About Tigers and Frontiers

The Differences Between the BRICS

2011-11-02T14:47:00.001+01:00

Goldman Sachs Asset Management - Annual Benelux Conference - Part 1

Emerging Markets in the Spotlight, more than 'Greece': The Differences between the BRICs

Like every year, LMG visited the GSAM Annual Conference for institutional investors. Always a good crowd, representing big pension plans, investment advisers and consultants on the one hand and a heavy GSAM delegation on the other. Like most of the times, GSAM Chairman Jim O'Neill did the main speech and it was - as always - a good one, especially for those of us interested in Emerging and Frontier Markets. Not a big surprise I guess, knowing that Jim is 'Mr BRIC' himself (he coined the phrase).

The venue was nice as well: the Taets Art Gallery in Zaandam, just north of Amsterdam.

Inspiring was also the panel discussion. Normally those panels are often created just to make sure all important people or entities that would like to say something do get the floor. But definitely not so this time. Led by a Dutch journalist who lives in Russia for more than 20 years already (working as on the spot reporter for Dutch TV and some newspapers) former Dutch ambassadors in India, China and Brazil sparred with him about the differences between the BRIC nations. A great session. Very serious stuff, but at the same token light enough to make people laugh, while at the same time presenting a broader picture.

Take for instance this one:

Former Ambassador to Brazil: ''Brazil has really advanced so much. In this democracy we have electronic voting and election results are available within 3 hours after closing of the ballot boxes. From Rio to the sub-tropical far away rain forests near the Amazon.''

Russia journalist: ''Now that would really not impress anyone here in Russia. Here the election results are known 3 years before the elections!!

Russia: Stability as the Keyword

Funny and sad at the same time? Maybe yes, maybe no. The Russia journalist continued to explain that in Russia stability is one of the key issues and that would probably not come as a surprise, taking into account that it is a country with just 138.7 million people but with 1/6th of total land surface of the earth. Russians take pride in the fact that they did not just defend that territory so far with big success, but also - whenever there were big wars in the world - could show/maintain their role as super power.

Does that mean that there is a big sense of 'Russian Nation' in Russia? An 'us' versus 'them'? Not really, except when attacked. Other than that, people do not really trust each other and definitely not the intelligentsia or elite. Some even estimate that corruption comprises more than 25 percent of GDP! But what they do share is their appreciation of Russian 'Culture'. And they are right so. Just check out Literature, Arts, Music, Architecture and you will know WHY.

Leaders in this country have to be tough. Trying to be popular? Well, up to a certain percentage that can work by being mister Sweet Guy, but both Yeltsin and Khrustyev know that this will in the end fail. A nice anecdote about the recent visit of Dutch Prime Minister Mark Rutte to Moscow is indicative. Rutte had a chance to present himself on one of the few relatively independent news media in Russia, one that would normally NOT present the Russian ruling elite's point of view. In other words: one of the few stations where he would have a broader platform than Putin. Viewers could vote if they felt that Rutte would be a good guy to be PM in Russia. A stunning majority voted YES. But to be frank: even if one of our LMG seniors would present there, a YES might be the result. Why, because this channel was intelligentsia related hoping to make statements against the ruling elite and since they can only do so indirectly, this survey was one of those scarce opportunities!


Rutte Meets Putin and Learns about the Difference between expected Leadership Qualities in both countries.

Now, Rutte did visit Putin afterwards and our rookie, nice guy PM wanted to break the ice by referring to the survey (with a big smile on his face so as to not look seriously, but just friendly). Putin reacted with a face, cold as ice: ''It is good for Russia and you (!), that you do not have a Russian passport.'' Welcome in Russia, Mark Rutte!

Russian lack of humor? Well, doing business with Russians regularly and knowing them via earlier work with the Chess Federation and as chess sponsor (FIDE, the world chess federation is to a large extent influenced by top level Russian representatives), we can only say: No Way!

The moment you know more of them, they are loyal, good friends and incredible fun to be with. Just be careful with the drinking, because their stamina is huge. This is not where Too Much Love Will Kill You (as in the Brian May song), but Too Much Drinking. So the stereotype about drinking is true. And it partly explains why Russian men die at a so much younger age than gender colleagues elsewhere in the world (true, crime and corruption are part of the explanation as well!).

The drinking stereotype is far more correct than the one about Russians being trustworthy or not, with the verdict than most of the time being that they cannot be trusted. I rather do business in Russia with the right partner without a detailed written contract than I would do so in the US. Of course I am aware of the fact that critics would say that this is so because with or without a contract wouldn't make a difference in Russia anyway. Even if that were true to a certain extent, then be fair and compare that to the US situation where I could have a contract but even if I were right a court case against a multinational or the government would kill me financially before I end up winning the case.

In terms of market valuations Russia is the cheapest of the BRIC nations and one without a real middle class. Result: an interesting country for those who do business with the elite and top ranks, a total waste of time for those who focus on the lower layers of society. So do not bring supermarkets to Russia, but if you have luxury products to offer or want to buy stakes in Russian firms focusing on the upper classes: understand that this market might be more interesting than China, especially at current valuation levels. Add to that the resource availability and you might be willing to overcome doubts about crime and corruption to such an extent that you even start to like the Stability aspect!

Brazil: Where the Keywords are 'Future' and 'Crime'

Brazil has done a great job and in a reasonably democratic fashion. Is the so-called 'Country of the Future' this time really the country of the future? A cynical Brazilian saying was that 'Brazil is the Country of the Future and it will always be!'.

Well, a lot has been achieved and in mining, energy and agriculture the country has made huge progress and Embraer is now the third largest Aviation company in the world.

Embraer: Showing that Brazil is more than Football, Samba and Carnival

But at the same token Brazil is still the country where you should make sure NOT to use your GPS to find your way, because those damn things tend to go for the shortest routes. And short routes could take you through the favelas. Those shanty towns where crime rules.

But that is not to say that the country did not make great progress under former president Lula da Silva. It did, especially in the aforementioned industries.

But democracies do always struggle with their balancing act whenever crime and corruption are important, and a period of less economic progress could easily translate into a shift in the balance of power between those responsible for regular economic growth and those in control of the invisible economy. At the moment the government is winning, but there is no guarantee that this will remain the case.

But it would be unfair not to give the Brazilians both credit and benefit of the doubt for their achievements.

India: The inward-looking biggest democracy of the world

India is the world's biggest democracy. But also, as many people forget after Indonesia home to the largest Muslim population albeit that they are a minority in India. But notwithstanding Western folklore India versus Pakistan is NOT the main issue in India politically. Not at all. And it was good to hear that, because those of you who follow our LMG Facebook Page do know that we have our biggest traction in India and Pakistan with most often great discussions between our Indian and Pakistani friends. The real problem in India is China and India giving home to the Dalai Lama is in that respect a logical move. What is good for India is bad for China and vice versa. Although India is far less of a problem for China than the other way round. Our explanations about China below will help explain this dichotomy.

Balance in India: Inward-oriented but definitely a High Growth Country

Indian society is about balance, equilibrium, traditions and going back to business as usual et cetera. This is even so after terrorist attacks or other turbulence. And Indians are incredibly good at this shifting back to normality. This enormous focus on balance does have its weaknesses when having to perform cross-border geopolitics inside supranational bodies like the World Bank, IMF, G-20 et cetera. It always seems as if India is not capable of getting the role it deserves. Even with its current recognition of the importance of Africa as the resource rich continent that has to be uncovered, they are again lagging the Chinese who are more aggressive when it comes to promoting their national interests internationally.

But the Indians are not at all silly. And they know about their international weakness. Result: they focus more than the other giants on domestic growth instead of exports. And that has helped them tremendously during the period of the Global Financial Crisis when contagion between markets made the other giants struggle when Western financial systems ended up in disarray.

Not so India: the focus on domestic growth insulated them from a lot of the Western problems. Add to that the fact that India has a relatively young population - unlike China - and India knows that sooner or later the Chinese (although they are good long-term chess players as well!) will have to struggle with their internal demographic time bomb. In other words: India's glory days will come, sooner or later.

But the problem is of course: how much sooner or later. And what will the country do about its biggest internal time bomb: poverty and inequality?

But all in all: there is definitely a good case to make for India as well. And again, Indians are smart. If inequality is a problem nationally and export orientation is not there, then one can also export laborers. With the Middle East next door this strategy has worked and might continue to work. Just check out the average company or office building in Abu Dhabi, Dubai, Saudi Arabia and you know what we are talking about. And this is not just an export of educated workers. The brain drain has been a problem in India in the past, but the Indian top level educational system is such a fantastic rat race that the Institute's of Technology and Management will continue to deliver top talen in IT, Physics, Economics, Finance, Chemistry et cetera. Dozens of Western multinationals recognize this and have created research laboratories in India, with cities like Bangalore thriving on them, and on internal Indian entrepreneurial initiatives along the same lines.

China: The Middle Kingdom, Heaven on Earth ruled by a Social Contract

Then let's end our BRIC travel in China. The Middle Kingdom is back to where it was before the Industrial Revolution. That is: on a growth path toward a 30 percent stake of world GDP. Not sure if they will get that far, because of the demographic troubles (the population is getting older), but growth is there and high single and low double digit economic progress seems to be standard.

China: The Renaissance of the Middle Kingdom. Back where it belongs.

But will China develop into a world power? According to a former Dutch ambassador to China that way of thinking is totally wrong. It is Western thinking. China is the Middle Kingdom. A kind of Heaven on Earth concept, ruled by an elite based on a Social Contract: for and by Chinese. That social contract is simple. The elite - be it the Emperor like in the past, or the Communist Party now - has to deliver progress. If they do, the average people focus on economic growth and spiritual balance and happiness at the family level. The ruling class has to deliver the infrastructure in which this progress can be achieved. If they do, fine so. Just the occasional intellectual will be worried about democracy, human rights and moral values. Not so the bulk of the Chinese. They worry about what car to buy, which Luis Vuitton bag to get and: in case corruption and organized crime might want to fool people by selling them fake products without people knowing it (i.e. different from what the Chinese try to sell naive foreigners!), those rulers should act with severe punishment.

It is therefore no surprise that the Chinese government is one of the toughest fighters against corruption and other crime. Penalties even worse than those in countries like Iran. At the same token - so as to complicate matters - do not try to do business with Chinese without offering them presents. There is a thin line between the regular gift policy and corruption, but it is there.

China's goal is not global dominance. The goal is growth of the Middle Kingdom. Foreigners? They can benefit as long as they deliver what the Middle Kingdom needs. That explains the Chinese 'Grasshopper Capitalism' in Africa. Westerners having trouble doing business with Iran? Because that country has a different system that Westerners don't like. Who cares? The Chinese care about China. And they are more than happy to do business with anyone as long as it benefits the Middle Kingdom.

If you keep all this in mind you can do fantastic business with China as long as you remember that you will never become Chinese. And also remember that you should not address the issue of the three T's in some kind of intellectual way, hoping to change the vision of the Chinese leaders. Three T's? Tibet, Taiwan and Turks (the Uyghur people): don't even think about the Chinese being willing to discuss the issue or change their mind. They won't. The only thing you will achieve is that they might reduce the amount of business they do with you.

Therefore: China the number one catalyst of global growth? Yes, for sure. China a certain success story? Maybe. Markets are markets and if too many foreigners from the outside want to go in and benefit from this obvious growth story, prices go up and you might pay too much. And the Chinese won't stop that process. After all you are one of those foreigners aren't you, so who cares?

