The new Global Trends 2030 report is a good road map to the future--but how do you invest in it?

12/14/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

What do you as an investor do with predictions? Even well researched predictions by experienced “predictors” like those at the U.S. National Intelligence Council that produced the recently published Global Tends 2030: Alternative Worlds.

And most challenging of all what do you as an investor do with predictions about which countries will grow most rapidly. I think the default response—put your money into the financial markets in the fastest growing economies—is actually mostly wrong. Or at best it’s the “GDP growth equals market returns” trap. Let me use the recent Global Trends 2030: Alternative Worlds report to explain why I believe that.

By 2030 China will be the world’s leading economic power—with the U.S. second.

The world’s oil producers—especially Russia—will see their influence wane in part because the U.S. will attain energy independence.

For the first time in history—as far as we can know—a majority of the world’s population won’t be impoverished. But half of the world’s population will live in areas with severe shortages of fresh water.

At least 15 countries will be at risk of state failure by 2030—Pakistan, Yemen, Afghanistan, and Uganda among them. Aging populations will slow growth even further in Europe, Japan, South Korea, and Taiwan. China and Brazil will have stepped up to new global roles, and countries that include Colombia, Indonesia, Nigeria, and Turkey will become newly important to the global economy.

Those are some of the conclusions in the recently published Global Trends 2030: Alternative Worlds, a four-year effort by the U.S. National Intelligence Council. (You can get your copy http://www.dni.gov/index.php/about/organization/national-intelligence-council-global-trends/ here in multiple electronic and paper formats.)

Some of the themes—the economic rise of China and the rest of the emerging world, global aging or a scarcity of water, for example--in the study will be familiar to readers of my posts and 2008 book The Jubak Picks (out of print but you can buy a used copy here with http://www.amazon.com/gp/product/0307407810?ie=UTF8&tag=thejubpic-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=0307407810%22%3EThe .)

In other areas—the risk of a computer network attack on global infrastructure that affected millions or the possibility that a global health pandemic could reverse economic globalization—the study raises issues that I haven’t thought about at any length (except in the occasional nightmare.)

But to me as an investor the most useful function of the study is the challenge that it throws down. What, if anything, do I as an investor want to do about these predictions?

In some cases I think the answer is relatively clear. For example, in the case of global water scarcity if the study is even just mostly correct in its predictions—and I think the evidence is remarkably strong in its favor—then you want to look for shares of companies involved in moving, purifying, conserving, metering, etc. water. My most recent take on what stocks to buy on the water trend was in September http://jubakpicks.com/2012/09/04/water-water-stocks-everywhere-and-here-are-10/ .

I think responses to such trends in the study as the growth of the global middle class and the rise in consumption of food and especially protein are also relatively straight forward. Find companies that fulfill demand created by these trends and buy their stock.

But responding to other trends is harder—and in no case harder than the very large trends in GDP growth during the period. What do you, as an investor, do about faster growth in China, Brazil, Colombia, India, Indonesia, etc. and relatively lower growth in Japan, Europe, and the United States? The knee-jerk response is simple: You buy the markets of the faster growing economies. Because economies with faster GDP growth show higher stock market performance.

Very simple. And, current research says, very wrong.

There doesn’t seem to be much of any correlation between GDP growth rates and stock market returns.

The best-researched example is a comparison of Germany and China from 1993 through 2011. During the period China’s GDP grew at a real annual rate of 10.2% a year. Germany’s real GDP growth was a piddling 1.3% a year. And yet the return produced by the MSCI China index during the period was a cumulative loss of 44%. The return for the MSCI Germany index was a gain of 180%.

Astonishing no? And other academic studies of the connection between GDP growth and financial market returns come to pretty much the same conclusion: that there is no simple connection between the rate of GDP growth and the rate of financial market returns.

There seem to be a lot of reasons for this. For example, one peculiarity of GDP is the way that it doesn’t distinguish between good/efficient growth and bad/inefficient growth. The recovery from a storm like Hurricane Sandy adds to GDP even though the storm and the recovery when you net it out might result in a decrease in national net worth. Financial market returns, on the other hand, ultimately measure increases in net worth. From the point of view of a pure GDP calculation a factory that increases production by hiring a lot of poorly trained and inefficient workers isn’t better or worse than a factory that increases production by increasing productivity by adding better machines or hiring workers with better training. In the short-run (and the short run can run of quite some time in a country with a large supply of surplus labor) what counts is the gross production from the factory and not the profitability of that production.

But one set of reasons that should be intensely interesting to investors is research that shows that risk and the cost of capital is a key to determining how GDP growth relates to financial market returns. I’d summarize the research this way: If a country with a high rate of GDP growth also has a high risk premium and a high cost of capital—perhaps because of political instability or a history of inability/unwillingness to control inflation—then the financial market returns lag the rate of GDP growth. Building new capacity to keep up with growth is expensive because of the high cost of capital and the investment returns on that growth are therefore relatively low.

I don’t think this means that investors should ignore differentials in GDP growth among countries. And it certainly doesn’t mean that you should ignore faster growth in a China or a Indonesia when you’re building a portfolio and load up on low-risk but very slow growth Japan. (That would be a very odd view coming from someone who started a global mutual fund in 2010 in order to tap into global growth outside the U.S. economy.)

But it does mean that you need to rethink the way you try to profit from higher GDP growth rates in emerging economies.

How? In two ways.

