Imagine that it’s 1992. The UK is slipping into recession, but world stock markets are taking off.
The Berlin Wall fell three years ago. The United States won the Gulf War and Saddam Hussein is defeated. Russian Communism has crumbled.
Your stockbroker calls to tell you how to make money from global growth. He says you can invest in either China or Brazil. Both countries have great prospects. China has the world’s largest population, and Brazil has the largest economy in the Americas outside of the United States.
Which country will you choose to invest in - China or Brazil?
Remember, it’s 1992...
Now let’s look at the investment returns from both countries. The Shenzhen and Shanghai stock markets opened in 1990. By 1992, the aggregate market value of the market was $20 billion. The number of stocks listed rose from 20 in 1990 to 70 in 1992. Trading volume went up 30-fold in just one year. And by 2003, China was the second largest economy in the world and the largest recipient of foreign direct investment.
Brazil, on the other hand, was swathed in turmoil. In 1992, President Fernando Collor de Mello was impeached. Inflation was an incredible 1,100%, and by 1994 it had passed 5,000%. Corruption was rampant, and a debilitating energy crisis led to blackouts and government-imposed cuts on electricity consumption.
Throughout the early ‘90s, Brazil’s GDP grew at 1.8% per year — less than one-fifth of China’s GDP growth.
Makes you want to invest in China, right?
Wrong. Wharton finance professor Jeremy Siegel explains why:
"From 1992 onward, China experienced the world’s worst stock returns as investors saw their portfolio shrink, on average, by almost 10% per year. A $1,000 investment in China at the end of 1991 shrank to $320 by the end of 2003...
"Brazil, on the other hand, produced extraordinarily good returns of over 15% per year, with the same $1,000 investment in 1992 accumulating to $4,781, handily beating U.S. stocks. China was indisputably the world’s fastest-growing country, but investors in China realized horrible returns - because of the overvaluation of Chinese shares. On the other hand, stock prices in Brazil were cheap in 1992, and all its economic troubles kept its prices low over the subsequent decade. As a result, the dividend yield on Brazilian stocks stayed high. Patient investors, buying value instead of hype, won out."
In his book, 'The Future for Investors', Siegel cites extensive research to show that when it comes to investing, conventional wisdom is usually wrong. Just because China grew faster doesn’t make it a better investment.
Investors’ fascination with high growth can lead to a lot of trouble. This is what Siegel calls the “growth trap". Countries and individual stocks alike have growth traps. Let’s look at another example from Siegel’s book...
When Conventional Wisdom Isn’t so Wise
Imagine that you can time travel and are capable of hindsight to make your investment decisions. Now go back to the year 1950 and pick a stock that you will want to hold until today. You have to choose between IBM and Standard Oil of New Jersey (now ExxonMobil). Which stock should you buy?
Remember, you’ve travelled back to 1950 to make this decision. Invention and innovation were transforming our society. Paper Mate had just developed the first leakproof ballpoint pen. Haloid (now Xerox) had invented the first copy machine. Diners Club introduced something called a credit card. And Bell Labs had just made the transistor, an important component of the computer revolution.
According to Siegel, “The future looked so bright that the term ‘new economy,’ so often bandied about during the 1990s technology boom, was also used to describe the economy 50 years earlier.”
Now that we’ve looked at a bit of history, let’s review the growth rates. Here's Siegel again:
“Although both stocks did well, investors in Standard Oil earned 14.42% per year on their shares from 1950-2003 - more than half a percentage point ahead of IBM’s 13.83% annual return. Although this difference is small, when you opened your lockbox 53 years later, the $1,000 you invested in the oil giant would be worth over $1,260,000 today...while $1,000 invested in IBM would be worth $961,000, 24% less.”
In short, what looks like fast-growth today doesn't mean you'll get growth tomorrow.
Kind regards,
Sala Kannan
for Profit Watch
PS: It's not just avoiding the "growth trap". Making big money, as we've just seen, is all too often about buying what's unloved...the uncool...and the un-hip.
They can put you way ahead – in the long run – of the latest stock market fad. That's what we're always looking for at the Global Profit Hunter. It's the little-known and under-valued shares that count.
P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.