So the Chinese growth story will continue to follow a long-term growth path. It is essential that the elite - under the existing social contract - ensures long-term growth. This is their advantage vis-a-vis other countries where democracy is a great and fair system, but one that penalizes long-term decision taking in comparison with an excess short-term orientation. But again: the Chinese don't care. They just expand. They have to worry about two weaknesses:

1) The population is getting older, which creates a demographic time bomb; and

2) The social contract is just that. As soon as the leaders don't deliver, the biggest population in the world will get dissatisfied. And unlike in many other countries, this will not translate into bad moods, grief, talking, debate and not doing anything. It will transition quickly into actions against the elite. And the latter know it. Even the soldiers in the People's Army are trained and educated with this perception as part of what makes them tick. If their elite doesn't deliver? Then they won't be too loyal anymore.

Of course China remains the catalyst in the short term, but we feel that one has to be careful not to get overly enthusiastic as an outsider. The probability of paying too much is too high. In the near future it might be wiser to benefit from China by investing elsewhere in the world in countries that might benefit from China's demands for certain products. Africa might be an interesting growth story because of China's needs and in the slipstream those of India.

In a next entry more about the technical stuff that was discussed at this seminar.

The Price of EU Indecisiveness, the New EU Debt Agreement: What Does it Mean for Investors?

2011-10-29T11:48:00.000+02:00

Introduction

As you know we aren't exactly big fans of what European leaders are doing: trying to solve their debt issues together without inviting those with big pockets to help solve the issue.

And not just that: the whole operation is not aimed at penalizing Greece or even PIGS nations as a group. OK, borrowers having a credit problem is part of the story. But we should also look at the lenders in this case. European government institutions and institutional investors (banks, insurance firms and pension plans) simply invested too much in Southern European nations. A horrible, naive mistake. Pretty much comparable to the investments of Dutch and British local government institutions in the Icelandic bank Landesbanki (through its affiliate Icesave).

Did investors really assume that when Europe would get one currency and a - not that powerful - European Central Bank (although the ECB under Trichet developed into Europe's best financial institution!) credit risks would be the same anywhere? I.e. that Southern European investments in sovereigns or corporate bonds would simply translate into higher returns? There was never such a simple free lunch in bond investments. Normally: when something like this happens, you have to penalize the borrower and the bad investors. And that is exactly where the problem is.

Already back in 2008-2009 European governments were not willing to play it really tough. Very quickly did they announce that a failure of one of the big banks, insurance firms or pension plans would imply 'too big a system risk'. So instead of Lehman like scenarios of bankruptcy or AIG like scenarios of 'scaring the shit out of managing boards in affected bad investors' they started to create one of the world's largest moral hazard problems through a series of support actions, including nationalizations. The outrage of Western and Northern European populations when hearing about bank bonuses 1-2 years later is totally understandable. Being in the management layers of big system investors is like getting a call option to take as much risk as you can, and in case something goes wrong the tax payer will get the bill.

But financial markets have become complex institutions. Somehow the major players, be they politicians, central bankers or institutional investors in Europe's North and West have succeeded in blaming only the South (including Ireland that seems to be recovering surprisingly by the way, thereby strengthening the argument that this is all about the behavior of Southern borrowers!).

However, when you increase the funding that is available for rescue: 'Isn't it then true, that the bulk of the money transferred to Greece and others will automatically move back into the North and West as payment (interest and/or principal) on earlier loans (yep, the bad investments) that Northern and Western European banks and other institutional investors invested in? If you know that a lot of these institutions are either led by former politicians or at least have strong ties with politics things sound totally different. But that is not the type of story European leaders want to tell, because failure to control in combination with poor investment skills is then becoming too much of an internalized story. The externalization into 'them' (the South) versus 'us' (the prudent North and West) is a far better political story to tell.


Northern and Western European Prudence: Not willing to Invest and Suffer. There are more beggars involved here. Not just Greece, but also Northern and Western Banks who made bad investments!

But what about the System Risk? The Introduction of a New Idea that might help

We are sure that when politicians or even those economists closely involved with institutional investors in Europe's North and West would read this, that they might classify us as 'dangerous rookies'. System risk could easily translate into total collapse. LMG agrees with the latter. But we believe that there are solutions possible. And in a way the US example shows that - if anything - that country did not collapse, unlike some of its big financial institutions.

System Risk: Are Big Financial Institutions really so big that they could make the whole system fail? Or is it the structure of the system that has led to this situation?

Why not do things in a way similar to sports competitions? Making tough rules, also for system risks by creating leagues (groups of financial institutions categorized according to size, international operations, financial solidity, etc.) and telling upfront that every year or every couple of years at least x percent of those in one of those leagues could fail. That will a) make people more careful before allocating to less solid banks or insurers that offer higher rates or lower premiums (freewheeling on the credibility of the more solid ones!) and b) reduces the moral hazard related to excess risk taking of bankers and other institutional parties within a certain league! Compare the system to the classification of hotels or restaurants with stars, where guests are willing to pay more for a larger number of stars and penalize those who do not live up to expectations.

LMG believes that people are smart enough to make their decisions when that type of system is introduced and communicated in an open and transparent way. As long as you don't do that and continue in the old-fashioned way any system will always lead to

Size being an asset, with bigger parties trying to get even bigger so as to reduce the risk of collapse thereby betting on the moral hazard game knowing that politicians could and would not let them fail.
Within any non-transparent, informal quality or size group of institutional parties the least solid ones will always get some kind of free ride on the shoulders of the more solid ones.

In the latest plan Europe's leaders went a different way. The new European Agreement with its insurance-like solution is not really a solution. Think about the insurance component. If you are afraid that your house might collapse since it is too close to a cliff in an environment that might be struck by an earthquake: would you really care about a 20 percent insurance for the first loss?

Rogoff's Warning

Yesterday, Harvard Professor Ken Rogoff told Bloomberg TV that he believes that the biggest risk for the US economy is Europe. Rogoff is a great economist and former chess grand master. He is so right here. The US is gradually but slowly getting there, leaving the problems of the 2008-09 financial crisis behind it. Not really through a sensational V-shaped recovery, but with a slow economic growth path bringing it step-by-step into safer territory. To quite some extent this is also the result of bold FED policy (keep interest rates as low as possible thereby keeping the dollar low while at the same time ensuring that the biggest lenders from countries that 'have' will not leave 'the world's biggest have-not' in disarray), but Europe is still a major risk.

Gradual growth at a low pace is the most likely scenario for the US but European indecisiveness to a) go for a painful solution, even if that pain could hurt some of the Northern and Western European big institutional investors, could still lead to trouble. Especially when you know that they are continuing to play music in an orchestra without a) a clear, good conductor and b) good instruments (all have debt and economic growth issues themselves!). True, Sarkozy and some high level bureaucrats are talking to the Chinese and other Emerging Markets leaders (finally!) but nothing clear there yet. And you can compare it to the rescue of Swedish automobile manufacturer Saab, also this week. If you wait long enough, once thing is sure. The conditions under which the 'haves' can step in will get better and better.

Is EU following a SAAB like scenario?

Nonetheless, also looking at the M&A data posted earlier this week by the OECD (with 2011 being the third best year in history) we do not think that a situation in which US growth is killed by what is going on in Europe is the most likely scenario. The most likely one is that things will gradually improve also in Europe (assume a 60-70 percent chance, 10-20 that things will remain volatile and nervous and 10-20 for the US being torn down by Europe's mess) with it only being uncertain who will benefit there: Europeans themselves or wealthy outside investors. But European indecisiveness and political games can still lead to renewed global problems.

Conclusion

In this scenario we would clearly favor US stocks over European ones. However, the interest of big financial institutions, wealth funds and conglomerates from Emerging countries in the asset and knowledge base of European relatively healthy financial institutions (they do still exist, although one has to be careful picking the right ones) might make them interesting speculation objects, also when knowing that the OECD's M&A data do confirm growing activity by EM investors (especially those from China, but Indian and Russian investors are also in the top-20).

And the longer Europe's leaders wait with getting the rich EM nations to the table the more the story will be like the one of Saab. In the Swedish car manufacturers case two Chinese firms were initially supposed to get a (rounded) 55 percent share for about Euro 250 million but ended up getting the whole firm for Euro 100 million half a year later.

A US overweight in your portfolio, in combination with a EU underweight is a logical top-down allocation with a - probably surprising - overweight to EU solid financial institutions with good asset and knowledge bases and 'too big too fail by European standards' characteristics within that EU sub-portfolio seems to be a logical strategy.

Will be continued.

Kazakhstan and the Neglected Country Effect

2011-08-14T14:26:00.000+02:00

Introduction
Yesterday we added a piece about Andrew Lo's Adaptive Markets Hypothesis. The AMH allows people to make mistake, even for a prolonged period of time. This in turn leads to arbitrage opportunities that are not immediately eaten away, like in the Efficient Markets Hypothesis that still dominates financial market theory and even - to a certain extent - practice.

The AMH is directly linked to psychological and neuro-physiological theories about the evolutionary development of the brain. And our brain does play quite a few tricks on us. Overconfidence, Loss Aversion, Overreaction, the Carol Effect or Syndrome, Herding Behavior, an unhealthy demand for details that in turn blur our analysis, and there are many more negative phenomenons that we all suffer from.

Geographical Misperception - We all suffer from it!

Even the way in which we look at the world seems to be sensitive to this. We do see the world in big blocs. In the Developed World the USA, EU and Japan are the leaders. This does already lead to an underestimation of what is going on in countries like Canada or Australia. They are geographically at the outskirts and somehow they do end there economically as well. But OK, with them culturally belonging to the same group of nations as USA and EU we can manage.

Now that Asia is developing rapidly with India and China leading developments there, we often translate growth of the Emerging Markets bloc into 'Asian Growth' with Asia meaning India and China. Singapore and Hong Kong, hubs that share an Asian background with acquaintance to the Western culture (due to their history), are therefore chosen as pivotal centers in our quest for a piece of the action there.

China, Japan, India....giants in Asia that are relatively commodity-poor, with especially a huge demand for energy-related commodities (oil, gas, coal etc). But the industrialization of China and India does rapidly increase the nead for other industrial commodities as well. And somehow we translate this demand into an interest in the Middle East, that tricky politically-dangerous area that we do know for its total energy dependence. But then again: for the next 5-10 years that dependence is definitely not a sign of weakness but a sign of market power.

Those of us who know the world a bit better, will suggest that Russia is a nice alternative. First, it has far more natural resources in a diversified mix. Second, it is politically far more stable than the Middle East.

Central Asia: The Forgotten Region
But somehow most of us always seem to forget about the region in the middle. The one surrounded by the others: Central Asia. And when talking to people it always seems as if they believe it is a rounding error. But hey: any idea how large the region is? Normally when telling people that Kazakhstan is one of the 10 largest countries in the world, 4 times larger than Texas, they find it hard to believe. That big?

And when they learn about the economic development and availability of resources it is clear that it is a forgotten gem stone for many, especially if you do believe in a world in which Emerging Markets are here to stay. Just take our World in the average map and change the often-seen Europe-centered presentation (with Europe in the middle, US on the left-hand side and Asia on the right) for one where the center is reserved for the fastest growing area economically. Yep, with Asia in the middle you can clearly see that Kazakhstan is not just commodity-rich, but also neatly centered between Russia and China on the one hand and India and the Middle East in the South and another growth pearl (Turkey) in the West.

A clear example of 'We never went there, never thought about it, so gosh...didn't really know about it'. Maybe I am biased. My first visit to Kazakhstan was already back in 1981, when it had a magical sound because of the Medeo Ice Rink in Almaty (back then called Alma Ata) where people set records that were always mistrusted in the West. And that kind of thinking was part of the same mental bias that led to the neglected country effect we are witnessing now.

