerging markets is to not to follow the herd into countries with the highest economic growth – this does not work – but rather to use volatility to buy companies mispriced because of volatility or market inefficiency.
  • The economic growth of emerging markets can be best captured by investing in small and medium sized companies. This is because a large part of emerging market indices is made up by large companies that do not only operate in the country with the fast economic growth. Smaller companies are thus in a better position to make use of the fast economic growth.

Valuation is king!

Thus always remember the importance of valuation. Growth is not of any value to an investor if he has to pay too much for it.

Your even more convinced of value investing analyst