Thick As A BRIC: Efficient Frontier via CSInvesting

Jay Ritter


It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

Thick As A BRIC: Efficient Frontier – Introduction

One of the livelier comic relief items to recently grace the world of institutional investing is the so-called BRIC fund phenomenon—emerging markets offerings restricted to Brazil, Russia, India, and China. (B-R-I-C, get it?) The rationale behind these bizarre beasts, limited to four of the world’s wildest equity markets, is that the four nations’ spectacular economic growth rates will soon catapult them into the front ranks of the world economy.

This has to be good for investors, right? As put in a Goldman Sachs paper touting the concept, “Higher growth may lead to higher returns… As today’s advanced economies become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for global companies. Being invested in and involved in the right markets—particularly in the right emerging markets—may become an increasingly important strategic choice.” You say you’re invested in fuddy-duddy old nations like the U.S., France, Japan, Australia, Canada, and Sweden?

Good grief, man, their slice of the global investment pie is shrinking. Dump ’em and load up where the action is before the world leaves you behind!

You’d think that folks smart enough to work at Goldman would occasionally read the finance literature. Yes, there is a relationship between economic growth and equity returns, but unfortunately, it has the wrong sign. There is now a pretty impressive body of data from folks like Elroy Dimson, Paul Marsh, and Jeremy Siegel showing a negative relationship between growth and returns.

You don’t have to go cross-eyed with regression analyses to convince yourself; a few anecdotes tell the story. During the twentieth century, England went from being the world’s number one economic and military power to an overgrown outdoor theme park, and yet it still sported some of the world’s highest equity returns between 1900 and 2000. On the other hand, during the past quarter century Malaysia, Korea, Thailand and, of course, China have simultaneously had some of the world’s highest economic growth rates and lowest stock returns.

What gives? There are several possible explanations. First, just as you learned in Econ 101, stock returns lead economic growth and not the other way around. In even simpler terms, just as growth stocks have lower returns than value stocks, so do growth nations have lower returns than value nations—and they similarly get overbought by the rubes.

There’s another possible explanation: share dilution. The bad news is that if a nation’s economy grows at x% per year, per-share earnings and dividends do not also increase at x% per year—they increase at (x% – y%) per year, where y% is the amount of share dilution. Rob Arnott and I wrote a piece on this topic in Financial Analysts Journal in 2003 in which we determined the leakage was 2.3% per year in the U.S. and higher in nations devastated by military conflict. We’ve since speculated that rapid technologic change might have the same effect. (Sorry, you’ll have to go to your local academic library to see the piece, but here’s the Readers Digest version from our website.) While Rob and I didn’t expect any early morning calls from Stockholm for this concept, we had at least hoped to stir up some discussion. For two years, we’ve heard nary a peep… until recently.
Jay Ritter, writing in Pacific-Basin Finance Journal, noted once again the negative correlation between growth and returns, and formulated several alternative hypotheses, the most promising of which being that managers expropriate wealth from minority shareholders. (In plain English, they steal.)


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