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There may be plenty of good uses for economic growth forecasts, but stock selection isn’t one of them, Horwood writes.Getty Images/iStockphoto

Investors love a growth story. Whether it's a hot startup or a new industry that promises to transform our lives, investors are naturally drawn to opportunities that are growing – and growing fast.

For many investors, the granddaddy of growth numbers is a country's gross domestic product, or GDP. If you can find the fastest growing economy, one would expect that should bode well for investment opportunities. Similarly, it's tough to envision a stagnant country as a prime hunting ground for promising ideas. The financial press loves GDP too. Newspapers report on official figures, revised figures (if the initial reports are off) and forecasted figures (which are usually off), and speculate how businesses and central banks will react. Pundits can spend hours debating the implications of a single quarter's GDP number. But what are the implications for equity investors?

Often, there aren't any. History suggests that investment returns actually don't have much to do with economic growth. Three finance professors – Elroy Dimson at Cambridge and Paul Marsh and Mike Staunton at the London Business School – looked at data from 1900 to 2009 for 19 countries (most of which are developed economies), and found there is little connection between real GDP growth per capita and real equity returns. For example, at 3.3 per cent a year, Japan's economy grew fastest among the countries analyzed, but its stock market returned less than 4 per cent annually – ahead of only five others. The best market for investors was actually Australia, which delivered equity returns twice as high as Japan's with less than 2-per-cent annual economic growth. And South Africa, the economy that grew the slowest in the group, experienced better equity returns than all of the countries which grew faster, with the exception of Australia.

A broader view confirms this. Since 1970, across as many as 83 developed and emerging markets, Profs. Dimson, Marsh and Staunton found there has been essentially no correlation between economic growth and equity returns.

Consider the 2000s. China's economy boomed, delivering a world-best 9.2-per-cent annual growth in real GDP per capita. And at 7.7 per cent a year, its real equity returns were certainly respectable. Yet they paled in comparison to the 14-per-cent annual return of Brazilian equities, despite growth of just 1.9 per cent a year in that country.

This suggests that forecasting economic trends may be a waste of time if your goal is to make better investment decisions – at least in stock markets. Although it may sound intelligent to comment on the latest GDP figures, the relationship between economic growth and stock returns is tenuous at best. Even if one were able to make consistently reliable macroeconomic forecasts – and that's a big "if" – it would not be a guaranteed way to reap superior returns.

Why is this?

Excitement about growth actually makes it less likely to be rewarding. Investors excited about a country's growth prospects may bid up stock prices in that market. Once prices reflect enthusiasm for growth, there is less potential for positive surprises, and greater scope for disappointing returns. The optimism that comes with growth also attracts competition and competition erodes profits. It also requires additional capital to compete, which can ultimately dilute shareholders and reduce equity returns.

In short, GDP growth is no guarantee of success in stock markets. So what are investors to do?

Rather than focus on economic growth, we believe it is far more rewarding to start from the bottom up and to focus on valuations. Instead of trying to guess which countries will offer the best growth prospects, consider the value of businesses based on their cash flow potential and reinvestment opportunities. Then ask yourself which stocks are trading at a price that appears to offer the greatest discount to the true value of the business.

This approach is by no means foolproof, but it does allow history to work in your favour. History shows that one of the worst things an investor can do is to overpay for stocks on the basis of unrealistic expectations.

Let's consider Japan again as a sobering example. Over the past 40 years, investors in the Japanese market have had very different experiences depending on the timing of their initial purchase. Though Japan's long-term returns aren't stellar, investors who bought when the market was cheap on a price-to-earnings basis have tended to earn 6 per cent to 8 per cent a year over the following 10 years. At times, however, the Japanese market has been very expensive, with average P/E multiples as high as 47 times. Such periods have coincided with great enthusiasm for the country's growth prospects and investors who bought at those levels went on to lose an average of 3 per cent a year over the following 10 years – a cumulative loss of roughly 25 per cent.

So, while it's tough not to get caught up in the hype, equity investors should remember that economic growth has little connection to investment results. Growth may not benefit local companies, and even if it does, enthusiasm about that growth may lead to valuations so high that subsequent returns are dismal. There may be plenty of good uses for economic growth forecasts, but stock selection isn't one of them. For better investment results, investors should focus on what they can control – the price you pay.

Chris Horwood, MBA, is an investment counsellor at Orbis Investments and is responsible for the firm's institutional business in Canada.