The most overstated concept in international investing is the idea of growth. We have all seen this in the advertisements for ETFs and mutual fund shares. They espouse the high GDP growth rates of China, South Korea, Taiwan, India and many others. The idea of buying shares in a high growth environment is you will get more top-line lift for your shares. The more top-line lift, the better growth fundamentals add to your shares' earnings.
Up go share prices, right? Not so fast!
What I have learned over the last few years of investing in such countries is that growth, simply put, is not enough. Benefiting from high growth rates actually requires a more complex investment exercise. This article is about laying out the pitfalls in growth-only investing. And providing you the insights and solutions I have gained to make a better way forward in international investing.
Why Doesn't Growth-Only Work?
First of all, a real GDP growth rate is a measure meant to help the management of economies by central banks. Central bankers separate out the 'real' growth from the inflation. As investors interested in top-line revenue growth, we are actually interested in nominal GDP growth. That's an economist word for combining the 'real' growth rate with the inflation rate.
For example, Mainland China grows at a +7.5% 'real' rate per year now. That comes with +3.5% inflation. This implies the nominal growth of top-lines, on average inside China, should be about +11%. In neighboring Indonesia, 'real' growth is now just below +6%. The inflation rate is around +8%. That means average top-line growth in Indonesia is actually higher at +14% a year.
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Zacks' international initiative just signaled "Buy" for a hospitality company in a country growing much faster than the U.S. It has handily beaten earnings estimates for the last seven quarters and its shares have really been on a roll.
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What Does Nominal Growth Tracking Mean for Investors?
It means when you look for great companies inside fast-growth countries, a better 'outperform' test exists. See if the company you are interested in easily exceeds the home countries' nominal growth rate. For example, for the International Trader's portfolio at Zacks, I looked at adding a big Mainland Chinese computer manufacturer. It expects next year's top-line revenues to grow +21% a year. Given it is a big firm; this means it is a 2X outperformer. The nominal benchmark growth rate for Mainland China is +11%. It passes the test.
What are the Big Problems?
Let's stay with Mainland China and Indonesia to answer that question. Stocks in China trade at very low price/earnings multiples now. Shares often see big swings in prices too. The reality in China is that corruption is found in parts of both the government and private sector. This factor depresses valuations and creates unnecessary share price volatility. Corruption is a word that relates to having your investment principal just flat out stolen. High growth rates raise the incentive for corrupt practices.
We recently saw this firsthand with the arrival of a short-seller report by a firm called Muddy Waters, appropriately issued just before Halloween. This firm makes a living by delivering reports to hedge funds on companies in China that the company claims are frauds. A number of targets have been de-listed over the last few years. A number of targets proved to NOT be frauds. Once this firm issued its latest fraud report, all shares of Chinese Internet firms that looked remotely like the putative fraud suspect sold off. This was not the first panic.
In comparison, the U.S. central bank targets inflation at +2% a year. With a forecast for +2.5% real growth, this offers investors a much lower +4.5% nominal growth rate. But the stable low inflation U.S. environment doesn't erode your principal's value as fast. Low inflation rates also don't push around the U.S. dollar much. Protections and supervision afforded by the SEC, SIFMA, FINRA and other securities institutions dramatically lower risk to the outright theft of principal. Our securities markets trade with much greater liquidity, and at higher multiples, partly as a result.
The Flip Side to Fast Growth
You can also see, in Indonesia, other problems with high GDP growth rates. Low labor costs offer its government a clear pathway to deliver a high annual growth rate. Global firms raise profit margins by locating production in industrial zones where labor cost is much, much lower. Less than $4,000 U.S. dollars a year per worker is the going rate. The higher labor content is in production, the more attractive the re-location incentive.
What's the flip side to Indonesia's growth?
Labor exploitation produced massive strikes. Firms later met up with wage demands and wage inflation. This pushes up consumer inflation to +8% and more a year. Volatile currency movements followed along with the massive shift of investment capital into the country. Does that all-in macro environment sound attractive to you? It might. But I am sure you are starting to get the fuller picture.
Advice to Investors
My advice to you as an investor is to be wary, and to apply old-fashioned investing principles in the non-U.S. context. First of all, make sure you stay diversified across country and region and industry sectors. Second, use a quality stock picking system like the Zacks Rank in the non-U.S. context. That way, you have the quality forward earnings outlooks baked into your portfolio.
Finally, never put all of your eggs in one asset class basket. Keep holdings in both U.S. stocks and in other less volatile securities. There is risk reduction (of the macro sort) in asset class diversification.
Having said that, hiding your assets in a safe under your bed, in a CD paying 1% annual interest, or staying away from non-U.S. markets is a mistake. With the proper strategy, and careful oversight that adjusts your portfolio as global/macro change happens, you stand to make much greater profits in non-U.S. markets over time. We have already proven that with our International Trader portfolio.
Greater risk should come with greater reward. The key point of this article is to show you that chasing a high GDP growth rate assumes a greater risk to principle in the same stroke.
Which Are My Favorite International Trades?
Today in my portfolio, I am recommending eight trades with exceptional gain potential. In fact, I am planning to add a ninth early next week that offers upside for both the short and long-term. It's a Zacks Rank #1 Strong Buy in a hot global industry. And it is based in Europe, a region where stocks are selling at a deep discount relative to the U.S.
This Zacks International Trader has been running far ahead of the S&P 500 since it launched in late September. To protect our members, it quickly closed to new investors. Now (for a few more hours) it is open again, so you are welcome to see what I believe to be the best trades in the world.
Please note that the portfolio is closing again Saturday, November 16, so the time to look into it is now. At the same time, for the next 30 days, you may also see all the buys, sells, and commentary from all of Zacks' other services. Remarkably, your total cost to take part in this unique program is only $1.
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John Blank, Ph.D., a noted global economist, is Zacks' Chief Equity Strategist. He leads an exclusive investor group to the world's most exciting investment opportunities with his new International Trader portfolio.