The Growth Trap

From 1990 to 2004 China’s economy grew at a rate of more than 9% annually, while Brazil’s grew at about 1.3%. If you knew that in advance, in which country would you invest. China? Wrong! China’s stock market delivered an annual rate of return of almost -10%, yes, minus¸ while Brazil’s delivered more than 14% annually. How can that happen when China’s economy more than doubled during that period while Brazil's barely grew? Questions like these are addressed in Jeremy Siegel’s new book The Future for Investors : Why the Tried and the True Triumph Over the Bold and the New, which addresses what he calls the “Growth Trap”, a phenomenon that value investors have known and talked about for decades. The Growth Trap is the tendency of investors to overpay for growth stocks/countries to the point where they price in so much growth potential, that the companies can never over-deliver, and those stocks end up underperforming the market. The same applies to IPOs, which underperform the general market by a huge margin. On the other hand, “boring” firms that grow at a slower pace that the “hot” sectors/stocks go on sale many times and this causes their total returns to outstrip both the broader market and growth stocks. Siegel summarises his theory in a simple principle which he calls “The Basic Principle of Investor Returns” that states that returns on investment capital is a function of actual growth relative to expected growth, not of growth alone. The following BusinessWeek article talks about the subject and the book.