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Just because an economy is growing at a faster relative rate does not necessarily make it a good investment for equity investors. The formula for investing seems simple: Faster GDP growth means higher profits, and those higher profits translate into higher share prices. If it were that simple, however, one would simply find the fastest-growing economies and invest there.

Certainly, the first obstacle is valuation. If prices are too high, returns will lag for a considerable period of time. Buying at the top is an increasing risk as an investor shortens his time horizon. In February 2007, Cheng Siwei, vice chairman of the Standing Committee of the National People’s Congress, said that 70% of Chinese stocks were not worth investing in, due to the high valuations. He triggered a bigger sell-off in Chinese stocks than had occurred in the two years previous to that point, but the Shanghai index went on to gain another 120% through October, when it peaked. It currently trades 60% below the peak. Or consider the S&P 500 and U.S. Treasuries since 2000—an investor could have earned more money by holding 10-year government bonds than investing in the S&P 500 Index, even at the market highs in 2007. For another example, the Taiwanese index lagged the S&P 500 over 10 years through 2007, despite the fact that Taiwan’s economy grew faster than the U.S. economy. When currency is factored into the equation, an investment in the Taiwanese market would have lagged the S&P 500 by an even greater percentage. Similarly, although China had a breakout year in 2006, the Shanghai index declined by 30% over the previous five years—at a time when the entire Chinese economy grew roughly 50%.

Quite a few of the companies on the Shanghai Stock Exchange are former state-owned enterprises that are losing out to nimbler private competitors. Those private companies find it difficult to list on the stock exchange, however, so many have chosen to list in Hong Kong, New York, and London. The new companies are in fast-growing industries like the Internet, software, and technology, while the state-owned companies are in slow-growing mature industries. The result is that the domestic stock market fails to fully capture the economy’s true makeup.

Besides valuation, there are factors such as taxes, transparency, and minority shareholders’ rights. The last may be the most important. As companies such as Enron, WorldCom, and a myriad of financials proved, if management’s interest does not align with the shareholder’s interest, the shareholder will lose. In developing countries, there is typically far more leeway for management to abuse minority shareholders. American and British equities trade at premiums to European and Asian equities because a greater percentage of the company’s profits flow to the shareholder. This does open up an area of opportunity, however, if developing countries improve securities laws and regulations.

Another major consideration is currency risk. Here’s an example of how currency fluctuations impact returns. In the five-year period from the beginning of 1997 to the end of 2001, the Brazilian stock market gained 95%. However, an American invested in the Brazilian market realized only a 43% gain. Conversely, the Dow Jones Industrial Average rose 56% in U.S. dollars, but a Brazilian invested in the Dow earned 129%. The difference was caused by the changing exchange rate. At the beginning of the period, one American dollar purchased 1.04 Brazilian real. At the end of the period, one dollar purchased 2.41 real. Undoubtedly that period was a volatile time in world markets, with the Asian Crisis, Russian debt default, and Argentine default all occurring during that span. The impact may have been extreme, but events like that happen more frequently than most investors think, as we’re currently witnessing. In the past six months, the Brazilian Bovespa index lost more than 30% (through March 2, 2009) versus a 45% drop in the S&P 500 Index. However, the U.S. dollar rallied 40% percent versus the real. An investor holding iShares Brazil (NYSEARCA:EWZ) lost more than 50% of his or her investment.

In the long run, currency fluctuations will tend to even out. But in the short run, fluctuations could account for a considerable amount of returns. Major currency moves can take several years to play out, so if your time horizon is less then five years, you should either diversify, hedge your currency risk, or at least be sure to investigate the currency of the country you are about to invest in. Remember, too, that some nations do a better job of managing their currencies than other nations do and betting on a nation with a bad history of currency management can be a recipe for disaster.

Source: Country Funds: Growth Is Only One Piece of the Puzzle