Forget crystal balls, just buy cheap

Anthony Hilton
3 Sep 2009

Coming back from their holidays the big dilemma faced by investors is whether or not to bet on economic recovery by taking a plunge into the stock market.

If one believes the evidence that the economy is over the worst, then perhaps now is the time to buy shares. After all if you are not going to buy equities now, when would you buy them?

Alas it is not that simple. It is a comfortable assumption which almost everyone shares that if an economy is doing well then the stock market will also do well. It seems self-evident that a prosperous economy ought to mean profitable companies and that, in turn, should feed through to higher dividends and good returns on equities.

This is also the logic which underpins investment in emerging economies. One might have reservations about the way some of these companies are run, and whether they are wholly committed to the protection of outside investors. But counter to that, if China, India, Thailand, Brazil and the rest are going to enjoy double-digit growth for the next couple of decades while mature Western economies are struggling to hit 3%, then surely growing companies in these emerging markets are the place to put your money. Well you may reasonably think that but you would be wrong. Research produced by investment house Lombard Odier shows conclusively that there is no correlation between the rate of economic growth in a country and either earnings per share or the total returns generated by its equity market.

What this means to put it bluntly is that even if today's investor knows exactly where the green shoots are likely to appear, it will be no help at all in knowing where to invest.

This finding echoes work done a few years ago by the London Business School's academic trio of Professors Dimson, Marsh and Staunton who found that emerging markets underperformed mature markets over time. Each year it seemed that an emerging market was top of the charts. The problem was that it was never the same one twice. Year after year the shares of one of the sample would go up like a rocket but then they came down like a stick. The result was that boring mature markets — Germany was their example — did much better on a 10-year view than any mix of emerging nations. It was the story of the tortoise and the hare all over again.

This is so counter-intuitive that it does require some attempt at explanation. One put forward by the LBS team was that the growth in an economy, particularly an emerging economy, may not be reflected in its stock market. The economic expansion could be in infrastructure, in education or in agriculture which, while real enough, is not the stuff of stock market legend. A second is that most share price performance comes from dividends but fast-growing companies may not pay dividends because they want to channel that capital into investment for further growth. A third factor is that fast growing markets attract a lot of players so competition tends to be ferocious. The result is that nobody makes very much money. This echoes one of the maxims of US investor Warren Buffett. He says investors should never follow fashion — because any fashionable sector will be too competitive to be profitable.

This is not to say that people should not buy shares. What it does mean though is that the key to successful investment is to buy when shares are cheap, irrespective of where that market might be, or what might be the chances of faster economic growth. As Lombard Odier's research concludes: “Worry about where you are starting from, not what you hope will happen in the years ahead.”

Putting a price on better advice

Everyone in the savings industry knows that if you want to sell a financial product all you have to do is offer a massive commission to the nation's independent financial advisers (IFAs). As if by magic they will discover its virtues, see it as absolutely what their clients need and recommend it to them. The money then rolls in. When the provider of the product has sold enough they simply reduce the rate of commission. Suddenly the product becomes less attractive to the nation's IFAs and the flow of money from their clients slows to a trickle.

Meanwhile, investment trusts which are the ideal vehicle for most people who want good-quality, low-cost equity investment never get a look in because they are not allowed to pay commission, so IFAs rarely recommend them

The Retail Distribution Review from the Financial Services Authority is designed to put a stop to this nonsense by trying to wean advisors off commission so that they will be forced to offer genuine, independent guidance and charge a fee instead. Good news for the investment trust industry? Not necessarily. Rather than get their minds round what investment trusts have to offer, it seems many IFAs would prefer simply to allow themselves to be re- classified as salesman — and carry on taking commissions in the tried and tested way.