A fast-growing economy is great for investors, right? The economy grows, companies do better, and investors reap profits. That's not necessarily how it goes, at least according to a recent paper in the Journal of Applied Corporate Finance, "Is Economic Growth Good for Investors?" by finance professor Jay Ritter.
According to the paper, there's a negative correlation between economic growth -- real per capita gross domestic product growth -- and real stock returns. That means that high returns not only do not accompany quick economic growth, they may sometimes go in the opposite direction.
"One possibility is that part of the negative correlation reflects the tendency of investors to build expectations for high growth into prices at the start of the period," the article says.
Great companies are generally not a secret. A high ratio between the price of a company's stock and earnings can indicate that investors expect high returns, which means earnings have to grow at a commensurate level or that investors need to invest more to get the same returns. When economic growth is strong, expectations rise for companies to do better and produce higher returns.
Lifting investors' boats
A rising tide may lift all boats, but investors may not be at the helm of those boats. Another reason for the low correlation between per capita GDP and stock prices, according to Ritter, is that companies may over-invest capital in order to keep up with their industry when the economy is booming. Investing capital in new projects or taking over businesses will help the economy, but it doesn't necessarily lead to an increase in earnings per share -- which means investors see no benefit.
Instead of waiting for the economy to improve to make investing decisions, investors should focus on dividends and growth in earnings per share at individual companies. "There is a strong association between high dividend growth rates and high overall stock returns. In one sense, such an association is not surprising in that growing dividends tend to reflect increases in earnings per share," the story reports.
Regular or even increasing dividend payments are generally indicative of a healthy company, as are stock buybacks, according to Ritter.
For instance, Apple and Cisco "have given investors very high returns without the companies paying a lot of dividends per share. However, Cisco, for instance, has given money to shareholders by repurchasing stock. By shrinking the number of shares, that boosts the earnings-per-share growth. For the same amount of earnings, the fewer shares outstanding, the higher the earnings per share is going to be," he says.
Various points in the economic cycle will have a predictable effect on stocks; a recession is generally bad for stock prices while a recovery is good. But in between, investors have many decisions to make -- they should rarely be made based on current returns or trends. Instead, a long-term investor will benefit by looking at the fundamentals.
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