One of the pleasures of working in finance is interacting with many brilliant people who have great insights and ideas about the best ways to build portfolios and what are the best strategies to maximize returns while minimizing volatility. Discussions such as “What is superior: valuing a company based on price-to-book or EV/EBITDA?” or “Are emerging market stocks core or satellite positions?” are fascinating and compelling, but I am beginning to wonder if they are not my industry’s version of the famous theological dispute about how many angels could dance on the head of a pin.
What I am getting at is that it is largely a mythology that stocks advance ad infinitum. Take, for example, this bit from The Economist:
“Much of the data quoted by investment advisers [about stocks usually rising over time] is based on America, which is something of an outlier; it turned out to be the most successful economy of the 20th century but that was not guaranteed in advance. An investor in 1900 might have picked Germany as a rising power, only to see their assets wiped out in the 1920s hyperinflation and the Second World War; they might have picked Argentina, which was a perpetual disappointment. In other countries, there have been very long periods in which equities have not been a great investment…As of February 2013, the longest period of negative real returns from US equities was 16 years. But it was 19 years for global equities (and 37 for world ex-US), 22 for Britain, 51 for Japan, 55 for Germany, and 66 for France…”
What difference do the minutiae of investing in stocks matter if the conditions for stocks to thrive are not present?
I can see where people could make the argument that Japan, Germany, and France were ravaged by war, so long droughts for equities in those countries should be discounted. However, it should be noted that even though they were devastated, depopulated, and occupied by world war, German equities still returned 3.3% in real terms from 1900-2015, and Japanese equities returned 4.2% over the same timeframe. Obviously, these countries had to have had periods of spectacular growth to offset the very long droughts mentioned above. Such humanitarian disasters leave their mark, but they do not ensure that is all lost for investors. There are many examples of countries that dealt with far less than Germany and Japan in terms of war and economic malaise, yet their investors were far from rewarded.
Take the example of Argentina, which, in the early 20th century, ranked among the top ten wealthiest countries, only to see inflation, dictatorship, and poor policies destroy the economy by driving off capital and investors, and diverting would-be immigrants to more welcoming shores. In the 20th century, Argentina’s military conflicts were minor compared to the devastation in Europe and Asia, yet Argentina’s per capita GDP declined significantly to around 50th in the world. You can imagine how Argentine equities have performed over the same timeframe.
Furthermore, even if an economy performs well in terms of growth, it is no guarantee that equities from that country will do well. Consider the case of Brazil (a country much older than the US*), which, per JP Morgan, averaged 4.9% real growth (versus 3.5% for the US) for much of the last century. However, US equities grew from 15% of the world’s equity capitalization (in 1899) to more than half currently:
Despite higher rates of growth, Brazilian equities are even now worth just a fraction of the value of the US market.
What is even more compelling is that there seems to be very little correlation between economic growth and equity returns. In the 2014 edition of Credit Suisse’s Global Investment Returns Yearbook, the case is made that such measures as per capita GDP matter very little to equity returns as you can see from the Credit Suisse graphic below:
What is interesting about this graphic is that the Anglo-Saxon countries, – the US, Canada, Australia, UK, – rank among the best performers. Obviously, they avoided devasation and occupation unlike Germany, Japan, and Norway, but the authors have anticipated that argument:
“The lack of a correlation was not attributable to two catastrophic world wars. In the post-1950 period, the correlation between growth in per capita GDP and and stock-market performance, whether judged by real dividend growth or by real returns, remained indistinguishable from zero.”
So, the UK generated real equity returns of 5.3% versus 3.2% for Germany, even though the latter, – despite all its troubles, – generated higher per capita GDP growth.
The results are not all that different when the authors compared aggregate GDP and real equity returns:
So what has made the Anglo-Saxon countries among the top performers in terms of real equity returns despite being outgrown over periods by other nations?
I would argue that what has made these countries rewarding to investors have been their dedication to stable government, stable currency, limited inflation, open trade, and property rights. Furthermore, in Anglo-Saxon countries, managers have a fiduciary duty to act in the best interests of their shareholders. In other words, if the economy is weak, managers might lay off workers or delay expansion and return corporate cash to shareholders via buybacks or dividends to make up for weak EPS growth. This type of thinking is largely unthinkable in Germany or Japan, where employees are treated as “stakeholders” of the company, and mass layoffs are rare. Increasing shareholder value is not job number one for managers in these countries. In Japan, where non-financial corporate cash is roughly equal to half the market capitalization (versus about 10% here in the US), there is no fiduciary responsibility to shareholders to maximize their value by returning cash to them. Instead, the economy founders, and cash hoarding continues. It is little surprise that equity returns in Japan have been subpar for decades now.
So, to come full circle, my point is this: it is a very real possibility for equity investors to suffer very long periods of anemic if not negative returns. Furthermore, these long droughts don’t seem to have much to do (longer-term) with easily explainable events such as natural disasters or war. Instead, they seem to have everything to do with abandoning good policy, poor monetary stability, and lack of incentives to reward shareholders.
Especially that this is an election year, I feel it is important that, – rather than agonizing over passive vs active, CAPE vs forward P/E, or what have you, – investors should focus more their energies on ensuring that the conditions and policies that have proven best for shareholder returns continue because absent these conditions and policies, none of the minor details will matter anyway.
*By older, I don’t mean political independence, which occurred early in the 19th century. I mean development began with European settlement in the 16th century.