In my last column I showed you that when it comes to understanding global stock market returns for 2017, valuation is only a small part of the picture. What is the big part of the picture? Earnings growth. Over the long run, the largest driver of investment returns is the underlying productivity of the people working in the economy. Businesses gather people together to help them be more productive. That's the point of companies. As Nobelist Ronald Coase argued a century ago in The Theory of the Firm, business firms exist because putting people in the same organizations cuts down on the coordination cost which it takes to get them cooperating if they were not working for the same business. They are more productive together.
Let's imagine that we look at the year 2017 as though it were a gigantic field on which the investible nations have gathered their markets together. I introduced this form of chart in the last column. But in this case, they line these market indices from highest earnings growth for the year at one end, down to lowest earnings growth down at the other end. Then we have our indices march across the field, unfurling streamers behind them and rearranging themselves into order from highest annual performance during the year to lowest performing.
If performance rank during the year coincided well with rank in earnings growth during the same year, then the chart would look mainly of horizontal. There would not be much crossing of lines, and especially not much crossing from top to bottom.
And that's what we saw in the year which just ended.
The countries below, arranged in order of greatest investment return to worst generally coincide with countries which had the highest corporate earnings growth.
In general, national indices that were among the top quintile of growers were among the top quintile of performers, and so on down to the bottom. Not a perfect fit, but pretty good one. This makes sense: We already saw that valuation was not a big driver of things and we know that there was not much interest rate suppression compared to some of the other years since the great recession. Something had to be moving this markets, and that something was earnings.
In fact, earnings tend to explain the previously unexplained anomalies we talked about last column. For example, the extremely attractively-priced Russia was a terrible performer. That’s because Russian earnings were the worst in the world last year, and Russia was the second worst performer. Israel was the worst or second worst in earnings growth and the worst in global performance. We saw in the last column that Poland was unattractively valued and yet a stellar performer; ditto for Chile, unattractively valued but a god performer. In both cases, earnings growth explains the paradox. Poland was by some measures the world's fastest earnings grower and also the world's best performer. Chile's South American neighbor Peru tells a similar story: unattractive value goes together with high performance because of terrific growth.
When we take the same data as above and instead of arranging it by rank, test the correlation between two factors we see that the relationship is a great fit. In fact, there is a greater than 80% correlation between earnings growth and stock market performance during this same period.
When you take a principles-based approach to investing you’re more likely to do well over the long run, but it's important to remember that not every principle is equally important in every time period. The banner year we just left behind us was one where both value and earnings growth mattered, but earnings growth mattered quite a lot more.