Don't confuse growth with returns, says Aberdeen AM

Investor assumptions that economic growth will naturally lead to greater market returns are not necessarily correct, Aberdeen Asset Management has argued.

Instead, other factors such as interest rates, sentiment and cash flow matter more to a stock price return, said Richard Dunbar, London-based deputy head of global strategy.

“Whenever we give an investor presentation, the preamble tends to be what we think about the global economy or the economy we are investing in. There’s a presumption that these two pieces are somehow related,” Dunbar told a recent Aberdeen forum in London.

“But if you look at academic research from people like Jay Ritter, who did a study on research of returns over a century, they show there is no evidence of stock market returns being related to GDP per capita, despite evidence that most investors thought there was.”

One reason for this may be that asset classes are not necessarily linked to the economy, with the FTSE 100 a good example of this, given that three quarters of FTSE listed companies’ earnings come from abroad.

“When you buy into most stock markets, you are not buying those countries,” said Dunbar. “An investor asked me how to hedge against a ‘bad outcome’ in the recent UK elections – however you define that – and I said you want to buy something that has underperformed other global markets; you want to buy a currency that has underperformed the dollar and doesn’t source much from the UK. And what would that asset be? The FTSE 100.”

Another example of a dislocated market was late-1980s Japan, when the Nikkei 225 peaked at close to 40,000 points before collapsing after the bursting of a massive asset bubble.

“There were many optimists about Japan [back in 1989],” said Dunbar. “They looked at the technological wizardry and cross-holding of Japanese companies and how that justified P/E multiples of 60 plus, and the economic miracle of post-war Japan and all the disruptive technology and how it enriched the country."

Technological changes may bring economic benefits, but shareholders do not necessarily profit from innovation, with Dunbar citing the auto sector as an example.

“Consumers have benefited from unbelievable advances in technology, but shareholders made virtually no money out of it,” said Dunbar. “The price of a car is virtually the same as 30 years ago, but everything added to it has been given for free.”

This is compared to sectors such as the tobacco industry where there has not been any significant innovation, but where returns have been around 125% since 2010, according to the S&P 500 tobacco sub-index, against 30% for the S&P 500 car manufacturers’ index.

And with the greater number of stakeholders that businesses now have to deal with, shareholders may often only be a second thought. This is  especially true in the financial sector where regulators, bondholders and the public hold greater sway in the running of a business and ultimately place a drag on shareholder returns.

Governments often try to cash in on economic good times by raising taxes, with Dunbar citing as examples the decision by Peru to slap a $1.1 billion tax levy on mining companies in 2011 as well as the 30% levy for Australian iron ore and coal mining in 2012.

Instead of linking economic growth to stock prices, Dunbar suggests investors should focus more on what drives stock prices, in particular interest rates, earnings and sentiment.