By Edward Chancellor
LONDON- Investors make two profound errors in their approach to emerging markets. First, they are entranced by GDP growth even though there is no evidence of a positive correlation between an expanding economy and stock market returns. Second, they assume that valuations are a reliable predictor of returns. The strong outperformance of Indian stocks relative to Chinese equities since the financial crisis of 2008 shows how wrong this approach has been.
The very word “emerging” suggests that less-developed economies with strong growth prospects can be expected to deliver superior investment returns. Let’s see how that turned out. Over the past 15 years, the Chinese and Indian economies have both grown rapidly. China’s GDP expanded by roughly 2 percent a year more than India’s, when measured in constant US dollars. Back in September 2009, the price-to-earnings multiple of the MSCI China Index was 25 percent lower than for MSCI India Index. Yet despite starting out cheaper and experiencing faster economic growth, the Chinese stock market since 2014 has delivered total annual returns of just 2.5 percent in dollar terms. Indian stocks have compounded annually by four times that amount, according to Jefferies.
There’s a relatively simple explanation for this divergence. In late 2008, the Chinese government in Beijing launched a huge stimulus to stave off the global financial crisis. It used the country’s vast domestic savings to finance an extraordinary investment boom. Gross domestic fixed capital formation soared from 38 percent to 44 percent of GDP and has remained elevated. The investment splurge was accompanied by rapid credit growth and supported by easy money. By contrast, India had relatively low savings and investment. Between 2009 and 2020, investment fell from 34 percent to 27 percent of GDP. Indian interest rates on average were twice as high China’s.
Economic theory posits that the return on capital should eventually equal its cost. Sure enough, China’s low cost of capital has delivered meagre returns. Capital has been misallocated on a grand scale, as evidenced by chronic levels of excess capacity across the economy. Since its housing bubble burst in 2020, the People’s Republic has been beset by debt deflation. India enjoyed no real estate, credit or investment boom and thus avoided the ensuing hangover. Its relatively high cost of capital produced relatively high returns on investment.
This macroeconomic analysis is evident in the reports and accounts of listed Chinese and Indian companies. One gauge of whether a company is investing prudently is the ratio of new capital expenditure to depreciation on past investments. Gillem Tulloch, founder of Hong Kong-based GMT Research, has examined the returns of Chinese and Indian companies which have a minimum of 10 years of data, which equates to about a quarter of the listed firms in both markets. In 2014, the average capex for Chinese public companies was 2.3 times depreciation. The ratio for their Indian counterparts was considerably lower, at 1.5 times. Since then, Chinese firms have consistently invested more than their Indian counterparts.
A key component of profitability is measured by the ratio of a company’s sales to its total assets. More efficient businesses have a higher level of asset turnover. Tulloch finds that this measure in India averaged around 1 times over the past decade. -Reuters
