The price you pay for emerging markets

Jason Zweig writes the weekly Intelligent Investor column for The Wall Street Journal. I don't subscribe to the WSJ but this column seems to be freely accessible on the web every week. Sometimes the articles are good; sometimes they are not. For someone who is a fan of Benjamin Graham, he writes a lot of articles that are more suited for passive investors than stockpickers. Nevertheless, sometimes the articles are pretty good, like last week's.

In Under the 'Emerging' Curtain, Jason Zweig tackles emerging markets. More specifically, he quotes some study by Elroy Dimson that shows that fast growing emerging markets produced less profits for investors than slower growing ones. This isn't really news to me—it's like growth stocks versus value stocks—but some may find it surprising (as usual, bolds are by me):

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns -- by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

That isn't a typo. Over the long run, stocks in the world's hottest economies have performed half as well as those in the coldest. When Prof. Dimson presented these findings recently in a guest lecture at a Yale University finance program, "a couple of people just about fell off their chairs," he says. "They couldn't believe it."

But, if you think about this puzzle for a few moments, it's no longer very puzzling. In stock markets, as elsewhere in life, value depends on both quality and price. When you buy into emerging markets, you get better economic growth -- but, at least for now, you don't get in at a better price.

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"The logical fallacy is the same one investors fell into with Internet stocks a decade ago," says finance professor Jay Ritter of the University of Florida. "Rapid technological change doesn't necessarily mean that the owners of capital will get the benefits. Neither does rapid economic growth."

High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors. Last year, at least six of the world's 10 largest initial public offerings of stock were in emerging markets. Through June 30, Asia, Latin America, the Mideast and Africa have accounted for 69% of the dollar value of all IPOs world-wide. Growth in those economies will now be spread more thinly across dozens of more companies owned by multitudes of new investors.

If you are top-down, like Jeremy Grantham, or driven by some macro thesis, like Jim Rogers, then it doesn't matter if you invest in high growth countries or not. But if you are simply doing it because the economic growth is forecast to be high, be careful...