The emerging market traps

2. Top line economic growth does not mean top line shareholder returns

Many EM bulls maintain that the driver of future returns from holding EM stocks is an obvious one – top line economic growth. And there's no doubting that economies such as China are growing at a relatively fast rate, exceeding 10 per cent in 2010. But Paul Marson, chief investment officer of Swiss private bank Lombard Odier, and others maintain that historical analysis of past equity returns in high growth economies demolishes the myth that growth equals capital gains. According to Mr Marson the weight of academic analysis is clear: "Emerging markets have produced faster GDP growth but lower equity returns over the longer time span".

Given that most investors have been brought up to link GDP growth with earnings growth rates, what's gone wrong? Surely earnings growth is always a factor of GDP growth? The key for contrarian types such as Mr Marson and commentators including James Montier, formerly of SG and now at value firm GMO, is to look at dividends and the amount of new shares issued by these fast-expanding companies.

According to Mr Marson: "Your equity return is defined as dividend yield plus growth in earnings per share plus change in price. Typically, in most markets historically, around 70 per cent of the return has come from the first two elements". Mr Marson says most EM stocks don't pay much in the way of dividends and most have also struggled to post strong real EPS growth.

What goes wrong with EM stocks? According to Mr Marson the answer is financing. "Typically, companies issue lots of new equities to raise the funds to pay for the investment to drive the growth. That dilutes shareholders enormously. Also, when a company grows, the proceeds can go to: [1] workers as higher wages; [2] managers in the form of funds to build empires; or [3] to shareholders in dividends... typically, the latter is not much in evidence in emerging markets."

3. Corporate governance in much of the emerging markets is dreadful

Survey after survey shows that corporate governance in sexy markets such as China, Russia and India (Brazil tends to score fairly highly) is nothing short of dreadful. In Asia, for example, a series of surveys has shown that China is usually close to the bottom of a long list, challenged only by countries such as the Philippines and Pakistan. Local economists based in China back up this analysis – economist Professor Michael Pettis teaches in Beijing and is deeply negative on the quality of corporate governance of locally listed companies and he even harbours doubts about some New York and London-listed Chinese companies and their corporate governance. "I think there is a lot of discrepancies in the numbers, there's a lot of lack of priority in the numbers and there's also just a physical problem [a shortage of accountants]," he says.

4. Beware the East Asian development model – it causes spectacular busts

One of the greatest dangers in emerging markets – especially in Asia – is that key states such as China are following an economic development model pioneered by the likes of Japan, Taiwan, Singapore and South Korea. Nicknamed the East Asian Development Model by economists, this emphasises top line economic growth to produce more jobs – jobs that guarantee stability.

The net effect, though, according to Paul Marson and Michael Pettis, is that wages eventually rise, forcing up the local exchange rate. According to Mr Marson: "As the real exchange rate appreciates, your export engine switches off. And that's basically when the baton is passed to the next economy."

5. Not all EMs are equal – you need to pick your countries and styles carefully

Andrew Lapthorne is a quantitative strategist at French bank Société Générale – he's a convinced value investor and is profoundly sceptical of EM stocks although he suggests that at varying times some markets and some sectors can be cheap. The key in his view is not to treat all EM stocks as a monolithic whole. According to Mr Lapthorne, long term analysis of data suggests that "you need to focus on individual markets at different points in a cycle of returns". At Research Affiliates in the US, that caution on individual markets suggests a focus on particular kinds of stocks: value stocks where the share price is cheap. John West analysed all EM stocks but found that an index that focused on value stocks produced bumper returns: "An emerging markets portfolio using the Fundamental Index methodology would have returned 16.2 per cent per annum from 1994 through to 2009, a nearly 1,000 basis points premium to market capitalisation-based weightings". The moral of the story: if you buy EM stocks try to be discriminating about markets and hunt down value stocks.

6. EMs are much more volatile

The best measure of recent returns on EM stocks can be found by looking at the MSCI EM index – it's tracked by a number of exchange-traded funds (ETFs) and active fund managers.

One of the key findings of this authoritative study was that EM stocks were substantially more volatile than developed world stocks. According to the report's authors: "The MSCI Emerging Markets Index has been more volatile than the MSCI World Index with an average volatility of 25 per cent, while the MSCI World Index had an average volatility of 10 per cent."

7. EM markets are more correlated with developed world markets

One of the favourite arguments for EM bulls is that countries such as China and India can become independent powerhouses of long-term returns – they provide alternative exposure or beta as it's called in the trade, that is, they are lowly or even negatively correlated with mainstream, developed world equities.

But, according to the MSCI research on its own index: "The MSCI Emerging Markets Index correlation with the MSCI World Index has increased from 0.48 to 0.8 in the 20-year period from 1988-07, with the progressive integration of financial markets across the world. The correlations of all large emerging markets, except Russia, are higher than the correlations of Japan and Hong Kong over the most recent period."

8. EM countries are not paragons of economic virtue and low indebtedness

Another argument deployed by EM bulls is that countries such as China are paragons of economic, fiscal and monetary rectitude compared with the (morally) bankrupt west, mired in debt. There is some truth to this argument although most economists now expect the major EM economies to move from structural trade surplus to deficit, necessitating external capital financing. Professor Michael Pettis notes that true Chinese debt levels are many times greater than publicly admitted. According to the Beijing-based economist: "Government debt levels most of us now agree are much, much higher than the official numbers of 20 per cent of GDP. Probably anywhere from 70 to 80 per cent of GDP and growing quickly."

9. Growing populations do not equate to growing stock markets

Another EM story is that their great future prospects are down to growing populations – while the west struggles with both falling and ageing populations, countries such as India and China can power ahead courtesy of their young workforces. But there's no evidence to back this assertion. In his book The Global Economy and Millennial Perspective, former OECD economist Angus Maddison looked at 2,000 years of economic data, which was then crunched by Paul Marson's team at Lombard Odier. "What you see is not what you expect. There is no positive correlation between population growth and equity price returns," concluded Mr Maddison.

10. Beware money flows

At the London School of Economics, former fund manager turned academic Paul Woolley (founder of GMO here in the UK) has been looking at the role of professional bankers and fund managers in inflating asset prices. He maintains that markets aren't based on 'fair values' extracted from an analysis of underlying cash flows of companies. In fact markets tend to price based on asset flows – the more money floods into a sector or asset class, the higher the share price goes. Professional fund managers suddenly engage in a game of catch-up and pile into the hot sectors, pushing up prices to record multiples, forcing an inevitable price crash and bubble. This is exactly what has happened to EM markets time and time again.

11. You're paying more for EM growth, and it's getting more expensive over time

EM economies may be growing faster than their developed peers, but when it comes to local equities, as an investor you’re paying top dollar in terms of price multiples for the privilege of owning a bit of a booming economy. Looking again at the MSCI study on its key emerging markets index, the report's authors noted that "MSCI Emerging Markets Index valuations have progressively risen since 2002 and have caught up with the MSCI World Index in 2007".

According to a growing consensus of strategists the promise of jam tomorrow – of future top line growth – always results in the same thing, higher multiples and future dashed expectations. As Mr Marson at Lombard Odier observes: "Investors typically overpay for unsustainable growth."