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Tuesday, February 23, 2010

Does economic growth lead to higher returns for stock market investors?

A recent article in Business India magazine warned that investors 'should be wary of relying on a link between overall growth of the economy and returns on specific company stocks'.

The article written by Hugh Sandeman, MD of Langham Capital, concludes with the following statement:

"...the macro-economic growth story is a cue for caution, not just celebration."

That sounds counter-intuitive, doesn't it? If the economy is growing, then more goods are being manufactured, roads and bridges are being built, every one has more disposable income, so more shares will be bought and their prices will go up. Right?

Not quite. In his book 'Stocks for the Long Run', Jeremy Siegel presents some interesting research data to show that 'economic growth has nowhere near as big an impact on stock returns as most investors believe'.

In one chart, percentage returns (in dollars) for 16 developed countries was plotted against each country's percentage real GDP growth from 1900 to 2006. Real GDP growth had a negative correlation with returns from the stock market. Higher the economic growth in individual countries, lower was the returns to equity investors.

A similar chart for 25 developing countries (including India and China) shows a similar negative correlation, in spite of the massive returns provided by the stock market indices of these countries in recent years. Are we missing some thing?

Turns out that the growth in aggregate earnings and dividends do increase along with GDP growth. But for investors the returns are based on earnings and dividends per share.

Economic growth is dependent on expenditure on R&D, technology upgradation, increase in manufacturing capacities, building new factories and offices. Such expenditure needs to be funded - either through loans, or through issuing new (or additional) equity shares, or both.

The interest burden and equity dilution leads to lower rate of growth in EPS and dividends per share. While internal accruals (read: positive cash flows from operations) can fund expenditure in the shorter time frame, Siegel's research shows that in the longer term a 10% increase in GDP requires a 10% increase in the equity capital.

The cautionary note in the article was directed particularly at asset heavy sectors like infrastructure, energy and shipbuilding. Investors in IVRCL Infrastructure may have noted the recent downgrade in its credit ratings due to a large debt burden.

Pantaloon and Cranes Software are other examples of how rapid growth funded through loans and equity can quickly lead to poor share holder returns.


Madhu said...

Good article.
Stock market movement is more of a lead indicator.
May be the stock market would have already moved up ANTICIPATING economic growth. Instead of same year returns, he should have calculated correlation of economic growth with previous year stock market returns. May be it may have better correlation.
However the article is an eye opener for those who buy stocks after reading morning newspapers.

Subhankar said...

Thanks Madhu.

Siegel's research is over a long enough time period that it smoothens out short-term aberrations.

The point of the article was to question a widely held belief. Stock markets 'discounting' the future is another such belief that should be questioned!

Bharath said...

Dear Dada,

Info in the article is a news to me !
Then I really doubt on investing my money on "India's Growth Story".

Sir, Just want make this info simpler, do you mean to say actual growth ( in GDP term ) is not linked with stock market growth ? Is BSE numbers are inversely correlated with GDP growth rate ?

Please clarify.

P.S : Pls reply even if you find my question soo stupid :)

Subhankar said...

EPS and dividend per share may not grow at the same rate as the GDP - particularly for asset-intensive companies.

During the recent bear phase, the GDP grew by 6% - lower than the earlier 9% - but many companies reported lower (or negative) EPS and slashed dividends.