text: Blinded by Growth W - IESE Business School
  Blinded by Growth by Javier Estrada, IESE Business School* ho does not like a growth story? Investors often W hear recommendations to invest in China, or India, or Brazil to participate in the growth of these economies. Investors also often hear recommendations to invest in fast-growing companies like Google, or LinkedIn, or Facebook. And who can deny the appeal of these and many other growth stories? But there is a problem with growth: as an investment thesis, it is not enough. In other words, high economic or corporate growth may not necessarily turn into high returns for investors. In fact, from an investor’s point of view, growth is typically overrated; it often disappoints and, over the long term, as shown by an impressive body of research, it is outperformed by investing in cheap, underrated, unfashionable companies. And this is not because growth per se is detrimental or irrelevant. It is because growth should be a part of the story, but never the whole story. In other words, investors should pay attention both to growth and to how much they pay for growth. This article will consider growth from three different points of view. First, we will look into the relationship between economic growth and equity returns. Then we will discuss the relationship between corporate growth and equity returns. And, finally, we will compare investing in growth-oriented companies with investing in value-oriented companies. Economic Growth and Equity Returns Most investors take it for granted that investing in fastgrowing economies like China or India will translate into high returns in their pockets. That is a big mistake. Figure 1 shows, for each of 19 developed economies, the annualized real equity return (the first bar for each country) and the annualized growth of real GDP per capita (the second bar for each country) during the 112-year period from 1900 through the end of 2011. 2 As a quick visual inspection will tell you, economic growth and equity returns are clearly not positively correlated. In fact, the correlation coefficient between these 1. I would like to express my thanks for the comments of Tom Berglund, Jack Rader, David Walker, and the many participants that attended my “Blinded by Growth” presentations around the world. Sergi Cutillas provided valuable research assistance. The views expressed below and any errors that may remain are entirely my own. two variables is a negative 0.39. Some may question the relevance of evidence from over 100 years ago because economies and markets have changed substantially over time. But evidence from a more recent period comes to essentially the same conclusion. Figure 2 shows the annualized real equity returns and growth rates of real per capita GDP for 21 countries over the most recent 42-year period (1970-2011). The correlation coefficient of -0.04 together with a p-value of 0.87 clearly indicates no correlation between growth and equity returns. Others may argue that economic growth and equity returns should be correlated in emerging countries, but not necessarily in developed ones. This argument is also somewhat questionable, but a look at the evidence again reaffirms our previous conclusion. Figure 3 shows, for 15 emerging countries, the annualized real equity returns and growth rates in real per capita GDP over the still more recent period 1988-2011. Once again, simple visual inspection of this figure makes clear the absence of any positive correlation between economic growth and equity returns. And as before, the correlation coefficient of –0.41 and a p-value of 0.13 suggest that growth and returns are simply not correlated. Note that in all three exhibits, the equity returns are measured in local currency. Would the correlations discussed change if returns were measured in dollars instead? Not substantially, and not in a way that would affect any of the conclusions drawn. The correlations between economic growth and equity returns when the latter are measured in dollars are –0.32 (with a p-value of 0.18) over 1900-2011 for the countries in Figure 1; 0.01 (with a p-value of 0.95) over 1970-2011 for the countries in Figure 2; and –0.47 (with a p-value of 0.08) over 1988-2011 for the countries in Figure 3. Obviously, many other arguments can be raised, particularly in terms of how economic growth and equity returns are measured. Exhibit 1 reports, for 24 developed countries and 21 emerging countries (as well as 45 countries combined), the correlation coefficients between economic growth, as measured by both real GDP and real GDP per capita, and 2. The data for Figures 1-3 was kindly provided by Jay Ritter, who discusses it more in depth in his article in this same issue; see Jay Ritter, “Is Economic Growth Good for Investors?,” Journal of Applied Corporate Finance, Volume 24 Number 3 (Summer 2012). See, also, Jay Ritter (2005), “Economic Growth and Equity Returns,” Pacific- Basin Finance Journal, 13, 489-503. Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 19
  Figure 1 Economic Growth and Equity Returns, 1900-2011 8% 7% 6% 5% 4% 3% 2% 1% 0% Australia South Africa Equity Return USA Sweden New Zealand Canada Economic Growth UK Finland Denmark Netherlands Figure 2 Economic Growth and Equity Returns, 1970-2011 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Sweden Finland South Africa Denmark Netherlands Singapore Germany Equity Return Economic Growth Norway Belgium Canada 20 Journal of Applied Corporate Finance • Volume 24 Number 3 A Morgan Stanley Publication • Summer 2012 UK Norway Switzerland USA France Ireland Switzerland New Zealand Japan Australia Spain Ireland France Spain Germany Austria Belgium Japan Italy Italy