Generalisation groupings should be viewed with caution

Investors like to sort things into neat categories; it helps make sense of a highly complex world. Categories like ‘Emerging Markets’, ‘BRICs’ – Brazil, Russia, India, China – and the ‘Fragile Five’ have all been invented as easy-to-understand groupings of supposedly similar countries. Yet we have to be careful of such generalisations, because the more research you do, the more you realise that there are often more differences than similarities between these groupings.


Developed market status

Take ‘BRICs’ as an example. Aside from the fact they are all large countries on the cusp of developed market status, you’d be hard pushed to find four more different countries than Brazil, Russia, India and China. Linguistically, culturally, historically, politically and economically, they are actually about as different as you can get.

Looking more closely at India and China, far from being similar, India and China are so different they often look like negative images of each other. India is a raucous, noisy democracy; China is a single party system. India’s development has been heavy on consumption, light on infrastructure; China’s has been heavy on infrastructure, light on consumption. China has a current account surplus of around 2% of GDP; India has a similar-sized deficit. China has less than 3% inflation; India has over 9%.

Broad-brush decisions

It’s hard to see how the two can be squashed into the same artificial investment grouping when the fundamentals are this different. So if you generalise about ‘BRICs’ or ‘Emerging Markets’, and you sell them as a group or buy them as a group, you will potentially miss out on big differences in performance between them.

The difference between China and India’s stock market performance is a good example of one of the most important things to understand about markets – that is that the second derivative drives performance. If you examine the economic fundamentals, you might conclude that China is a better investment than India. It has much higher GDP growth, a sounder currency, a current account surplus, a stronger fiscal position, lower inflation and lower interest rates. Yet the market has performed worse than India. Why? Because it is the second derivative that is important. What we mean by this is that it is not the absolute level of things that matters, it’s whether at the margin they are getting better or worse.

GDP growth rate

Take China as an example. China’s GDP growth rate is high at 7.5% – much higher than India’s and far higher than the developed world. But the rate of GDP growth has been steadily declining over recent years. This change in the second derivative of GDP – the rate of growth of the rate of growth – is one of the main reasons that Chinese equities have not done well over that period. India, on the other hand, has a large current account deficit. But at the margin, it has been improving recently, from around 5% of GDP to around 2.5% of GDP. This marginal improvement is one important reason the India equity market has done well.

Just as generalisation in the form of grouping countries or markets together can be dangerous, generalising at the country level is also a mistake, because it hides a wide variation in sector performance within the country. The poor performance of China equities in aggregate has been driven by the very large sectors such as banks (down 18% over 12 months), energy (down 21%), materials (down 20%) and telecoms (down 16%). These sectors are often grouped together by those who like to generalise as the ‘old economy’ sectors or state-owned enterprise (SOE) sectors. These sectors, because of their size and therefore weight in the index, have outweighed the excellent performance of the smaller ‘new economy’ sectors which have done so well.

Catalyst for profit

Perhaps the answer lies with our old friend the second derivative if, at the margin, some of the old economy sectors are looking ‘less bad’. Examples of this could be sectors like cement, where consolidation driven by the Government’s need to remove capacity may be to the benefit of the surviving players in the industry, or perhaps selected banks where the fundamentals don’t look too bad and the valuations are supportive. Equally, if some of the ‘new economy’ sectors are looking less good at the margin, and are already very expensive, then that could be a catalyst for profit taking. An example of this could be something like increased government focus on regulating Internet finance, a recent but fast-growing part of the Internet sector.