Efficient Frontier
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William J. Bernstein

Thick as a BRIC

One of the livelier comic relief items to recently grace the world of institutional investing is the so-called BRIC fund phenomenon—emerging markets offerings restricted to Brazil, Russia, India, and China. (B-R-I-C, get it?) The rationale behind these bizarre beasts, limited to four of the world’s wildest equity markets, is that the four nations’ spectacular economic growth rates will soon catapult them into the front ranks of the world economy.

This has to be good for investors, right? As put in a Goldman Sachs paper touting the concept, "Higher growth may lead to higher returns... As today’s advanced economies become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for global companies. Being invested in and involved in the right markets—particularly in the right emerging markets—may become an increasingly important strategic choice." You say you’re invested in fuddy-duddy old nations like the U.S., France, Japan, Australia, Canada, and Sweden? Good grief, man, their slice of the global investment pie is shrinking. Dump ’em and load up where the action is before the world leaves you behind!

You’d think that folks smart enough to work at Goldman would occasionally read the finance literature. Yes, there is a relationship between economic growth and equity returns, but unfortunately, it has the wrong sign. There is now a pretty impressive body of data from folks like Elroy Dimson, Paul Marsh, and Jeremy Siegel showing a negative relationship between growth and returns.

You don’t have to go cross-eyed with regression analyses to convince yourself; a few anecdotes tell the story. During the twentieth century, England went from being the world’s number one economic and military power to an overgrown outdoor theme park, and yet it still sported some of the world’s highest equity returns between 1900 and 2000. On the other hand, during the past quarter century Malaysia, Korea, Thailand and, of course, China have simultaneously had some of the world’s highest economic growth rates and lowest stock returns.

What gives? There are several possible explanations. First, just as you learned in Econ 101, stock returns lead economic growth and not the other way around. In even simpler terms, just as growth stocks have lower returns than value stocks, so do growth nations have lower returns than value nations—and they similarly get overbought by the rubes.

There’s another possible explanation: share dilution. The bad news is that if a nation’s economy grows at x% per year, per-share earnings and dividends do not also increase at x% per year—they increase at (x% - y%) per year, where y% is the amount of share dilution. Rob Arnott and I wrote a piece on this topic in Financial Analysts Journal in 2003 in which we determined the leakage was 2.3% per year in the U.S. and higher in nations devastated by military conflict. We’ve since speculated that rapid technologic change might have the same effect. (Sorry, you’ll have to go to your local academic library to see the piece, but here’s the Readers Digest version from our website.) While Rob and I didn’t expect any early morning calls from Stockholm for this concept, we had at least hoped to stir up some discussion. For two years, we’ve heard nary a peep... until recently.

Jay Ritter, writing in Pacific-Basin Finance Journal, noted once again the negative correlation between growth and returns, and formulated several alternative hypotheses, the most promising of which being that managers expropriate wealth from minority shareholders. (In plain English, they steal.)

In a recent volume of Journal of Investing, Larry Speidell and three coauthors used our algorithm to measure dilution in several emerging markets, and their results were eye-popping: double-digit dilution rates—as high as 30%—in most Asian markets. In Latin America, which has had a harder time of it economically, dilution was in line with Western levels. What does 30% annualized dilution mean? That earnings growth at the corporate level also has to clip along at 30% per year just to keep the price even. Rises in market cap, as you might expect, drove dilution, the highest rates being seen in the hottest markets, the lowest rates in the coldest. (That’s right: Hugo Chavez just may be good for long-term stock returns. You heard it here first.)

This raises a larger point—just what are the long-term expected returns of emerging markets stocks? We simply do not know. We only have data on their returns going back to 1988: Between January 1988 and April 2006, the returns for emerging-markets equity and the S&P 500 were 18.78% and 12.07%, respectively. However, beginning the analysis in 1988 is the mother of all look-back biases; the lion’s share of the emerging-markets return was earned before 1994, when there was little international interest in them. Begin the analysis on January 1994 and numbers change to 7.76% for emerging markets and 10.72% for the S&P 500.

One thing we do know, dividend yields in developing nations are, on average, about a percent higher than they are in the developed ones. Do the 100 or so basis points extra yield, added to the higher economic growth rates, compensate for their higher dilution? Maybe yes, maybe no. About the best you can say for the asset class is that it’s still one of the finest diversification plays around and, occasionally, it gets really cheap. You can be sure when that happens, you won’t see a plethora of gimmicky funds and wirehouse flacks babbling about investment opportunities in places like Brazil, Russia, India, and China.

Copyright © 2006, William J. Bernstein. All rights reserved.

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