Medeo Ice Rink - Miracle World Records in the 80s

Turkey is determined to do more in Central Asia and some kind of collaboration there might have looked relatively unimportant a few years ago, but taking into account the economic growth in those nations and relatively healthy economies without huge debt loads, the world has changed. It is important now, especially when taking into account that Russia, China and Iran might like to see - and be involved in - a stronger Central Asia. If only for the sake of ensuring that lawlessness and terrorism are better controlled by forces in or close to the region.

Kazakhstan
Within the region Kazakhstan was already a favorite for quite a few years. But only discovered by those of you who were not afraid of Frontier Markets. The Global Financial Crisis and its aftermath led to a bit of stagnation. But the economic figures that Kazakhstan posts are still nothing but good.

Therefore: better to take a closer look. And sure: the Nazarbayev family, led by Nursultan himself, has a tight control of the country and the economy. But the same holds for the Communist Party in China. All in all the political situation is reasonably stable and the business climate not too bad, and corruption does exist. But it is not really that much worse than in comparable nations where we are doing business. In other words: those factors are often used as excuse for us having forgotten the opportunity. And besides: Kazakhstan is too rich and interesting to be hurt by some kind of embargo. If you want to make a difference, then the only way to do so is to help the country develop further. Result will be growing wealth for the country and the investor, and most probably reduced inequality and corruption. Only when the relative power of foreigners vis-a-vis ruling elite changes from within, will things change.

Nursultan Nazarbayev - Tight control, but getting older

And it is a good sign that Kazakhstan is not fighting that. On the contrary, the country tries to open up to foreign investors. Our feeling is that - and that fits neatly with the cultural and religious background of the population - the Nazarbayev family understands that increased wealth will imply less direct political control. However, it might lead to more risks from their perspective, but when ensuring that the family has stakes in different industries in the country the end result could be that heirs of Nursultan Nazabayev don't really care about political power anymore but focus on their businesses instead. That seems a reasonably likely scenario.

But bottom-line: Kazakhstan the Forgotten is more than Borat or cyclist Vinokourov who those of you who follow the Tour de France might now. The Astana cyclist team is a clear indication of Kazakhstan wanting to be discovered, but neglect and opportunities are still there.

Astana, capital and second city of Kazakhstan

The videos that we added to this report were shot in 2007, before the Global Financal Crisis, and under guidance of the government. So of course, they are biased. But so are government sponsored videos in most countries of the world, including our own. We therefore also added a link to the latest CIA Factbook report on Kazakhstan. All in all, it is clear that it is an interest story with according to us the following top-5 pluses and minuses:

Kazakhstan YES
1 Since 2000 average GDP growth rates of 7% (ie doubling of the economy every 10 years); and with commodity strength no reason to believe that this will change
2 Government handled the GFC well and started to diversify the economy and current debt levels around or below 20 percent of GDP
3 Investment Grade Credit Rating since 2002; and reasonably well developed banking system for a Frontier Economy
4 Vast resources, both energy- and non-energy related
5 Strategic and Economic Importance for BRIC giants Russia and China

Kazakhstan NO
1 Environmental and pollution issues related to former defense industries (Soviet times) and today's agricultural and industrial activities
2 Young population, but still questionable demographics (net migration negative)
3 Infrastructure needs enormous upgrading, because of export orientation of economy
4 Economy still relatively small (GDP USD 200 billion)
5 Political uncertainty? What will happen after Nursultan Nazarbayev?

All in all we believe that the pluses outweigh the minuses, especially because some of the minuses will be mitigated because of some of the pluses. The joint interest of Russia, China and Turkey in a strong Kazakhstan are helpful as well.

Therefore: don't forget about Central Asia and get your geography and economic math right!

Links:

CIA Factbook - Kazakhstan

Video Kazakhstan Part 1 (2007)

Video Kazakhstan Part 2 (2007)

Video Kazakhstan Part 3 (2007)

Video Kazakhstan Part 4 (2007)

For more about Central Asia and other regions (news and music) see also our You Tube Channel

The Link between Behavioral Finance, the Adaptive Market Hypothesis and Today's Financial Market Crisis

2011-08-13T17:15:00.001+02:00

Introduction; Interesting Times

We are living in interesting times. Within academia top level professors like Andrew Lo of the Massachusetts Institute of Technology (MIT) present innovative work that links Economics to Psychology and Neuro-Physiology to explain why our traditional, rationality-based treatment of financial markets doesn't lead to solutions that work.

Prof Andrew Lo - MIT ''Adaptive Markets Hypothesis''

In-and-of-itself we already know that the so-called Efficient Market Hypothesis that played - and still plays - a central role in mainstream Economics and Finance is under siege. Behavioral Science literature (both within and outside Economics) provided us with too many strange examples of situations where people acted anything but rational. A few examples:

Overconfidence

Russo & Schoemaker (1989) performed a fascinating experiment. They asked a group of test candidates 10 general knowledge questions. But instead of asking them for their 'best guess' answer, they asked for a 90% confidence interval. In other words: 'Answer the 10 questions in such a way, that you expect to score 9 out of 10'. Outcome: only 1% of the participants succeeded!! The actual number of mistakes (i.e. answers falling outside of the confidence window) was 3-4 out of 10! This is indicative of decision takers suffering from a tendency to overestimate their abilities. Juggling around with numbers in today's Financial Crisis it is quite clear that it is not unlikely that quite a few decision takers that are at the helm in the Developed Economies of Europe and the US are suffering from this behavioral bias.

The unwarranted appeal of details

Kahnemann & Tversky (1982) created a nice experiment that indicates what happens with us when provided with more details. They told their test candidates about a lady called Linda and painted a picture of her: she was a bright, socially-engaged, sympathetic lady, active in her community and assertive. Through the various pieces of information that the test candidates received about her, they did more or less get the feeling that they knew Linda. Then, Kahnemann & Tversky asked them to provide them with the most likely answer to the question 'What do you think Linda is?':

a) A bank teller; or

b) A bank teller and woman activist

The funny thing is that 90 percent of the respondents chose b!. But obviously the best answer is a) since - with more details - the likelihood of b) being correct is smaller. This strange phenomenon of feeling more confident when knowing more details is also at work in today's Crisis, where you see that problems in Debtor nations in the Developed World does also translate into the phenomenon that a lot of funds are withdrawn from markets that do not suffer from the same fundamental problems. Emerging Markets went often even more down than the developed markets. Reason: in general Western investors know far less about these markets than they do about their own markets and they translate that into the 'certainty' that those markets will therefore be ''more risky''.

Loss Aversion, Risk Aversion and Gambling Behavior

When asked a choice between a certain profit of USD 240,000 or an uncertain gamble with a 25 percent probability of a USD 1 million gain and a 75 percent chance of leaving with nothing, most people will opt for the first option: the certain profit. Of course, when calculating expected gains, the second one will score USD 10,000 higher (0.25 x 1 million plus 0.75 x 0). But obviously, we have to subtract a risk penalty > 0 in the second case. Result: only the least risk averse or even risk-seeking (positive reward to risk) persons will choose the uncertain gamble.

But now, to make things a bit more relevant in today's Crisis, let's slightly change the example. Suppose we can now choose between a certain loss of USD 240,000 on the one hand and another uncertain gamble with a 25 percent probablility of a USD 1 million loss and a 75 percent probability of breaking even. Applying the standard expected result mathematics we end up deriving that the certain example leads to a USD 240,000 loss of course and the uncertain example a USD 250,000 loss. In other words: the uncertain gamble is USD 10,000 less good already before subtracting the risk penalty!

Kahnemann & Tversky (1979) showed however that whereas the bulk of people opted for certainty when faced with a chance to generate profit, but with the uncertain gamble when faced with a loss chance: risk aversion was replaced by loss aversion. Not rational, but still it happens. And here we are in the Financial Crisis. Developed nations are nations that - most of the time - are led by politicians who have to be democratically re-elected. They will for sure take the risk in an uncertain gamble when the choice is between 'bad' (certain bet) and 'very bad but with a chance that results will be good' (uncertain bet). The bulk of the difference between negative and very negative outcomes will be visible after the next election date anyway, so better not to play it too safe when it is about negative things. In that case all will pin this event's tail on your government's donkey. Result: the likelihood of representatives of those parties finding a solution together that will reduce global risk is not too big. On the contrary: they will lavish themselves in the risky game with a lot of praying, postponing of tough decisions et cetera.

The Carol Effect

Game theory does also report about the so-called Carol Effect which implies that the prettiest, most wanted girl in town might actually not be the one being courted by most guys. Guys will analyze their chances using three potential scenarios: first, I approach her and it works. Most guys will immediately think: if it would be that easy, what about the other guys? They would then compare their chance of success with the chance of failure and embarrassment. With the latter obviously being much larger than the first, except maybe for the most overconfident macho's. The embarrassment scenario with all its negative repercussions would get a zero or even negative utility score. Of course: winning the heart of Carol would be fantastic, but when multiplied with a very low probability it is not that likely that this score will really outweigh the multiplication of a much more probable non-successful event multiplied by the zero or even negative score. And: if we add to that the option that we don't approach Carol in the first place and continue to do what we are doing right now (i.e. ignore her), then it is very unlikely that Carol will be asked to have a drink with us.

Uma Thurman: Experienced the Carol Effect in Real Life

Actress Uma Thurman has confirmed that the Carol Effect does exist. When asked about it, she told interviewers that she did always have far less men approaching her than other girls did....

You might think: What is the relevant of all this for today's Financial Crisis? Well, when thinking of Carol think of China, Russia and Arab nations with big Wealth Funds filled with oil and gas dollars and you might understand what we mean when thinking of the macho guys as Western government leaders struggling alone with their Debts. Only when the Debt levels reach such levels that they have no choice anymore, will they go after Carol and ask her for help.....but by that time Carol might be old and not so pretty anymore. The latter could even be the result of us not going after her: because the Crisis will also affect her financial beauty.

Of course: there will be new Carols around, and new guys. But in democracies the new guys are probably new government leaders and the whole game will start again!

One thing that worries us though, is that part of the Carol effect - when applying it to the Financial Crisis - is not about the guys not being brave enough to approach the rich Carols of this world - but about Western leaders being too overconfident and cocky: 'We don't need Carol! We can do it alone!'.

Efficient or Adaptive Markets Hypothesis

The Efficient Market Hypothesis states that all publicly available information has been incorporated in prices in an unbiased way. This is the result of the interplay of rational decision takers and arbitrageurs. Whenever they find a mispricing their buying and selling behavior will automatically imply that prices will quickly adjust until equilibrium is re-established and prices reach their fair value again. This neo-classical doctrine has been the basis of important investment theories like Mean-Variance, the Capital Asset Pricing Theory, Black-Scholes option model et cetera. On the other hand the behavioral flaws mentioned above where presented as evidence that markets are not efficient. But most of the time the proof was presented in an ad-hoc manner.

Over the last decade top-level scholars like MIT's Andrew Lo have tried to structure the anecdotal, fragmented behavioral evidence in a way that would contribute to the derivation of a more structured alternative to the Efficient Markets Hypothesis (EMH). Lo's paper on the Alternative Markets Hypothesis (AMH) seems to be a good effort to do so. It links standard economic thinking - the bulk of which was the basis for mainstraim EMH style theory - to psychological and neuro-physiological ways of thinking. The latter is very much linked to evolutionary thoughts about how men's brains can be seen as a combination of a more reptillian emotional core, combined with a mammalian mid-layer and a humanoid upper-layer. The lower levels are more emotional, less deep and less logical, more spontaneous and less 'controlled' by us. Result: especially in situations of fear and/or greed these layers tend to gain in importance unless we really establish mechanisms to control them. Strange? Not really. Our history as mankind was one in which in the end the only thing that matters was 'survival'. But 'survival of the fittest' and 'preservation of the species' are not the same as 'survival of the richest' in financial markets. But a lot of our behavioral biases are related to us not being capable yet of controlling our lower level behaviors sufficiently when faced with new risks in financial markets. Compare it to the strange behavior of fish when out of the water. They make similar movements as the ones they would make when in the water. Difference: under water it would help them swim away from the danger or predator. On the land it is useless, and just tiring them.

