Which company would you rather own: a highly profitable retailer with a history of growing dividends, or a stodgy manufacturer in a dying industry? And would you rather invest in an emerging economy with a snowballing GDP, or a nation mired in recession?
When I put these questions to investors, the answers seem almost ridiculously obvious. Common sense would say you should buy profitable companies with glowing prospects, preferably in parts of the world with vibrant, growing economies. But what if common sense is wrong?
Over the years I’ve tried to explain to my clients that information about the prospects of a company or a region cannot help you make better investment decisions. It’s a difficult message, because it’s the opposite of what intuition tells us. Surely it matters a great deal whether a company’s earnings are likely to be higher than those of its competitors, or that one part of the world is in economic turmoil while another is enjoying tremendous growth. But the point is that this information is already baked into current prices, so it cannot help you predict future returns.
A Trip To the Store
Let’s start with an everyday example. You’re at a Wal-Mart checkout next to three customers with carts full of Pampers. You consider how many diapers the store must sell every year, and how profitable that must be for Wal-Mart and Johnson & Johnson, the makers of Pampers. And you’d be right: Wal-Mart’s revenues were $419 billion in 2011, and J&J raked in $65 billion. Both companies have also increased their dividends annually for more than 25 years. Who wouldn’t want to own a share of these blue-chip cash machines?
Yet it turns out that both Wal-Mart and Johnson & Johnson have seen long periods where they’ve significantly lagged behind the overall US stock market. That’s not because they’re bad companies. On the contrary, they’re excellent companies that are very profitable and very safe. The practical issue for investors is that this past record of profitability and future rosy expectations both get built into their current price. Over the years, whenever those rosy expectations were not met—for example, their earnings were less than forecast—their stock prices suffered.
It works the other way, too. Five years ago, most investors had low expectations for Ford, a troubled company in a difficult industry. Yet since then, Ford’s shares are up 25%—they’ve doubled in the last three years—while the broad US stock market was down 10% over that period.
As I’ve written before, good companies can turn out to be bad investments, and vice versa. That’s because what matters is not whether Wal-Mart is better or worse than Ford, but whether the performance of these companies was better or worse than originally expected.
Going Where the Growth Is
Now let’s apply this same idea on a global scale. You don’t need to be an economist to know that countries such as China, Brazil and India are growing much faster than the developed world. Investors might therefore want to put their money where the economic growth is, believing that’s where stock returns are likely to be highest. But again, this logic ignores the fact that these future expectations are already baked into current prices.
In fact, a 2005 study by Jay Ritter at the University of Florida looked at 16 countries from 1900 through 2002 and found that the opposite was actually true. It turns out that regions with stronger economic growth actually produced lower returns for stockholders. “Countries with high growth potential do not offer good equity investment opportunities unless valuations are low,” Ritter concluded.
More recently, Jim Davis of Dimensional Fund Advisors looked at emerging market countries between 1990 and 2005. He divided these nations into high-growth and low-growth groups according to their GDP to see whether their stock market returns would differ. Over the full 16 years, the equity returns in both groups turned out to be nearly identical. That isn’t surprising when we remember that the market should have factored those growth expectations into the price of stocks.
Not Perfect—But Close Enough
If expectations are already baked into stock prices, then there is no value in reacting to what you’ve heard on the news, what you’ve been told by a well-intentioned friend or family member. When you read that this company just had another outstanding quarter, or that country’s GDP growth is slowing down, it’s already too late to do anything about it. By the time you read it in the newspaper it will already be reflected in prices.
That doesn’t mean there are no inefficiencies in stock markets: it simply means that individual investors—and professionals , for that matter—are highly unlikely to profit from anything that might exist.
The good news is that you don’t need to try and profit from perceived inefficiencies to have a successful investment experience. In fact, the evidence suggests that investors who try to profit from “inefficiencies” end up with worse returns than investors who don’t. Successful investors ignore the short-term noise and focus the advantages available to long-term investors.
What is the important lesson for investors? Market prices may not be perfect, but it’s usually best to assume they are fair.