First, when thinking about investing in national economies with high relative GDP growth rates—I’d call this the ETF approach since it involves buying Korea or China or Brazil with the purchase of an exchange-traded index fund—it requires that you think about the direction of the risk premium in that country as well as the magnitude of GDP growth.

Here’s an example to think about. The return on the iShares MSCI All Peru Capped Index ETF (EPU) over the last three years is an annualized 14.29% as of December 12, 2012. The annualized return over that same three years for the MSCI All China Index is a loss of -3.36%.

This is not explicable if all you do is look at GDP growth rates. From 2009 to 2011 Peru averaged real GDP growth of 5.5%, according to the World Bank. China’s average annual real GDP growth rate from 2009 through 2011 was 9.6%

What happened during that period that to me partly explains the out performance of Peru over China despite the discrepancy in GDP growth rates in favor of China? I’d point to expectations. For China growth of 9% was close to expected. For Peru 5% was astonishing. And I’d also note the steady improvement of Peru’s credit rating with all three major credit rating companies raising Peru to BBB (or equivalent) ratings by August 2012. In Moody’s Investors Service August upgrade it cited Peru’s prudent fiscal and macroeconomic policies and the continued decline in the share of Peru’s debt denominated in foreign currencies. (Less foreign current debt means less exposure for Peru to hot money flows from overseas investors.) In contrast worries over the health of China’s banking system and about the over-extended balance sheets of heavily indebted local governments have increased during that period.

As a working hypothesis let me suggest that if you’re trying to decide which relatively faster growing countries in the Global Trends 2030 report to overweight in your portfolio, think about countries such as Colombia, Mexico, and Turkey where growth expectations are still relatively modest and credit quality is improving. I’d also think about putting Brazil in this group: Growth has lagged so badly recently that expectations are modest minus and if some of President Dilma Rousseff’s structural reforms pay off Brazil could see it’s traditional double-digit interest rates start to converge with those in the rest of the world.

I don’t think this hypothesis rules out investing in companies in say, China, or other fast GDP growth countries. It does, however, suggest that the “buy-the-country” ETF approach might not be the best fit.

Think of it this way: If China is going to grow GDP by 8% or 9% annually in the next few years, do you want to own China or do you want to own companies in or outside of China that will be able to tap into that growth without taking on all the risk from weak financial markets to arbitrary economic decisions that China’s companies have to cope with very intensely? From this perspective it doesn’t matter whether your China exposure is from a U.S.-based company such as Yum! Brands (YUM) or from a China-based company such as snack and beverage leader Want Want China Holdings (151.HK in Hong Kong.) You just want to own shares of companies with the biggest competitive edge.

So, second, when putting together a portfolio to take advantage of higher relative GDP growth in emerging economies look for companies that are beating up on their competitors and/or who dominate their sector.

For example, in China’s retail sector you want to own Sun Art Retail Group (6808.HK in Hong Kong) despite its odd parentage as a venture between Taiwan’s RT-Mart and France’s Groupe Auchan. In 2011 Sun Art moved to the No. 1 spot in China’s hypermarket sector with a 12.8% against 11.2% for Wal-Mart (WMT) and 8.1% for Carrefour (CA.FP in Paris and CRRFY in New York.) Sun Art is thriving—Wall Street analysts estimate 20% growth in profits in 2013—while competitors such as Tesco (TSCO.LN in London and TSCDY in New York) are closing some stores and slowing expansion plans. The key seems to be Sun Art’s ability to run a Wal-Mart style low price megastore that is still attuned to local Chinese tastes. A Wal-Mart in Shanghai sells  snacks at low prices, but its Sun Art competitor has a kitchen where customers can buy fried noodles and steamed pork buns just like they do when they go shopping in traditional neighborhood markets.

What other (potential) competitor killers in fast-GDP-growth economies would I take a look at for my portfolio? How about cell phone tower operator IHS (IHS.NL in Lagos, Nigeria), which has pioneered tower operation in a country with very unreliable power supplies and shaky security—but which happens to be one of the largest and fastest growing markets for cell phones in the world? Or MegaStudy (072870.KS in Seoul), the largest of Korea’s 28,000 cram schools? (When the Korean government recently cut back on the country’s six-day school schedule so that Korean kids would have more free time and feel less pressure, Korean parents rushed to sign their offspring up for extra tutoring.)

And don’t forget developed market companies that have sunk deep roots in fast-GDP-growth economies. KFC parent Yum! Brands (YUM) is the biggest quick service food operator in China—and has India in its sights. Johnson Controls (JCI) has become a critical supplier to any automaker assembling cars in China. (Johnson Controls is a member of my Jubak’s Picks portfolio http://jubakpicks.com/ .) Luxottica (LUX) is the largest retailer of designer sun glasses in China. Japan’s Seven & I (3322.JP), the owner of Seven Eleven stores throughout Asia is one of my favorite emerging market GDP stories. I’d also look at newly public Fonterra Cooperative Group (FCG.NZ): the big New Zealand dairy producer projects 7% annual sales growth in Asia as far as a cow can see.

Investing in the future can be tricky, no doubt, but it is essential. After all we’re all going to live in the future one day.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund owned shares of Johnson Controls as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market- beating Jubak's Picks portfolio, the writer of the Jubak's Picks blog and the senior markets editor at MoneyShow.com. Click here to find Jubak's most recent articles, blog posts and stock picks. Get a free 60-day trial subscription to his premium investment letter JAM by using this code: MSN60 when you register here. [http://jubakam.com/wp-login.php?action=register

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