Behavior of market participants in financial markets can therefore remain irrational and illogical for quite some time to go, and - when the emotional/irrational actors have sufficient market power / financial resources - this could go on long enough to kill the rational ones that try to arbitrage these mistakes away. In a New World Order in which Emerging Markets are here to stay, with their own wealth, different cultures, different actors, different political systems it is more than likely that the old tricks of what has literally become a collection of one trick pony's (Western financial institutions) might not necessarily be the best way forward anymore!

Also because of that, it is best to get the Carol's of this world as quickly as possible to the negotiation table to find a proper solution. And yes, that solution might even involve that Western countries have to accept a sell-off of certain larger firms, other entities or infrastructural projects previously considered ''strategic''. But then again: when it was about the Western nations gaining market share in the colonial countries the definition of ''strategic'' has been implimented much looser as well. With a bit of fantasy - and along the lines of EMH thinking - we could see it as one big, longer-term equilibrating force!

Click here for the link to Andrew Lo's original article about the Adaptive Market Hypothesis from our LMG SlideShare page.

Click here for more about the Carol Syndrome

Greece, US Debt Ceilings and Kingdom Towers reaching the ceiling of the world: about a New World Order

2011-08-03T21:51:00.000+02:00

Introduction

The US government, in an effort led by president Obama on behalf of the Democrats but with the Republicans being the decisive factor, avoided Greek-like debt default. I know, European observers would like to correct us stating that there was no default in Greece and that the collective efforts of EU governments, ECB and the IMF avoided a default. But that is of course crap. If your debt is so high, that it is reaching twice the level of GDP we can all calculate that a country is bankrupt. With a GDP of 200 percent, even an interest rate of 2 percent would translate into a 4 percent required growth rate of GDP just to ensure that things won't eradicate further. And that 200 percent debt rate wasn't that far away anymore for Greece. So it was an impossible situation that could never be maintained without belt-tightening severe cost-cuttings. And that is why there was but one option for Greece. Go into a real default, which would then make investors look like big losers who would lose face, or change the terms of debt in a kind of 'soft default'. With the bulk of financial institutions in the European Union now being to quite some extent owned by their governments as a result of the Global Financial Crisis we are not really surprised to see government leaders opt for the soft landing scenario so that 'their' banks don't look like bad investors. But let's be fair: that is basically what they were. There was far too much money lend to and invested in the non-performing economies in Southern Europe in general and Greece in particular.

There is not really a credit crisis, but it is a liquidity crisis: money is elsewhere

But in an earlier Twitter message we also indicated that in the end Greece is not really the issue, and neither is Ireland nor Portugal. They are all relatively small compared to the economies that really matter in the world today. It is just a sign of times and huge nervousness that the Western world moves from one exaggerated crisis to another. At a time when Europe is struggling how to tighten the knots and cover the deficits prince Abdulwaleed of Saudi Arabia announced that he will - together with the Bin Laden (!) Construction Group build the tallest building of the world in Jeddah. The Kingdom Tower will be 1km tall. Higher than the Burj al Kalifa in Dubai. When will the Western world understand that the Changing World implies that when you pay a lot of money for oil, gas and other commodities and for cheaper products from China and India that then sooner or later those countries will be rich whereas you will have to make ends meet?


The Kingdom Tower in Jeddah:

The solution was and is simple. Get those with money to the table and convince them that investments in the Western world are worthwhile since it could buy them a stake in economies that are still more advanced, based on superior human capital and a superior financial infrastructure. The Chinese, Arabs and Russians are ready. When will the Western world be that far?

The US Debt Ceiling and why its level was - of course - increased

The clearest example of the changing world and the demise of former global empires and rulers is the debt crisis in the US. For weeks and months it was clear that without any interventions the US would reach the point where it could not continue to pay for all government activities and debt service anymore. The debt ceiling was reached. Democrats basically wanted a solution based on increased taxes, with Republicans as always opting for reduced spending. It was a fascinating theater play with in the end a logical outcome and somewhat obscure plot. Of course - finally - an agreement was reached. Reason: a non-agreement was too expensive to afford. In that case the credit rating of the US would definitely be reduced and that would immediately translate into higher interest rates and even more costs. And not just that: what is a bigger demise of a country that once was responsible for almost 40-50 percent of global GDP and 50 percent of global stock market value than to come out with a press release stating 'Sorry guys, we cannot pay our debts anymore''.

Analyzing the US Government Debt : 1970-current

LMG took a closer look at the data since 1970 and you see the result in the table below.

Development of the US Government Debt : 1970 - current

In the period 1970-current there were 5 Republican presidents and 3 Democrats. During that period GDP (nominal) went up from USD 1024.8 billion to USD 15227.1 billion. A huge increase but let's not forget that it was also a very inflationary period. We could have adjusted the figures for inflation of course, but we decided not to because the debt levels are in nominal values as well. Over the period Government Debt went up from USD 388 billion to USD 14332 billion. If we now calculate the Debt percentage as share of GDP we went from 37.9 percent of GDP in 1970 to 94.1 percent of GDP today. Scary numbers. Of course nothing like Greece - as a percentage - but be aware. The US is now by far the largest debtor nation in the world. One big credit card, financed by saving Chinese, Japanese, Russians and Arabs.

As you can see our table consists of 4 windows. The first one gives information about the presidency, party etc. The second analyzes the government debt, the third the development of GDP and the fourth links the two together. In the fourth window we also asked ourselves the question: which presidents were capable of reducing the debt percentage during their presidency? Answer: 4 out of 8. Their names: Nixon, Ford and Carter - not coincidentally the first 3 in our analysis period! - and Bill Clinton. Father and Son Bush, Ronald Reagan and current president Obama were the one who saw the Debt to GDP ratio deteriorate rapidly.

What is clear is that debt, so often associated with Democrats, is not necessarily a Democrat thing. Ronald Reagan, whose presidency is so often seen as one of the better ones with the economy recovering after the poor 1970s albeit at a huge price when it became clear that Supply Side economics based on the so-called Laffer curve didn't really work, was one of the champions of increased net spending. If the net spending is the result of excess government spending on social welfare, jobs, health care, education etc (popular with Democrats) or defense (the latter often popular with Republicans) or simply because tax rates are too low (also a favorite of Republics) is basically a non-issue. When you spend more than you earn as a nation you do exactly what credit-card addicts do. The US did and does get away with it to a large extent, simply because a) the US Dollar is still a reserve currency; b) it is still the most powerful nation in the world militarily and economically with a 25 percent share of global GDP but remember: we started in the 40-50 percent regions. So, in other words: when you try - with just about 300 million people - to rule the world as a leading policeman while at the same time supporting your struggling domestic economy with 'credit card like' debt, it is obvious that it is a bigger burden to do so when you represent 25 percent of the world than when you represent 50 percent of the global cake.

Evaluation

LMG believes that it is a dead-end street that will - if we like it or not - lead to a New World Order, one in which the former have nots in the Emerging world will now play a far more important role. We believe that the multipolar equilibrium that will result from it will - in the longer run - be of the best interest to all parties involved, including the US. We do not see them fall back into Splendid Isolation but simply giving up part of that Global Police role will automatically translate into healthier economic fundamentals when combining it with bringing tax levels up to levels similar to what we see in other developed nations.

We are pretty confident that this will happen and when it does, that not the US but Europe will be the sick man in the developed world. Do not underestimate the vitality and dynamics of the US economy in the longer run. But in the short run, as long as the Western world is not yet ready to adjust to the New World Order, make sure you act careful using this confused interbellum to increase your exposure to Emerging Markets winners.

Reps or Dems: who are to blame?

Last but not least: typical US question.....who are to blame? The Republicans or the Democrats? The answer might be surprising and a paradox, but it is stated by the facts: the Republicans! They delivered 5 presidents who ruled the US for 28 years in the period that we analysed. The Democrats delivered 3 presidents who ruled a combined 14 years. The Republican Presidency translated into percentage debt increases of 49.9 percent net (see last column in the table), or an annualized increase of 1.78 percent. The Democrat Presidency translated into a percentage debt increase of 6.3 percent net (see last column in the table), or an annualized increase of a mere 0.23 percent. The problem of the US is not their health care or social security, it is the facilities for the rich and their defense spending.

What about Global Security?

Are we blind? Don't we see that without that spending the world would be an enormously dangerous place? That is what a lot of rightist politicians and other interested people might ask us. Of course we are not blind, but the fact is that the more you try to superimpose your own ideal system onto a world that clearly wants something else and that does have the big pockets now to go elsewhere - being not so dependent on you anymore - that sooner or later you stimulate and trigger terrorist uprisings in a similar fashion as what has led to the uprisings in the colonial empires of the past. The French, Portuguese, Spaniards, Brits, Dutch....they all know that sooner or later an expansionist system becomes too expensive. And the more you try to maintain it, the more expensive and violent it gets.

Time to get the rich Emerging Markets nations at the table. They are willing to invest. Sooner or later Kingdom Towers and other toy spending become boring. And it is a fact that the superiority in several areas (human capital, education, financial infrastructure etc) of Western economies is still there. If we allow leading business men or Ministers of Finance and Economics from Emerging Nations in, the likelihood that terrorists will be the ones showing up and taking the lead is actually getting smaller.

It might in the end be a sign of times that we should now focus on the Bin Laden Construction Groups of the world and not the Osamas!

Balancing Act - Beggars can't be Choosers

2011-07-21T10:55:00.002+02:00

Introduction : Maximum Debt Levels in the USA

The financial world continues to be in what we could label a situation of 'Red Alert'. In the US Republicans and Democrats try to avoid that the US will become one big Minnesota (although politicians in that state did finally reach an agreement concerning the new budget) with Obama's challenge now being to ensure that maximum acceptable debt levels will be increased on the one hand, and - an even tougher challenge - making sure that these maximum levels will remain maximum levels for quite some time to come. In other words: start working toward a reduction of debt levels. And of course: the second part of the challenge is the more complicated one.

LT Chart of US Debt Ceiling - Looks like Credit Card Debt of a Shopping Addict!

With rating agencies considering to reduce the credit rating of the global leader from AAA to a far lower level, the US is already struggling. But when taking the value of the US Dollar as a refereeing judge it looks as if financial markets are still more or less OK with what is going on.

Reason probably being that the US understands that it does at the moment need the support of those with the big pockets, read: China and sovereign wealth funds in the Middle East. If you increase debt levels to new record levels, you better gain support from those who have the fullest pockets. Obama's talks with the Dalai Lama made it clear that the US president understands this simple business concept.

PIGS in Europe

But what about Europe? Nervousness remains in Europe, with a totally different approach so it seems. Greece, Portugal, Ireland and to a lesser extent Spain, Italy and maybe even Belgium are countries with external debt to GDP ratios that are troublesome or even disastrous (Greece). This is not just bad news for the Euro, but it should also be bad news for those who invested in these international securities. These countries were never of the same credit quality as German or Dutch or Swiss government bonds. It is the same old situation: lower rating or higher risk (and with ratings often not as good as they should be, this is not the same!) translates into higher interest rates. Those who go after these rates should know that sometimes this 'excess interest rate return' won't happen because of default.

