Monday, August 18, 2008 2 comments ++[ CLICK TO COMMENT ]++

Investing & Econopolitical Risk

UPDATE: I want to clarify others regarding John's decision. Basically, he considered investing in the troubled region but ruled it out in the end (if you read his blog post, that's obvious.) I was simply referring to him because he went through the whole process of identifying the troubled region and then contemplating an investment. He ruled out any investments in the region in th eend but my intention with the post is to examine the risk in such regions and the thought that shold go into them.

One of the most important things for newbies (like us) to understand the political risk inherent in investing. It is one of the first lessons I learned when I started investing a few years ago (more on that later.) Given my rants on the Georgian conflict--I hope it doesn't drive too many of you off (just ignore it if it's not your thing)--it presents a good opportunity to look at the issue.

John from Controlled Greed touches on some thoughts he had about investing in Russia, Georgia, and Ukraine given the Russia-Georgia war in the background. Investing during a war or in war-torn areas likely has massive upside. Recall how John Templeton is famous for investing through the start of World War II. Or how Jim Grant pointed out that Iraqi bonds were one of the best performing bonds 2 years ago (or maybe it was last year--don't recall.) Marc Faber also pointed out many examples in Tommorrow's Gold, his book on historical trends and commodities, including one which showed that foreigners investing in Argentina during the hyperinflation of 2001 did really well (one of the big reasons is because the currency plummets so much that assets in, say, US$-terms is really cheap; Argentina wasn't in a war but many countries in war can face a similar situation) John seems to have given up on the idea after reading this Barron's piece. SeekingAlpha has a brief summary of the situation, along with with bearish and bullish views from some bloggers. I'll critique some of the blogger opinion but let's look at how countries stack up when it comes to econopolitical risk.

Econopolitical Risk

There are many ways to look at, what I call, econopolitical risk. I essentially like to lump economic risk together with political risk (most people just call that political risk.) Almost always, risk in this context is taken to be the opposite of freedom. In other words, the lower the freedom, the higher the risk. This should be plausible to all freedom-loving humans--like me and you (I hope :) .)

There are several "liberal" or left-leaning measures, which tend to emphasize political freedoms (typically produced by humans rights focused think tanks or the UN.) While there are some "right wing" measures that focus on economics (typically produced by economics-oriented think tanks.) American Libertarians do not split behaviour in terms of left and right but differences exist in real life (most libertarians consider one to be a libertarian or authoratarian--can be both left and right). You'll see the left/liberal and right/conservative split when you look at Singapore in the rankings below. A lot of right-leaning measures, that emphasize economics, will rank Singapore high on the list; while left-leaning measures, that focus on human rights or political freedoms, do not place Singapore anywhere near the top. Singapore has done exceptionally well in terms of economics but is governed by a so-called "democratic" dictator. Basically one party has ruled since independence and anytime that happens in a democracy, you really have to assume that either we have found utopia, or that it isn't really a democracy. Most think tanks that rely on economics as opposed to (political) liberties considers Singapore as extremely free--even more free than USA or Canada.

Anyway, since we are investors, for our purposes, let me look at right-leaning measures that focus on economic freedoms. There are two popular ones in North America: Economic Freedom of the World index from Canada's Fraser Institute, and Index of Economic Freedom from the Heritage Foundation.

(The scale in the images below go from the blue side of the colour spectrum (more freedom) to the reddish spectrum (less freedom.) Unrated countries are in gray.)

The following map represents the Economic Freedom of the World index by the Fraser Institute:

(source: Economic Freedom of the World Index 2007 (last data up to 2005). Image from CATO Institute.)

This map is from the Index of Economic Freedom from the Heritage Foundation:

(source: The 2008 Heritage Foundation Index of Economic Freedom. Image from

I have also produced some tables showing roughly the top 25 rankings, along with the BRIC countries, and the bottom 5. Note that some countries weren't rated and the list is not consistent between the two studies. As always click on the images to view a larger image.

Economic Freedom of the World

Index of Economic Freedom

Like a typical "liberal" who values political freedoms (speech, press, etc) I personally would not consider Hong Kong or Singapore as the top two investment destinations. Things may look rosy there now but things can fall apart any minute (not that I'm predicting anything.)

Although John was relying on some comment from someone quoted in Barron's, Russia's rankings line up well with his interpretation of the inherent risk. Russia is near the botton third, way below the other BRIC countries (Brazil, India, China.) Safest of the BRICs is probably Brazil. China is totalitarian and who knows what will happen in 5 years; and India, although underpinned by a British legal system, is highly corrupt and unpredictable.

