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Dan Richards is president of Clientinsights. He is a faculty member in the MBA program at the Rotman School at the University of Toronto.

Recent research sheds new light on the payoff of investing in emerging markets such as China, India and Brazil.

Historically, many practices in fields such as medicine, teaching and investing were articles of faith; things were done because they made sense on the surface and because they had "always been done that way."

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In all of these fields, the past 40 years has seen an accelerating shift to an "evidence-based" approach, looking at hard data to evaluate the conventional thinking on which decisions were historically made.

The father of evidence-based thinking in medicine is Archie Cochrane, a Scottish physician who first wrote about this concept in the early 1970s - and evidence-based decision making is among the elements of the new health care program of U.S. President Barack Obama that hopes to reduce spending by eliminating low-payoff treatments.

Economic growth and emerging markets

Fuelled by access to better information and the explosion of processing power, the evidence-based approach has spread into investing, replacing anecdotal observation with the careful examination of data.

In 2002, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School published Triumph of the Optimists: 101 years of Global Investment Returns. Looking at a century of returns, the book provided an in-depth analysis of 17 countries, among them Canada.

In 2005, Profs. Dimson, Marsh and Staunton turned their attention to whether faster-growing economies translate into superior returns for investors.

They first examined the connection between high-growth economies and emerging markets, looking at the rate of economic growth in 53 countries and ranking these countries from the fastest-growing to the slowest-growing.

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This confirmed that emerging markets tend to be faster growing. Of the 11 "fastest-growing economies" at the end of 2004, all but one were emerging-market countries. Of the 11 "lowest-growth economies," eight were more mature developed markets.

Growth rate and investor returns

The authors then looked at the connection between faster-growing economies and investor returns - and here reached some surprising conclusions.

Each year, countries were ranked based on the growth of their economy over the past five years in "real terms," after inflation was taken out.

They first looked at the 17 countries for which their data go back 105 years and compared the pace of growth with stock market returns.

Going back 105 years, there was a negative correlation between the fastest-growing economies and the returns they provided to investors - in other words the slowest-growing countries provided the best returns, the fastest-growing the worst.

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The returns for the slowest-growing economies averaged just under 8 per cent, the returns for the fastest-growing economies averaged about 5 per cent. (Remember that the countries in the fastest- and slowest-growing categories changed every year, depending on growth in the previous five years.)

The authors also looked at their full sample of 59 countries, for which data do not go back as far - and here the results were even more striking.

The slowest-growing economies averaged stock market returns of more than 10 per cent - compared with between 5 and 6 per cent for the rest of the sample.

And the economies with the very worst stock market returns? Those that had just experienced the fastest economic growth.

Implications for investors

The study authors concluded: "It is clear that the total return from buying stocks in low-growth countries has historically exceeded the return from buying stocks in high-growth economies.

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National equity markets have behaved rather like stocks within a market: low-growth, 'value' markets have performed better than high-growth, 'glamour' markets."

The authors identify a number of possible reasons for this. Countries with faster-growing economies tend to have higher stock market valuations, as future growth has already been priced into share values.

Valuations in these economies may be overstating the good news from expected future growth. And since emerging markets generally have less-developed capital markets, it may be that the best investment opportunities are in private companies that are unavailable to investors.

The research by the London Business School professors mirrors the study of the U.S. market by Jeremy Siegel of Wharton.

In his 2005 book The Future for Investors: Why the Tried and the True Triumphs Over the Bold and the New, he demonstrated the disappointing experience from investing in stocks of the fastest-growing U.S. companies, simply because their valuations reflected this growth and were too high as a result.

None of this means that investing in faster-growing emerging markets can't provide good returns for investors - there are clearly some great companies there that will be terrific investments.

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But it does suggest that investors need to be very selective about the companies they buy in emerging markets - based on historical experience, buying these markets as a whole has high odds of a disappointing outcome.

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