In the old days with those countries having separate currencies, these defaults did not happen directly but indirectly. Instead of a default the Ministries of Finance would simply print more of the local currency, with the latter depreciating. But: in Eurozone we are now talking about a situation in which the local currency is international currency as well. Result: the borrowing countries cannot simply do that. And that means that they have but one choice: restructure the economy and/or go into default.

If we take Greece as the leading example (it is indeed also the show case that does get most international attention, because the catastrophe is worst there), then it becomes clear that we see on the one hand a lame restructuring effort with Greece expecting that international lenders will in the end take the bulk of suffering. The international financial community in Europe (ministers of Finance, ECB, Central Banks, Financial Sector) and abroad (IMF) seems to forget what the Americans understand perfectly well: in the end it is best to involve the have's when trying to find solutions for the have not's.

Financial Ruins are no Tourist Attractions: So don't talk and watch, but do something

Balancing and How to accept the New Reality

China did already indicate that - as part of their international diversification policy for the reserve position - they will not necessarily let the Euro fail (if only for the sake of creating a better international power balance that isn't too dependent on the US Dollar!) but so far European leaders and IMF (with the exception of Germany beggars themselves, with struggling economies) have chosen to go for a DIY strategy. United we stand together: but without money.

Well, in that case the only way out is either loans that are almost perpetual with very low interest rates (and therefore effectively pose a subsidy to the weak financial countries!) or a restructuring that includes a default with lenders not getting everything back. Some Ministers of Finance (including the one here in the Netherlands) try to score points nationally by talking tough language, but of course they do realize that a tougher stand implies that it is their own lenders who will take a substantial part of the loss. And those lenders are - yep - the same banks that were to a large extent saved or even bought by Western governments during the Global Financial Crisis.

The bottom-line remains: Beggars can't be choosers. There was and is no credit shortage. It is just that flows went from Europe and the US into Emerging Countries and Gold and Switzerland (the latter two as example of flight into safe havens due to the onging nervousness, with the latter also caused by the imbalance that western leaders are now cultivating).

But still: we can listen for hours to TV, read opinion articles for hours and the only thing we do not hear is the story above. The beggars want to continue their belief that the world hasn't change, only to realize far to late that it did!

Beggars can't be Choosers: Looks as if this time the biggest Beggars will be best off!

Gender Diversity 'Free Lunch' Factor in Bottom-Up Investment Selection?

2011-07-15T14:32:00.001+02:00

The New 'Free Lunch' Diversification

Nobel Prize Laureate dr Harry Markowitz (Nobel Prize 1990) taught us that diversification can create value by reducing risk levels more than that returns will suffer when combining different investments ranging from high-return, high-risk to lower-return, less-risk. And yep, if you click on the link to Markowitz in Wikipedia, one of the articiles in Selected Publications is joint work with your author, LMG's co-principal Erik L van Dijk.

This 'free lunch' is a reality of life most-of-the-time, but not always. Markets are also moving dynamically, with new asset classes and countries gaining in importance and others going into oblivion. At the same token the process of 'Globalization' will have an impact on diversification, because Globalization will increase correlations between asset classes and countries, thereby making the potential gains from diversification smaller.

But research has indicated that there is another type of diversification with potentially untapped, and maybe even larger potential benefits.

Dutch newspaper De Telegraaf reported on Karmijn Capital

a firm led by 3 women with decades of experience in Private Equity and with a very interesting strategy. As one of their prime filters when selecting their investments they look for firms with above-average female boardroom presence. Required: a female CEO and/or 25-75 percent female board representation. Just another effort by feminists to discriminate positively?

Nope!

Women in the Boardroom? Facts show that it does make sense!

McKinsey research has indicated that gender diverse companies generate 10% higher returns on equity and 48% higher earnings before interest and taxes (EBIT). Companies with more women in the board outperform those with less women by very high margins, both with respect to Return on Equity and Return on Investments. And even when we look at negative statistics we do see a positive difference in favor of the gender diverse companies. When analyzing bankruptcy statistics, Graydon found that 14.6 percent of entrepreneurs involved in a bankruptcy were women and 85.4% were men. If we compare that with the fact that about 25 percent of entrepreneurs in the sample was female and 75 percent male, women are underrepresented by 10.4 percent in the negative category, with men overrepresented by 10.4 percent.

Logical? We believe so. Behavioral and neurological research indicates that women are better multi-taskers and entrepreneurship is a complicated activity that involves a lot of multi-tasking. On the other hand, men are hunters, good in activities that require a lot of focus and quick decision taking. But with the bulk of management boards or entrepreneurs being male, an overfocus on these qualities could easily lead to trouble. Men do also have a tendency to overestimate their qualities when successful, whereas women's careful combination of various factors in a more realistic multi-factor setting will provide a countervailing power that - when combined - will lead to a better outcome. Other research has also indicated that when looking at stock market results, this mutlifactor/multitasking quality has also resulted in women being at least as good - if not better - than herds of their male peers.

But still: inner circle effects, glass ceilings and the competitive strengths of men in inner-office 'combat' - in combination with cultural factors - have led to a situation in which women are underrepresented. LMG believes that the strategy of Karmijn - when applied in an objective manner without falling for a positive discrimination like trap - does hold a lot of potential, and we will carefully follow the initiative to find out if it could be of interesting to our investment clients, be they institutional or high net worth investors.

Gender Diversification: A Free Lunch within Private Equity?

Power Struggle in Iran: What to Expect? And why Khamenei versus Ahmedinejad is a non-battle with important global effects

2011-06-26T17:35:00.000+02:00

Over the last couple of months, IR Iran saw a real political conflict develop into something that caught the attention of analysts all over the world. President Ahmedinejad wanted to fire the Intelligence Minister, but was summoned by Supreme Leader Ali Khamenei not to do so.

It was remarkable to see how a lot of Western observers indicated that this might be proof of a weakening of the leadership in Iran. Some even said that this was probably directly related to the Arab Spring elsewhere in the Middle East. But as so often 1+1 is not always 2 in the Middle East.

The first thing that all outsiders always seem to forget is that IR Iran is just that: an Islamic Republic, i.e. a theocracy where the parliament has operational and political responsibilities defined within the guidelines laid-out in the Constitution with the Shariah and Quran as important other beacons. So important that they themselves - as the Word of God - are not questioned and/or left open for discussion by politicians within the parliament.

You can argue as long as you want about a system in which the leading beacons are embedded within the religious system. if it is not yours, then oppose the system or leave the country if it is not collapsing from within. Just like you - when you don't like an orthodox Christian political party like the SGP in the Netherlands - probably don't want to be part of it. Of course, there is a big difference in that the secular structure in the Netherlands and the fact that the SGP is normally gaining just 2 seats in the 150-seat Dutch parliament doesn't translate into tremendous powers for mr Van Staay, its party leader. And neither does it make the religious leaders (and the Bible) who he will consider its guiding beacon that important. Although.....a recent Senate election in the Netherlands led to a situation in which the seats of the SGP will be decisive in giving today's Christian-Liberal right wing government the edge in parliament. But with or without that power, whatever is going on in the Netherlands politically on the left sight of the political spectrum - and that is more or less everything for SGP members! - they won't mind either. Their roots and power base are built upon the Bible and its teachings. And at a smaller local and regional level the SGP strongholds do in a way have elements in them that are quite similar to the cultural and political infrastructure in Iran. Of course, most Westerners would strongly oppose this suggestion but being from such a region originally your author is not afraid to write it down anyway.

But back to Iran: the thing is totally different when the majority of the population is of such a religious background (Shiah Islam) and treated in such a way in the past (both within the country and outside) that it can be reasonably assumed that the Supreme Leader is like a kind of 'Pope' to them. And just like the powers of the Pope do still indirectly seem to be there to their fullest, and even dominant, amidst huge problems for his Roman-catholic 'system' (pedophile priests) the Supreme Leader in Iran is in a position of power not known in many other countries.

Does that make him a dictator or some thing? No: First, the Supreme Leader is appointed by the Council of Experts and the ''search'' is a tough one since the Leader has to be a) a leader, i.e. good manager of the system; and b) a religious scholar of the highest standing. And be sure that many ambitious people in such a system would like to gain this position of power. Just like Karol Wojtyla (John Paul II) or Cardinal Radzinger (today's Pope Benedict) liked to become Pope. But still: the system is stable when looking at the fact that Ayatollah Ali Khamenei is just the second Supreme Leader of the Islamic Republic after replacing the late Ayatollah Khomeini in 1989 after the latter's death.

But he is also no 'real' dictator in that he can be very sure that as soon as he would 'forget' what the religious guiding beacons are all about (Islamic Law, Shariah, Quran) and fall for less divine traps so prominent in the secular world (e.g. kings, politicians and dictators falling more in love with themselves, money and other 'fringe benefits') the Council of Experts would be quick to correct this and start an impeachment. That it did not happen so far is maybe an indication of 'dictatorial' powers (as opponents suggest). It is however more likely an indication of the prudent use of powers bestowed upon them by mr Khamenei and before him mr Khomeini.

But obviously, if the Supreme Leader is just as much a religious leader (a Pope) as he is the ultimate decision taker (e.g. a kind of king or president in the US meaning of the word), then it is also very likely that he needs a cabinet with a president and prime minister to make sure that things run smoothly operationally.

And don't forget: the Supreme Leader of Iran is a true religious leader in that he is the Grand Imam for Shiah Muslims all over the world, similar to the Grand Imam in Egypt for Sunni Muslims, the Pope for Roman-Catholics or the Dalai Lama for Tibetans.

Now, in such a ''stable'' structure at the top, it is not strange when the political power structure that surrounds parliamentary elections will occasionally lead to situations where political figures 'test' their powers. Maybe not so much to challenge the Supreme Leader but far more to ensure that their own followers and associates are given the best possible positions as soon as society is starting to think about elections again.

And that is what happened to mr Ahmedinejad. He overestimated his powers seen in the light of a) a political faction that was built around anti-American and anti-Israel feelings (and which was clearly hurt by recent Arab Spring tendencies!); and b) previous elections that weren't clear in the first place with the more liberal camp led by Mussavi losing surprisingly, leaving people with the idea that the election was fraudulous.

Now, it is nothing more but human to err in such a situation. Ahmedinejad is too intelligent to see him challenge the Supreme Leader himself openly if the Supreme Leader were to be the target. If ever there would be a power struggle at THAT level, be sure we wouldn't be analyzing about it before the system collapses or the president would be imprisoned or executed (depending on who wins). That is not the issue here at all. Ahmedinejad is not the type to be afraid of death and power struggles, but he is not suicidal in a situation that would label him an idiot instead of a martyr.

An older picture still clearly showing who is calling the shots. On the left two reformists who are now also not in a strong position anymore: Rafsanjani and Khatami. Ali Khamenei is standing stronger than ever when we assume that his power in early days was more or less the result of him being catapulted in the position after the death of the incredibly strong and charismatic Ruhollah Khomeini.

So: what does this mean for us? It means that within Iran the religious leader made it clear to the extremist faction led by Ahmedinejad that they cannot go too far. Or in other words: the Supreme Leader uses his authority to overrule decisions. We believe that this is an extremely good sign for what we can expect from Iran in the next couple of months/years.

Of course, the outside world might always think of the religious leader of Shia Islam as an extremist, but be sure: he is not. And to the extent you refuse to go this far: he is at least a more or less predictable one. His position of power has further increased. Maybe to some extent because of what he had to 'show' Ahmedinejad. But also to another by what the world has shown Shia Muslims in Bahrain, Iraq, Lebanon. That their rights are not part of the Arab Spring but more or less secondary to geopolitical and energy interests.