I personally would be wary of Russia. I think it has the potential to do well due to some macro factors: highly skilled population, lower cost than Western Europe, natural resources, and strategically located and very close to China, India, Middle East, and Europe. The downside to Russia from a macro point of view is their declining population (birth rate too low and xenophobic immigration policy), question over stability of government after Putin, and too dependent on commodities. I think it is worth looking at after Putin leaves, and hopefully greater freedom.

As always, investors tend to ignore the econopolitical risk until something bad happens. It wouldn't surprise me if a lot of investors overloaded on BP shares without realizing how flaky their ownership of oil&gas assets in Russia were. I personally think the market has been underpricing the emerging market risk (as you can tell by equity valuations or EM bond spreads over Treasuries) for the last few years. A lot of people are going to be shocked and lose a lot of money. An example is China, which should be discounted a lot more than what investors have done in the last few years. Time will tell.

Petrobras: One of my First Lessons

One of my first lessons in investing was econopolitical risk. One of my very first investments was a Brazilian oil&gas supermajor called Petrobras (PBR). I didn't understand it but I picked it because it seemed to have the lowest valuation. It was trading at a P/E of something like 5 or 6 whereas ExxonMobil, Chevron, PetroCanada, and Suncor were trading at higher P/Es. I thought I was buying an undervalued oil company but I was actually wrong. PBR traded at a low multiple because of political risk. I never realized that PBR was controlled by the Brazilian government and it doesn't act in the interest of shareholders (as American or Canadian oil companies would.) For example, some of the proposed pipelines and refineries seemed designed to placate foreign nations than to satisfy shareholders. My investment thesis was that the P/E multiple would increase and get closer to the American supermajors. But that was completely wrong since the market was discounting the political risk (I didn't know it.) Fortunately, I actually ended up making money because of the oil bull market but it was a bad investment.

So one of the newbie lessons is that if something is cheap, check to see if it is due to econopolitical risk. If it is, then the valuation can stay low forever. So the real homework question is whether the valuation justifies the econopolitical risk.

Is the Market Pricing Russian Risk Properly?

Looking at that SeekingAlpha post referencing the Barron's article, here is my thinking on some issues.

You can see the market discounting mechanism at work by read the Barron's story. They mention that Lukoil is trading at a P/E of 5 versus 7 for ExxonMobil and Chevron. I haven't looked at oil&gas companies in a few years but Lukoil likely has much better growth prospects as well (hence should have a higher P/E if all else were equal.) If you assume all these companies were similar (in terms of production reserves, quality of management, etc) then Lukoil is trading at around 30% discount (5 vs 7).

The decision for the investor is whether the 30% discount rewards you for the econopolitical risk. Without doing any homework on the specific companies, I would say that the discount is not large enough. I would want a 50% discount (which means a P/E of 3.5, compared to 7). Even then, you need to be willing to accept a huge loss if the government charges your company with "environmental violations" or "tax evasion" ;) But if you spread it across many countries, then you will likely do ok. This is how Marc Faber and Jim Rogers manage to make money even though they invest in super-high-risk regions of the world. I personally think this style of investing is more suited for macro or sector rotation investors than value investors. I really can't see Warren Buffett investing in some of these places. Admittedly he invested in China and Korea but it is a small portion of his holdings.

Short Selling Risky Countries

One of the bloggers quoted in the SeekingAlpha article suggests short selling Russia. Well, I'm not into short selling but doing so to a country because it is corrupt, doesn't support freedoms, or is hostile to foreign investors, is likely to not produce much profit. After all, Singapore is basically a "democratic" dictatorship and anyone that shorted in 15 years ago is bankrupt. Perhaps the best example is China over the last 10 years. If you were able to short China 5 years ago, you would have been bankrupt with the margin calls soon afterwards. Similarly, if you went and shorted the Middle Eastern countries 5 years ago because you thought they were terrible, you would be bankrupt now.

The fact of the matter is that countries, and hence companies, can do well under various conditions--including dictatorships, monarchies, and various other totalitarian regimes.

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2 Response to Investing & Econopolitical Risk

August 19, 2008 at 9:57 AM

I probably wasn't clear in my post -- I had decided against trying to make any Russia-Georgia-Ukraine play by the end of last week. The Barron's quote just reflected my feeling in a nice, succinct way.

There are plenty of safer ways to put money to work. One example is Montpelier Re, one of your holdings. No need to get too cute otherwise, in my humble view.

August 19, 2008 at 10:57 AM

Yeah, my understanding was that you decided against investing in that region as well. I guess I wasn't clear and I don't want to mislead anyone so let me clarify it.

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