Equity investing has become an increasingly global enterprise as investors cast a wider net in search of returns. A closer look at the conventional wisdom prevalent among many global equity investors reveals significant misperceptions and highlights the benefits of several timeless investment principles. I’ve listed some of these below:
Conventional wisdom: Diversification is dead. Since the early 1990s, globalization has contributed to rising correlations between the S&P 500 Index and stocks in emerging markets, Japan, Europe, and Asia ex-Japan. However, high correlation does not imply equal return. From 1999 through 2009, emerging markets, Asia ex-Japan, and European equities were highly correlated with the S&P 500, but annualized returns were markedly different: the MSCI Emerging Markets Index rose more than 10%, while the S&P 500 declined. Correlations rose further from December 1999 through December 2011, but major non-U.S. markets declined as the S&P 500 posted 10% annualized returns.
Practical implication: Diversify—or not—regardless of correlations.
Conventional wisdom: Avoid equity markets in times of stress. Most investors would say they disagree with this statement, but behavior tells a different story: beginning with the Asian crisis of 1996 through the European sovereign debt crisis of May 2011, net outflows from global equity mutual funds rose sharply at market stress points. Such stress points often emanate from political turmoil and other factors with little direct relationship to equity valuations. Not surprisingly, these crisis points have typically offered some of the best opportunities to buy stocks, with exceptional one-year forward returns over a broad range of equities.
Practical implication: Have the courage to buy stocks when it feels wrong.
Conventional Wisdom: Capital appreciation trumps capital return. Investors generally buy stocks expecting that increasing corporate earnings lead to higher share prices over time. Although capital appreciation is important, investors shouldn’t forget about capital return: according to Standard & Poor’s, dividends accounted for more than 40% of the S&P 500’s total return for the last 80 years. Dividend growers and payers also outperformed cutters and non-payers from 1979 through mid-2011, due in part to the financial discipline and shareholder-friendly management often associated with dividend-paying companies.
Practical implication: Don’t underestimate the power of capital return.
Conventional Wisdom: Consistent EPS growth is achievable by many growth companies. Most investors buy growth stocks anticipating that companies will be able to grow earnings consistently over several years. However, consistent earnings growth is not easy to find. Even Wall Street tends to be overly optimistic, with most companies in the Russell 1000 Index missing initial consensus EPS growth estimates in 23 of 33 years from 1979 through 2011. Only 2% of companies in the Russell 3000 Index were able to grow earnings above the median over five consecutive years from 1988 to 2011, and less than 5% of stocks generated above-median returns for five straight years.1
Practical implication: Understand how growth managers achieve returns.
Conventional Wisdom: Markets with the best economic growth generate the best equity returns. From 1999 through 2009, total return in faster-growing emerging market economies significantly outpaced advanced economies. Over longer time periods, however, there is little relationship between equity returns and GDP growth. Japan’s economy, for example, grew nearly 4% a year from 1900 through 2011, with only slightly higher annualized equity returns. In contrast, annual GDP growth in the UK was under 2%, but real equity returns exceeded 5% per year. Higher equity returns seem to depend more on mature political systems, predictable regulatory regimes, and stable legal frameworks than on economic growth. 2
Practical implication: Allocate capital considering fundamentals, not just forecast economic growth.
Ray Mills is Non-U.S. Equity Portfolio Manager, T. Rowe Price.
1 Sources: IBES, Russell, Thomson Reuters, analysis by T. Rowe Price.
2 Sources: Credit Suisse Global Investment Research, Dimson, Marsh, and Staunton data, IMF, Morgan Stanley, MSCI Indices, analysis by T. Rowe Price.