Economic Growth Is A Flawed Indicator

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(This story was originally written and published on Monday, 20th June 2011).

By Rudi Filapek-Vandyck, Editor FNArena

The mistake is often made and it has cost many investors a lot of money over the years past. And I do mean: a lot of money.

Economic growth does not automatically correspond with share market performance. The years past have brought home this message with a harsh reality check as share markets in high growth economies, including India, Brazil, China and Australia, have provided investors with equity markets that have significantly underperformed markets in weaker economies.

Of course, whenever economies take a turn for the worse and end up in negative territory, equities feel the pressure too and head south as company earnings won't remain immune to the negative pressure. But most of the time economies are in positive territory and unfortunately for equity investors this doesn't mean equities will thus put in a positive performance. There's much more in play than just economic growth.

In its purest and simplest form, investors who buy a share of capital in a listed company buy exposure to that company's ability to generate a return in the form of profits for shareholders. In stockbroker lingo this becomes "earnings per share". There are many factors that influence a company's ability to grow returns for shareholders.

Let's skip the company specific ones such as a sustainable business model, pricing power and good management. There's taxes and government regulations, consumer behaviour, competition and industry dynamics, currencies, interest rates, access to labour, capital and investments, cost levels, technology and productivity growth. It probably is not too much a stretch if I state that most of these factors for most companies in Australia have been negative since 2007, which then explains why earnings per share growth has lagged the rest of the world.

(Higher oil prices play an important role as they impact on several of the factors mentioned, and not only for transport companies).

Quite remarkable, if you think about it, but average EPS growth in Australia for fiscal 2010 did not exceed low single digits (circa 3%) while companies such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)) were recording increases of 100% and more. If my earlier analysis proves correct, FY11 will not be materially different. This makes it even more remarkable since Australia's economy has been the envy of many others around the world up until now.

I see a similarity with the shock waves that went through Australia when Australian banks started lifting mortgage rates and other interest rate-related fees independently of the Reserve Bank in the post-Lehman-collapse era of higher funding costs. Up until that point, journalists, investors and about everyone else had assumed a direct link between the RBA's cash rate and what the banks charged their customers. That never really was the case, it's just that it never mattered anyway, because there was no reason for the real dynamics to reveal themselves and force a gap between RBA and banks. Until it happened.

Similarly, we always read and hear commentators and other experts referring to "ongoing strong economy", which then serves as justification as to why investors should stick with their equities, or add some more, and yet the past two years have revealed what these GDP-oriented strategies are: they are flawed. What matters most is whether companies can maintain or even improve their margins, plus grow their sales. The combination of both can be a powerful profit accelerator which then translates in expanding multiples and thus a rising share price.

Historically, investors will find that companies outperforming the broader market are those which manage to increase profit margins. This is also one of the base factors in the market approach as suggested by Joel Greenblatt's "The Little Book that Beats the Market", a true classic amongst investment books.

Gradually, Australia is catching up with the reality that internal dynamics are not at all favourable for companies' profit margins. Economists at UBS recently did a lot of work on this issue and concluded that when it comes to productivity growth (a key factor if companies want to improve margins and profits), Australia has been among the worst performers in the world post 2007. To illustrate exactly how badly Australia has performed on this matter: according to UBS's assessment, only Ireland, Greece, Romania and Norway did worse. I know, this is part of ongoing debate and UBS's conclusions will not receive a warm reception in all corners of society, but the economists' conclusions contain a hard lesson for business leaders, politicians and investors alike.

In a nutshell: compared with Australia's now softening economic fundamentals it would appear corporate Australia is over-employed. This does not only suggest a peak for the labour market (temporarily at least), it also explains why profit growth has been so sluggish and so lame thus far. UBS's conclusion is: we may have found the recipe for a "lower trend of economy-wide corporate earnings growth".

