Which market do you think will make the better investment over the next five years? China or Germany? The intuitive answer is China. After all we all know it is the fastest growing economy in the world – GDP is leaping ahead at an astonishing 8-9% plus a year and looks likely to keep doing so for some time to come. Indeed according to the authorities in China it is entering a “Golden Age” of high growth. And perhaps it is. But if so no one has yet told the stock market. It fell more than 20% last year and so far this year it has fallen a further 13%.
So what’s going on? For the answer we turn to the investment yearbook out a few weeks ago from ABN Amro and the London Business School – it clears the whole thing up nicely.
It turns out that there is no statistically significant link between a country’s GDP growth and its future investment returns. In fact it is the other way around: slow growth countries consistently deliver better performance. This is completely counter intuitive – every fund manager in the world thinks that high growth equals high returns. But think about it for a bit and it begins to make sense.
Firstly there is the fact that in high growth economies cash flow is likely to be poured into capital investment and expansion. In slow growth economies it is more likely to be paid out in dividends – and we know that over the long term high yielders always outperform so called growth stocks. Second, periods of low growth very often force companies to change the way they operate (for the better). Finally – and most importantly – low growth markets, that the financial community doesn’t expect much from, tend to be cheaper than those operating in the world’s go go economies. And if you buy cheap assets over time you will make more money than if you buy expensive ones. Simple as that.
Add all this up and the path to riches suddenly looks very straightforward: we need to look for assets that are creating cash in cheap markets where the corporate sector is undergoing a degree of positive restructuring.
This brings us back to Germany. It is not an obvious home for your money but it certainly fits all the criteria. There is for example no arguing with the slowness of German growth. GDP stagnated for most of last year and then fell by 0.2% in the last quarter. Over the last three years it has come within an inch of recession numerous times and no one is brave enough to forecast it growing by much more than 1% this year. Unemployment at its highest for 50 years, domestic demand is weak and the country suffers from both an aging population and a hugely expensive social security system. No wonder it isn’t very popular with the world’s investors.
But look at little closer and it isn’t so bad. Productivity is not much worse than it is in the US and labour market, pension, tax and healthcare reforms are underway. At the same time, dismal growth combined with a strong currency has forced German companies to cut to costs drastically: as a result they are expected to announce record earnings in 2005. Last year the German market rose over 35% but it is still absurdly cheap, trading on an average p/e of a mere 9 times.
A second candidate is Japan. The economy has recently had a technical recession (GDP has fallen for 3 quarters in a row) but over the last 5-6 years corporate Japan has really pulled itself together, cutting staff, capacity and costs and rebuilding balances sheets. The result? Profits jumped 26% last year and Japanese companies are producing cash at a record rate.
None of this is to say that Japan or Germany are perfect. Far from it. However they are no longer absolutely awful: their economies and companies are moving from bad to better and that is the perfect time to invest. If they were in the process of moving from good to better they’d be expensive. So why wait until then to buy in?