The combination of the two provides the Supreme Leader of Iran with an opportunity to show his powers without having to fear that the Arab Spring might endanger his or his systems might. On the contrary: expect a more confident Iran (led by the Supreme Leader with a president who could still be Ahmedinejad or if he steps down or is fired a replacement).

This should be good news for Americans. But will the US Government understand that? If there was ever a chance to get the dialogue with Iran started then it is now. Unfortunately LMG is not too optimistic about the Rest of the World being Shia-savvy enough to see things this way. At least not yet.

But we also believe that current events in Iran will have their impact on the next parliamentary elections in which the power of the Ahmedinejad faction has clearly deteriorated. And that will definitely translate into more dialogue. So: if we don't start it now, it will happen next year. It looks as if Turkey's PM Erdogan is the only top level politician who clearly understands where the Middle East is heading. A few years already. And yes: the Turkish economic growth story in that period cannot be analyzed without incorporating this background information. You don't believe it?

Travel to the South-East of Turkey (Diyarbakir area) and see the trucks driving back and forth. Turkey is enjoying a 'Wirtschaftswunder' more or less German-style but this time built on Iran as important catalyst at a time when the European Union is licking its wounds.

Attached an interesting Al Jazeera interview/report in which the tension between the guests at the end of the report is more than amusing.

http://youtu.be/GVC_0Cpk1Do

Not a Nice Story: Our Energy Vision, and How it Translates into a Focus on New Markets

2011-06-04T13:43:00.000+02:00

We just uploaded our SlideShare presentation on Energy Risk in Emerging Markets. Included are also a lot of tables and figures from our research that translate into analyses useful for other markets than just the Emerging or Frontier ones.

The Energy Trends and their Investment Impact

It is not necessarily a nice story for those in the Western world or even for China. This is a story that indirectly predicts good times for the LEAST popular Emerging Markets areas (Africa, Middle East and Russia). LEAST popular when looking to behavioral biases that is. Some countries are just more liked than others. China can top the tables in terms of executions year after year, but they remain those nice, friendly smiling nice people that we know from the restaurants in our towns and villages. Russians, Iranians, Arabs? They are the crooks! Not our LMG words, but it is too obvious that this is often how the implicit biases go. Sociologist Hofstede has done a lot of research into cultural and behavioral differences and a lot of other scholars have used his work to analyze these factors even further. See also our SlideShare presentation on the impact of Cultural and Behavioral Biases on our market picking activities in more exotic investment destinations.

Within the Western world these trends could play out well for France. The French are actively playing the nuclear card. Why? Because they are environmental crooks? Of course not! Not because we like it, but because some of us are realistic enough to understand that this will be an essential, necessary market niche that is not just here to stay, but will continue to grow explosively as well (and yep, we are aware of the fact that using the phrase 'grow explosively' is a somewhat careless one). But then again: just like people always translate a few deaths as a result of eating the wrong vegetables into bans on food exports or imports and fear for epidemic terror or crashed airplanes into new safety measures and fear of flying even when a 10-fold number of deaths in car or bike traffic and pedestrians never translates into us reconsidering those means of transportation, we believe that nuclear energy is here to stay with those panics gradually but slowly translating into less effective or outspoken populist sentiment against it. We are just not there yet.

Nuclear Plant in Belleville in France - Big Export Business for France in the Future?

And this means that we should also not forget a Central Asian powerhouse like Kazakhstan or other smaller Frontier Markets with energy or commodity wealth. Kazakhstan was basically Alma Ata (the other big city) and a well-known speedskating stadium (Medeo) some 20 years ago. Economy? Did they have that over there? And compare that with the newly created capital Astana now.


Astana - Newly Created Capital of Kazakhstan

These trends do also translate into continued tensions in the Middle East. Arab Spring? Westerners liking Democracy there? Doesn't make sense unless it maintains a status quo that will ensure an ongoing majority allocation of oil and gas revenues to Western energy companies and indirectly the countries they represent. We do not believe that this is feasible in a world in which US-NATO political dominance is challenged by Chinese (energy needy), Russians (still powerful and with energy and other resources) and sooner or later also loaded Wealth Funds from the Middle East plus growing richness in Brazil and India.

These realities will make Africa, MENA and Russia far more interesting investment places than most people tend to think, unless we are willing to start battles to stop it. Unfortunately we are not totally sure if that will be unrealistic (see the Middle Eastern experience), just comfortable that an equalizing balance of power in the world will make it a lesser option than right now or in the past.

What about Renewable Energy?

Note: does this mean that LMG is a non-believer in Renewable Energy? Of course not. What we believe is that Renewable Energy will be a huge growth market, but initially mainly for the West as a kind of fancy, elite choice to opt for things that cater to energy need AND the emotional well-being of the people buying it with them being willing to pay a premium for the latter.

It is simply impossible for it to be a realistic full alternative for traditional primary energy sources without people willing to pay that premium AND/OR change their lifestyle. But lifestyle change is also an elite choice that one cannot demand from Emerging Countries unless well-off Westerners pay for it directly. And that is where the story ends: no Western country is in the business of providing Developing Nations with much more than they are currently doing and preferably in a form (bibles, blankets, emergency medicine) that cannot help grow the economy in the longer run (so as to maintain market dominance). Result: Renewable Energy is a good product with growth opportunities (in a similar fashion like wellness centres are) with definitely good investment opportunities in Renewable but the bulk of the Energy Market growth will be in Traditional Primary Sources for quite some time to come.

Adding things up, nuclear is here to stay. Only caveat: that 'HERE" might be more 'THERE' in some countries (Germany probably using France) than in others (FRANCE, RUSSIA, USA) who want a piece of the action.

Windmill Park in New Zealand - Growth Market? Yes! Whole Story? No!

A Better Future for Africa: The How and Why of African Wealth and Poverty of Africans

2011-05-30T17:14:00.000+02:00

Introduction: Is it about the leaders?

Yesterday we presented you the link to an article by South African Gregg Mills for the Cato Institute. Topic: ‘Why is Africa so poor?’. Main point in the article was that this is the case, because African leaders are the ones to blame. They have indulged in excuses, nepotism and corruption, according to Wells. We do normally appreciate the work of the Cato Institute as outstanding, and will continue to do so. However, we believe that the explanations given for African problems were one-sided and not incorporating substantial parts of the truth to the extent that they related to Western activities and policies.


The Cato Institute: Top-level Think-Tank but is the treatment of Africa fair in the report Why is Africa Poor?

Of course it is true that the leaders of the 50+ African nations were – on average, when treating them as managers of ‘enterprises’ with potential in terms of incredible natural resources and a young population - below-standard. Example: oil giant Nigeria – the most populous African country – suffered from poverty in 1970 that looked less bad than at the beginning of this decade, notwithstanding the development in oil prices. In 1970 19 million of the 70 million inhabitants had to live of an income of less than $1 per day. Taking into account the purchasing power of the US dollar this number was 90 million out of a total population that had grown to 120 million as of 2000. In other words: the percentage of people living from less than $1 per day dropped from 27.1% to 75.0%. Unbelievable when taking into account that oil prices have since increased by a tenfold at least!

And the Nigerian case is not an exception, on the contrary. When we look at some other statistics the story remains bad. A lot of African people are dependent on subsistence farming, with the agricultural sector therefore being extremely important. But at the same token, the bulk of African nations are net food importers. And when looking at global agricultural exports Africa’s share has dropped from 8% to 4% since 1970.

Corruption and nepotism and lack of democracy, are they the factors that caused this prolonged misery and mismanagement? Maybe so to a certain extent, but is it correct to point our finger to African leaders only? At LMG we believe that this is totally wrong. Even when knowing that a continent where leaders like Idi Amin Dada are more of a standard than an exception should in all cases make sure it does investigate to what extent there is internal blame that can be transformed into positive actions.

Even with leaders like Idi Amin Dada it is too simple to put all the blame on Africa

Are Western nations playing games?

LMG believes that to a large extent Western influence in Africa has been a large factor in explaining what went wrong.

Let us start with the corruption part of the explanation in the Cato Institute piece by Wells. Transparency International reports the Corruption Perception Index (CPI). In the CPI almost all African countries end up with lousy scores. However, there are a few mitigating factors. The first one is related to the structure of the CPI Index. The CPI Index allocates corruption completely to the receiver. But when a multinational firm or foreign government institution spends ‘extra’ money or ‘gifts’ so as to ensure that the receiver will opt for its proposition – even when actions like this are totally against the laws and ethical rules in the foreign entity’s own country – is it then fair to blame the poor receiver? Shouldn’t we recalculate the CPI Index putting the blame for 50% on the sponsor and 50% on the receiver? That would make the poor African receiver look less bad and the sponsor less ‘ethically correct’. As you know, LMG believes that this ‘grayish’ solution is closer to the truth. Western institutions have way too long ensured that they received the goodies from corrupt, poor African representatives because this basically ensured that money spent in Africa would generate a good return, either as financial or political profit or – when talking about development aid – by ensuring that a large part of the aid would ultimately end not in Africa but in the pockets of Western advisers, institutions et cetera.

Unequal Power Balance between Africa and the Rest of the World, but with exactly the opposite color dstribution as in this picture!

Are African leaders ‘poor’ because they couldn’t defend themselves against this? Maybe so, but was it so easy to put up a strong defense? The answer is NO. Africa was and is the poorest continent. From the perspective of an international organization willing to use these corrupt methods it is therefore also the ‘cheapest’ continent. This is where you can probably get a good or maybe even excellent return percentage for your effort, but it is definitely the area where you need less money to achieve your goals in absolute terms. Example: when government officials or intermediaries earn decent wages of let’s say $ 2-5,000 on average per month in other continents (average of lower and higher level representatives) one needs larger gifts or sums of money to ensure their loyalty than in situations where already a good bottle of Champagne would be worth a monthly wage!

But there is more: Was or is the Western world really interested in African development? When hearing people talk, the answer is YES. But actions and their consequences talk louder than words. As you know LMG likes the work of Zambian economist Dambisa Moyo quite a bit. Moyo – in her book ‘Dead Aid’ – made it clear that what Africa and Africans need is economic support and not aid.

Africa needs Economic Support instead of Aid (Dambisa Moyo)

But the Western model focused all the time on aid, education, emergency packages etc. Of course, in-and-of-itself this is all well-meant and nice. But: if a country or continent has natural resources, agricultural potential and cheap labor isn’t it then most helped by opportunities to export its produce into richer, but more expensive markets? For many years it was clear that the European Union for instance created an agricultural tariff, duty and levy structure that made it complicated for exporters from outside its borders to sell into Europe with the latter protecting their own farmers. This was even the case when as a result of price subsidies Europe ended up building a 'milk lake' and 'butter mountain' (nick names for the strange result that subsidies led to producers producing more than needed, with the main problem actually being that these producers were too expensive to survive as a sector without protection of import duties and tariff walls).

At the moment these rules have been modified to some extent, but only under strict conditions and mainly for subsistence style farm produce only (the Fair Trade lobby). We believe that it would be much better for Africa to get no aid, but at the same time lower tariffs and import levies into Europe and the US as well. In such a way that it could start building an agricultural and food sector internally. Not a subsistence one focused on the poorest of the poor but one that can compete with the more expensive products from within the EU or USA higher up in the value chain within the food industry. Instead of aid, subsidies for Western investors who will set up these type of facilities in Africa (knowledge transfer!) would be an interesting and fascinating alternative. But at the moment these initiatives are paralyzed. True, western private equity providers and/or entrepreneurs could consider African initiatives but they have to deal with lacking local infrastructure, institutional and governance problems and other political risks next to uncertainty concerning the possibility to successfully focus their new African firms on the richer Western markets at home.

