Recent analysis by Cambridge Associates, an investment consultant, shows that from September 1995 to 2011 the aggregate earnings of companies in the MSCI Emerging Market Index grew at a compound rate of 13 per cent each year. As you would expect, such impressive earnings growth attracts a lot of capital. What then happened? Logically, companies issue more equity to satisfy investor demand. For example, the Financial Times reported in December, 2011, that Chinese companies raised $73 billion from initial public offerings (IPOs) in Shanghai, Shenzhen and Hong Kong during that year. This was almost double the amount of money raised in new listings on the New York Stock Exchange and the NASDAQ combined. In fact, the demand for Chinese shares in recent years has been so strong that the US has not been the world’s largest IPO market since 2008.
Such a high volume of equity issuance usually results in earnings dilution. This is evident in the 6.4 per cent compound earnings per share (EPS) growth of the MSCI Emerging Market Index from 1995 to 2011.
Developed markets have experienced much less earnings dilution. Aggregate earnings compounded at a rate of 9.3 per cent each year, while EPS growth was 7 per cent in the same period. So after the effects of earnings dilution have been accounted for, earnings in the developed world are higher despite lower levels of economic growth.
These examples illustrate the potential for earnings dilution to disrupt the orthodox theoretical link between economic growth and higher equity returns. Sadly, dilution isn’t the only factor that can affect earnings. As shareholders in Enron would know, crafty accountants can also manipulate earnings.
Shares are often valued by using a price/earnings multiple (or P/E ratio). The idea that economic growth equals higher earnings ignores the “P” in this ratio. Companies with sustainable and growing earnings usually command a higher price/earnings multiple. In other words, investors’ expectations of a bright future for these companies are already included in the multiple. If over-optimistic earnings expectations are priced in, then there is risk that the price/ earnings multiple will fall if the future is not as rosy as expected. The effects of a change in the price-earnings multiple have the potential to more than offset any increase in earnings caused by economic growth.
Taking all of these considerations into account, our revised model for the relationship between economic growth and equity returns can be seen in figure 2.