When put in the context of earlier analysis conducted by UBS's head of Global Asset Allocation, Larry Hatheway, the study then leads to the following standout conclusions:

– Equity markets in low productivity regions tend to correspond with slower earnings growth and lower "fair" Price-Earnings multiples (both have occurred post 2009)
– Dividend yield becomes a more important element in total investment returns achieved (yep, that one equally stands out)
– High productivity economies typically enjoy stronger currencies (Ooops, we seem to have a mismatch)

That last element is particularly interesting because the strong Australian dollar has been one of the most visible headwinds for corporate profits and for shareholder returns over the past two years. Is it possible that investors overseas have become too wildly enthusiastic about economic prospects and growth in Australia, at a time when central banks around the world are looking for diversification away from troubled USD and euro? Add yield-seeking investors in Japan and elsewhere, plus short term "hot" money playing the Aussie as a leading gauge of global risk appetite, and we may have found a powerful combination which first pushed up the currency to 1.10 against the greenback, and has then kept AUD well above parity since.

There is one strong argument as to why the Australian dollar might be too highly valued: even resources companies have been suffering earnings downgrades in recent times. More might be yet in store as prices for nickel, oil and most other commodities have sold off much more since April than the few cents in losses for the Aussie. Valuing a currency has always been a mug's game, and this time will prove no different. Flip a coin used to be the advice by former Fed Governor Alan Greenspan. However, Andrew Pease at Russell Investments has no hesitation. In his latest strategy update, the Chief Investment Strategist Asia Pacific nominated AUD as overvalued, with conviction.

Should we care?

Yes, but for different reasons as most of you are probably thinking. The share market is all about differences between the future and the past. This is why high multiple stocks sooner or later run into trouble (because the law of numbers makes it increasingly difficult to continue growing at 20%-plus each year). This is also why yesterday's losers will at some point turn into tomorrow's winners. It is early days yet, but it would appear many of the headwinds that have bogged corporate margins outside the resources sector in Australia are at the very least not getting worse. This might be the early stage of a turnaround in underlying dynamics.

The reason why global investors are turning increasingly skeptical towards prospects for corporate earnings in the US is because net profit margins have surged to an all-time high. The message here is: be cautious, the path of least resistance probably runs through lower margins which means: slower profit growth. Unless increased sales can make up for the difference, but that seems rather unlikely.

In Australia, the same applies to resources companies. When prices for natural resources put in a big rally from oversold levels to elevated prices, margins for producers go through the roof. Already, a growing number of market experts is now suggesting prices peaked in April for this year. Even if these experts are to be proven incorrect, it is not likely the years ahead will show a similar growth pace as in the years behind us. This automatically implies the underlying dynamics for resources producers are changing too. Constraints in labour, rising costs and other headwinds will increasingly start making a bigger impact on ultimate returns for shareholders.

Research conducted by analysts at Citi has revealed that, typically, 50% of price increases go missing for shareholders in resources producers due to labour, currencies and rising operational costs. This matters less when prices jump by 100% as has recently been the case for mineral sands producers and for rare earths, but once price increases fall to far less exuberant levels (not even mentioning they might fall) this will become a more prominent feature for the industry. This also implies, as I have been pointing out, that the enormous gap that has opened up between resources and the rest in Australia has reached its peak, and will start narrowing from here onwards.

Most importantly, for those investors who made the mistake by assuming high economic growth always translates into healthy investment returns from the share market, a potentially slowing economy in Australia (as well as in the rest of the world) does not mean that investment returns from equities will only get worse. To the contrary, it is far more likely the severe headwinds from the past years will loosen their grip on corporate profit margins in Australia -some might even turn into a beneficial factor- which then means we are far more likely to see the return of higher growth, and thus higher share prices.

It doesn't have to be spectacular to make a noticeable difference (share market returns ex-dividends are negative on a 23 months horizon).

This does not imply we will see a swift return to the double digit returns experienced in 2004-2007, but that's an item for another day. It remains my personal view that heavily de-rated industrials offering high dividend returns remain the best options available for long term investment strategies.

Bottom line: unless we're dealing with negative growth, there's no direct connection between economic growth and share market returns, but that might well be a good thing in the year(s) ahead.

(This story was written and published on Monday 20th June, 2011. It was emailed to paying subscribers on that same day.)

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