In the meantime aid (blankets, bibles and education) were an important ‘tool’ in regional control with weak local leadership being more a ‘pro’ than a ‘con’. Education in this list? Yes to some extent: Is it correct to stress educational initiatives at a higher level when you know that a country's main competitive strength lies basically in industries that need unskilled labor most?

Bottom-line: to a large extent the Western position was a post-colonial one. If you believe that LMG’s stand is a leftist one, don’t get us wrong. We are definitely not left wing, anti-Western or extremely negative about capitalism. On the contrary, we believe that a ‘private sector’ solution – when given a fair chance – will help develop Africa.

The comparison with other Emerging regions is a logical one, albeit not totally fair. Wells indicates that African leaders were too often lavishing themselves in poor excuses related to a past with slavery. But the fact is that historically those countries were coming from that background, with other Emerging regions being confronted with less misery and/or even being instrumental as indirect participants at a higher level within the Western slavery-based development model (e.g. the traders, logistical specialists from the Middle East, supervisors of Indian descent et cetera). So even if you don’t want to talk about historical excuses per se, you still have to recognize that the past for those regions that you compare things with was a better one.

Slavery Past an excuse? Maybe yes to some extent, but it definitely provided Africa with a tougher starting position than other Emerging Markets who in some cases actually participated in the Slavery model. So we shouldn't over estimate history compared to what can be done now, but we should also not explain the situation as one in which African leaders try to get away with things by using it as a lame excuse.

We do actually agree with Wells that there is far too much complaining about the past going on in Africa, albeit that we also recognize – see also above – that Africa was so far not offered the full opportunity set to do something constructive with respect to improvement of its own economic development path. And that was related to the unfair balance of power, i.e. having to deal with a partner who had no intention to really develop the continent while keeping it checkmate through aid.

But there is hope: the new development model of China

But there is hope. China has imported a totally different business model into Africa. Not based on aid, but on infrastructure support to develop roads, railways, harbors, airports all with just one goal: ensuring that natural resource development in Africa can continue or even expand. China needs resources and Africa can deliver them. Of course, the Chinese are not known for their benevolent activities in the countries that the deal with (see also our previous blog contribution on April 30, 2011 on Chinese foreign investments). It is definitely not aid, but it does help those countries further in that it generates employment and (the start of an) economy that can grow. And the latter is in the longer run of the utmost important, as Dambisa Moyo teaches us. Aid is dead, economic support the only way forward.

China increasing its influence in Africa (meeting PM Wen and Kabila in Beijing in 2007)

Skeptics point out that the Chinese goal of gaining additional influence in the African political arena is a bad side-effect of the Chinese activities. Maybe so, but let’s be honest for once. Is all support by Western nations in Africa solely humanitarian without any political agenda? Of course not, so basically this is a case of Westerners blaming China for doing what they themselves are doing as well albeit in a different format. We believe that it is a good thing that different parties with opposing political agenda’s do now have to compete for a piece of the action in Africa. The old balance of power with one strong party having to deal with a weak African leader and a poor African people was more instable and less good for Africa than the one that results when strong nations have to take into account counteractions by other strong nations. The Arab spring is a

nice example of the benevolent effect of these kind of semi-stalemates.

Our conclusion therefore: Africans are poor, but Africa is certainly not and the new equilibrium with activities by not just Westerners but also by Chinese, Indians and Russians (the leading Emerging Markets foreign investors) and Middle Eastern wealth funds provides for a future in which chances to develop African wealth have increased dramatically, be it in the Agriculture/Food, Resources, Tourism or other industries. LMG believes that good chances for Africa and Frontier Market investment strategies as a result of this is a logical side effect, with the increase in share prices leading developments in the real economy.

The Growing Importance of China - A Closer Look at their Foreign Direct Investments

2011-04-30T15:31:00.000+02:00

It is obvious that the influence of China in the global economic and geopolitical arena is growing dramatically. To a large part this is the result of the spectacular economic growth of the country. For many years now, GDP growth figures are close to or in the double digit zone.

And the Yuan Renminbi is one of the strongest currencies in the world, carried by China's position as the world's number one when it comes to Foreign Currency and Gold Reserves. This, combined with a huge current account surplus helps the Yuan. However, it is also clear that so far the Chinese have done all they can to ensure that the currency remains relatively affordable so that the export machinery won't be hurt.

Using data from the Heritage Foundation, LMG Emerge itself and the CIA World Factbook we take a closer look at the Foreign Direct Investment (FDI) activities of Chinese firms. This activity is linked to Chinese government activity to the extent that the government uses state-related firms for this expansion (e.g. oil company Sinopec).

Foreign Direct Investments by China, 2010

The table above lists the top-20 countries in FDI, with China as the investor. When looking at the absolute investment amount the USA and Australia were last year's winners with a total amount of USD 28.1 billion. Nigeria, Iran and Brazil are the other top-5 countries with a combined investment amount of USD 45.4 billion. Three countries from the Emerging Markets group who are all known as commodity providers with a strong export machinery when it comes to energy. Logical, when taking into account the energy hunger of China. Nevertheless, the top-5 positions of Nigeria and especially Iran (still suffering under Western embargo's) might be shocking to many Westerners.

As always, Western observers do immediately when numbers get bigger suggest that the Chinese investments have 'only one main goal, namely to buy political influence'. Interestingly enough, they always seem to forget about this idea when it is about Western FDI's in other countries. So as to analyze the potential political impact in more detail, we also created a column with relatively numbers by dividing the FDI by last year's GDP.

The top 5 changes dramatically, with now the Democratic Republic of Congo, Kazakhstan, Nigeria, Vietnam and Algeria the most important investment destinations of China. In all 5 cases the Chinese investments represent more than 5 percent of GDP, with the impact in Congo being 46.8 percent. Conclusion: true, China is important and might be a political factor. But, buying votes? Except for DR Congo this is just as likely as what one could say about investment activities originating in countries like the USA, Germany, France and the UK. We believe that the bulk of Chinese FDI is directly linked to the Chinese 5- and longer-term plans: ensuring a structural, smooth inflow of necessary resources (commodities, energy, knowledge).

Chinese PM meets DR Congo President Kabila

Beijing 2005

Generational Accounting and Why The West Needs Emerging Countries: The Work of Larry Kotlikoff

2011-04-18T15:49:00.001+02:00

Introduction
In this contribution we pay attention to the work of Boston University professor Larry Kotlikoff. Kotlikoff is a well-respected economist, but one with relatively negative views when it comes to the future of the rich, developed world. Already in 2006 he wrote a paper entitled ''Is the United States Bankrupt?'' that more or less foresaw a lot of what was about to happen 2-3 years down the road during the Global Financial Crisis, albeit that his paper was more general and longer-term (link to this article at the bottom of this page). In his work Kotlikoff suggested that the Western financial system was one in which beggar's acted as choosers in an environment in which the amount of saving was structurally too low. That was not a global problem, but a Western developed world problem. The global economy was and isn't doing that bad with a real growth rate in excess of 4 percent. However, liquidity is leaking out of the developed world into emerging markets who now run huge savings surpluses. Unless we find a way to re-establish equilibrium the system in the Western world will burst.

Larry Kotlikoff: Agent of Doom?

Yes, if you count out Emerging Markets. No, if you accept a growing role for them.

Generational Accounting
An important part of Kotlikoff's work about Government Finance is about flawed Public Accounting. Concepts like Budget Deficit, External Debt, Tax Burden et cetera don't mean anything according to Kotlikoff, the reason being that they are very sensitive to labeling. Idea: when the government would label its revenues as 'tax income' it would reduce its debt and run a lower deficit. It could then say that for the taxes now future transfers would be handed over to these taxed citizens. The other way round: if it would like to keep the tax burden low, it could finance things by borrowing. This would increase 'debt' and lead to a larger deficit. In the future it would then have to repay principal plus interest. At that time it could finance things by increasing taxes, or again finance by issuing debt. The government could always 'finance its way out' by issuing money and/or ensuring that inflation is high enough. But what it is all about is simply that the paper in these transactions - 'money' - will lose its value thereby adding to the generational mismatch: earlier generations enjoyed a good life with stronger value money and a better balance between lifetime resources and taxes than future generations will.

Inflation high enough? Financing your way out by printing money? QE2? Hmm....aren't we going through a period of money printing and inflation creeping up?

The above does also imply that it is not possible to simply evaluate the external debt burdens of countries and based on that conclude who is closest to 'bankruptcy'. The debt of Japan far exceeds that of the USA, but does that mean that the US is safe and Japan not? And what about the European PIGS nations?

The analysis of Kotlikoff is mainly US oriented and came to the conclusion that - when using Generational Accounting - already back in 2005 the overall shortage of the US was USD 65.9 trillion (i.e. more than 4 times more than its external debt, its government deficit and the size of the economy!) (for more information see the 2006 paper in our LMG slideshare account). Similar exercises can be done for other countries of course and they will lead to similar conclusions: Generational Accounting - when done the proper way - will show problems far bigger than what governments in Western nations tell us these days. Basically what it is all about in Generational Accounting:

Lifetime resources of a generation have to be linked to the lifetime fiscal burdens of generations.

And whenever there is a mismatch, you get inter-generational wealth transfers.

And these wealth transfers in itself can already may lead to problems for the system.

The models of Kotlikoff, Auerbach, Gokhale and others are ultra-long-term, incorporating and adding up the situation per age group (vintage group) over many decades into the future. True, technically the models are infinite but when analyzing things you have to apply a discount rate so as to bring things back to its net present value as a result of which the first couple of decades are relatively most important. However, with any reasonable discount rate - except for ultra-high ones! - we are still talking about an analysis that urges us to take into account the situation of at least 20-30 if not 50 years into the future.

Why Generational Accounting is not in synch with day-to-day Political Practice
Now when we match that with democracies that turn into short-term media circuses more and more, in which the average politician is already afraid to look further than 4-5 years into the future, there is a huge mismatch. Taking into account that young people, who are just starting their career or enjoying growth on their career ladder, care less about situations that arise when they are in their retired years than do older people, most policies 'sold' by politicians these years in developed economies are policies that imply a transfer of wealth from the younger generations to the older ones.

The older generations get more than prudent financial policy warrants. Political rationale: the moment the financial system seems to burst, you can always increase borrowing, taxes or print money and finance yourself out of the problems, again misusing future generations. But wait a minute! What are we saying here? That sounds like the situation of a once glorious firm that is now gradually but slowly losing its dominant position, seeing its cash flow position weaken by the year.

Evaluation
Kotlikoff's calculations show that most developed nations, and especially the United States, have reached the point of no return. A point where - when they want to continue doing things the way they always did - the end will be substantially lower real wage rates, unemployment problems and a demographic situation that will make our Western economies resemble large macro senior citizens homes. In that kind of situation successful firms with a product that they can sell globally will increase their foreign direct investments, thereby creating employment abroad - mostly in emerging nations - and sooner or later growing numbers of younger workers will follow the market drums and leave the country, thereby increasing the ratio elderly/workers even further.

The interesting thing is that Kotlikoff c.s. did also run calculations in which they added China - with its long-term policy, hunger for knowledge and technology and its huge savings surplus - to their models. When using realistic empirical input values the result was that China (and other Emerging Nations, especially those with big Sovereign Wealth Funds) could make the picture look less dim. Even when over time - with ongoing development - their savings rates diminish it would still be the only way out for Western governments to allow Emerging Countries a larger role in a global system, with that role implying that those nations would be allowed more direct investments in the Western world without immediately blocking them as being 'strategical' (as is done so often when it is about investments by companies, wealth funds or governments from China, Russia or the Middle East) but also a continuously growing role in the arena of financial investing. The role of Sovereign Wealth Funds will further increase and through their transfer of investment money (savings surpluses) into Western capital markets they will ensure that the amount of available capital per worker in Western countries will one or the other way translate into productivity growth that is sufficient to avoid the collapse of real wages.

