While the ongoing Sino-US trade drama has hurt many investors in China funds — MSCI has reported a 13% decline among Chinese stocks so far this month alone — the Asian superpower still has its cheerleaders. Many have raised their portfolio exposures to the country, apparently hoping to capture higher returns in the wake of its brisk economic growth.
But those efforts could all lead to heartache, thanks to a harsh counter-intuitive truth: “History shows that countries with faster-growing economies often produce lower—not higher—stock-market returns,” said Wall Street Journal columnist Jason Zweig.
Zweig noted that although China has held the mantle of fastest-growing economy for decades, its stock market peaked in October 2007, and has since trended downward to the tune of 0.2% in average annual losses; that means it’s lagged the S&P 500 by eight percentage points per year, counting reinvested dividends. Citing FactSet research, he said a US$10,000 investment in the MSCI China stock index would have ended just shy of US$19,600 over the past 10 years, as opposed to nearly US$39,700 from the same initial investment in the S&P 500.
A more rigorous study of the phenomenon came in the form of research published in the Financial Analysts Journal late last year. Conducted by Jean-François L’Her, senior adviser for strategic asset allocation at the Abu Dhabi Investment Authority, along with two colleagues, it examined the differences in stock-market returns across 43 countries between 1997 and 2017.
The research looked at different variables across those countries — including future dividend yields, inflation, and economic growth rates — to determine whether they could predict future stock-market returns. Where all others failed, one variable turned out to be a predominant determinant: whether the total supply of shares was contracting or expanding, which L’Her said explains more than 20% of the extent to which returns have diverged across stock markets over the past two decades.
Applying the thinking to China, that means the ramp-up of Chinese stocks being sold to the public — making shares more plentiful — will lead to diluted share values. “Corporate profits get spread across a bigger base of stocks, causing future returns per share to fall,” the Journal piece explained, adding that a tendency for investors to be less choosy lets lower-quality companies issue shares and thus raise the likelihood of losses.
An analysis performed by L’Her and his colleagues showed that between 1997 and 2017, China’s market capitalization ballooned at an average annual rate of 27.5%, with 26.5% coming from the issuance of new shares and a measly 1% coming from capital appreciation. That exposes one possible shadow aspect of emerging-market investment: it can offset the risk of domestic bias in investing, but developing economies can also “attract hot money from too many investors too easily swayed by superficial arguments.”
“People tend to be blinded by growth, so they may overpay for stocks in countries with fast-growing economies,” L’Her said. “You should consider additional factors. Do not stop at economic growth.”
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