But unfortunately....Western governments do still think they can 'solve' it the old way. I.e. do it themselves. Without the rich Emerging Markets. But the only way that that will work is by using all the instruments that Kotlikoff warns against and that will in the end lead to burdens on growing numbers of people in current and new generations that will outweigh a reasonable percentage of the resources available to them.

It is indicative that Kotlikoff - working together with various scholars that were linked to the US government as adviser (including himself!) when coming up with a proposed new tax system consisting of a retail sales tax of 33 percent that should replace income taxes (including all kinds of deductions that would lead to an opaque system that is prone to fraud), a restructuring of the health care sector and social security system - was not received with a warm welcome. On the contrary, the direct influence of him and co-scientists expressing this kind of ideas on the government went actually down! They did not want to hear this kind of stories about governments facing bankruptcy unless they overhaul the fiscal, health care and social security system.

Interesting stuff, that confirms that Emerging and Frontier Markets are the place to be. It also makes it clear as to why so many Western nations do not want to stop colonializing the Middle East.

But what we don't understand
Is the work by Kotlikoff that of a visionary that so far was not as well received as some of the others (e.g. Taleb and Roubini) were for the nomination as Professor of Doom? To a certain extent yes. We believe that the main reason for this is that the others translated their warnings into a so-called 'short'-selling strategy in which investors bet against the growth of the system. Kotlikoff feels that the Western financial system - taking into account the financial state of the system - is basically a pyramid game and going against that in short transactions would be way too dangerous and maybe even immoral. His solution would probably be increased pressure on governments and increased investments in Emerging Markets, with the reason for the latter being that the longer Western governments refrain from going for the 'only' solution the lousier their bargaining power when they will have to accept a large-scale entrance of EM investors to their markets. At that time the latter can acquire stakes in firms at a lower price per share, thereby further improving the relative position of EM investors and the firms they represent. Over the last 10-20 years the willingness to invest in EMs was lower than the willingness to invest in short positions. Maybe that explains.

And what we also don't understand - actually, we think it is the only big flaw in Kotlikoff's work - is why he did not touch the issue of Military and Defense spending. That is about one-third in the US. Why immediately go for Health Care and Social Security cost cutting when the policy of trying to rule the whole world your way through a dominant military force is so much against your longer term interests when knowing that you are - by doing this - acting against the interests of the nations that in the longer run are the only ones that can save you financially. This would only be rational in case you want to follow a colonialist strategy of gaining control over foreign resources (while telling the rest of the world it is because of security reasons that you act the way you act) and when you are indeed willing to go all the way with a policy that is so much against what you stand for as a country politically. With Western nations in the longer-run not willing to go all the way against bigger nations (China, Russia, Iran etc) it is clear that the cost of the military apparatus is way too high a burden when taking into account the state of the economy. Dialogue with giants - even the ones that you don't like - seems to be far more efficient and through international trade it could lead to a safer world with a larger amount of financial and political equilibrium. Let's hope that Kotlikoff in one of his future paper's will also address this issue.

References
For more information on all of this, visit Kotlikoff's Wikipedia page or his own personal website with a lot of interesting information.

And click here for the link to LMG's slideshare page with the original 2006 article by Kotlikoff.

The Fisher Equation in a Changing World: Why Emerging Markets are the Future

2011-04-10T20:33:00.000+02:00

Introduction

Irving Fisher was a great economist. One of the greatest actually, according to Chicago Professor and Nobel Prize Laureate Milton Friedman. But although his contributions to academic theory were gigantic in more than just one area, we do especially like the Fisher Equation that states that the money supply (M) multiplied by the velocity of money (V) – i.e. how many times do you use that money during a year to buy goods or services – is by definition equal to the number of transactions (T) multiplied by their average price level (P). Economists started to interpret this in such a way that T would be more or less equal to the real domestic product (Q).

Irving Fisher (1867-1947), one of the greatest according to Friedman

Now, Fisher was an American and the USA is an economy in which international trade and investments are of relatively marginal importance compared to what is going on cross-border. A situation that is totally different from what is going on in most countries. For instance: in LMG’s country of domicile – The Netherlands – about 50 percent (!) of both imports and exports are related to international transactions, with Germany being the most important market for us. At a global scale, a world version of the Fisher Equation

M(w) x V(w) = P(w) x T(w)

would be a neat tautology that is always right. With w indicating the global (‘world’) aspect.

Historically, with Emerging and Frontier Markets being poor, there was not much of a problem The world was basically the US, Canada, developed Europe plus Japan. And whenever we went through a phase where the US would import too much, the ‘Euro’ dollar market (M abroad) would one way or another find its way back to Wall Street as a result of which the US consumers and government could continue their spending – or should we say ‘’borrowing’’ ? – spree. In other words: financial markets were the equilibrating device that kept the whole system stable.

The World has Changed

But the world has changed. The moment we started to buy a growing number of products from countries like China in cheap labor related trade, money was flowing away to China. It is therefore no surprise that China is the world champion when it comes to foreign currency reserves and gold.

Foreign Currency and Gold Reserves: Look at the Emerging Countries (in Grey)

Actually: the Chinese foreign currency and gold reserves alone were 3-4 times bigger than what the US needed to save its banking system in the 2008-09 banking crisis. And a large number of the ‘big pocket’ countries – based on foreign currency and gold reserves – are from Emerging Markets (notice the grey backgrounds). And when we look at External Debt minus Foreign Currency and Gold Reserves as indicator we see all of a sudden that the top-20 consists of Developed Nations alone!

External Debt Burdens? A thing for the so-called rich nations these days!

And one of these days, Obama has to hope for some kind of agreement between his Democrat Party and the Republicans or otherwise the American government runs out of money. Not too surprising with a debt position of about USD 15 trillion!

But it is not just a Cheap Labor thing. True, economic successes in Asia make it look that way. But when we look at the list of the world’s top-25 Sovereign Wealth Funds we see that it is just as much an Energy story.

More than half of the world's Sovereign Wealth is Energy-related!

Renewable Energy will be an important factor in due time, but at the moment Oil, Gas and Coal are far more important (with Nuclear Energy suffering setbacks due to the Japan catastrophe). We actually love the following table from the famous BP Statistical Survey that is every year produced by the oil giant. It shows how many years regions could still survive if they would have to live on local production and reserves of main primary energy resources. Russia and the Middle East are the big winners, holding enormous trump cards and it is therefore no surprise that everyone wants a piece of the action in the Middle East. Post-colonialism in that part of the world is not so much related to Islam, it is related to the West not willing to accept that growing Middle Eastern nationalism is simply about getting a fairer share of what is theirs in the first place.

Available Energy per Region: Russia and the Middle East are here to stay and look at the potential of Africa.

Now, all of this would not really translate into a Global Credit Crisis if the West would allow investors from Asia and the Middle East full access to its markets. Either with the idea that they could acquire stakes in firms and/or to do big portfolio investments. In that case, we would still have some kind of equilibrium. But obviously, the moment you block this ‘return of money’, M is leaking out without translating into a neat PxT in Fisher terms. And that is what is going on in the world right now.

Conclusion

A bet on Emerging and Frontier Markets now, is definitely not a gamble. It is completely in line with structural trends in the world. Does that mean that we are totally pessimistic about the Western financial markets? No! We believe that sooner or later – forced, actually – Western markets will have to open up more to investors from Emerging Markets as a result of which they will become larger and sometimes even dominant shareholders in major Western firms. Something to be scared of? Well, we guess that it is probably just as scary as how scary it was for people from Emerging Nations when being confronted with a huge Western influence in their industries. Bottom-line is that we should start thinking in global terms. Otherwise there won’t be equilibrium. Western nations trying to solve their financial problems together, is actually pathetic. They are all struggling financially. All are faced with disadvantageous demographics. It is like the poor making plans without thinking about asking the rich if they want to invest in what is still a Western trump card: superior knowledge and education. Knowledge transfer is the key. And because that is the fact, interest by big investors from the Middle East, China and elsewhere in buying stakes in big firms or even universities in the Western world is guaranteed. And if you find that scary, you have been a colonialist for all your life. Because if you replace Knowledge by Resources that is what happened with trade between Emerging and Rich nations during the last 100-200 years.

Coercive Action: 'Yes, because…' or 'No, but…' in a Gray World Part 1 : Deriving a Matrix

2011-03-26T13:28:00.000+01:00

Introduction

Last week one of our FB friends, Usman Ahsan from Pakistan, sent us an interesting article about the Coercive Action in Libya

http://english.aljazeera.net/indepth/opinion/2011/03/201132093458329910.html

It is a clear example of a well-documented analysis of why one should not opt for Coercive Action in Libya. Usman and I ended up debating things because his position was a clear – equally well-founded - ‘No, because……’ and ours was a ‘Yes, but…..’.

Unfortunately the bulk of media representatives, politicians and scholars ends up in a Yes or No black-whitish style discussion. But we believe once again (see also our views about other issues) that international relations are almost never ‘Yes’ or ‘No’ or black-whitish, but almost always ‘grayish’.

The interesting thing of this specific case (see our Facebook Page http://www.facebook.com/NewEconomies for the dialogue with Usman Ahsan and other contributions about the topic) is that a ‘grayish’ position in which you try to weigh all factors involved, will almost always lead to confrontations with most people (!), because the ‘black’s’ don’t like what you say, assuming you are ‘white’ and the ‘white’s’ assume you are just another ‘black one in this disguise’. In other words: a gray point of view doesn’t win you the popularity prize. However, while being accused of being ‘communist’, ‘leftist’, ‘right-wing’, ‘fascist’, ‘Muslim’, ‘Christian-orthodox’, ‘Anti-Christ’ etc. (and we heard them all!) the remarkable thing is that you end up being respected by most of those accusing you. Not immediately, but after some time. When it becomes clear that you ‘say what you think, think what you say and try to do so being cosmopolitan, understanding that we are all humans, albeit with different roots and cultures, but that the things that bind us are far more important than those that separate’. Sounds soft? Well, maybe. But we do not consider softness our biggest quality. Sometimes the result of a ‘grayish’ analysis can be the tough implementation of harsh political, economic or military action.

The Gray World : More cohesion than in a Black-White one

In this and our next paper we will therefore reflect on the issue of Coercive Action using a structured approach that will of course not lead to clear-cut answers for international political issues that are often very much related to very different goal sets of those involved. But what it will definitely do, is to make clear which options are never in the interest of any of the parties involved.

Coercive Action

‘Coercive Action’ (CA) is a nice way of saying that a foreign force (or international forces) directly intervene in the political decision-taking process of a target nation or group of nations. Reasons to do so can be related to the direct local interests of the intervening nations or of the real or alleged interests of the population or a political fraction in the target nations. A combination of both is also possible of course, and very often parties try to ‘sell’ the actions as either in the interest of the international community of nations or – the opposite – totally against these interests.

When analyzing these actions it is important to understand what happened before them. What led to the status quo that in turn resulted in the interference? This is important as it will give us a lot of information about the how and why of the CA. CA is in a way an expensive and very high-risk ‘investment’ project. Its costs are high (both monetary and in terms of other damage, including loss of lives) and its revenues – monetary, political and other – are often highly uncertain.

Only when one tries to define all aspects – and do so from the perspective from not just the ‘actors’ (both CA participants and the target nation) but also ‘interested outsiders’ – at the level of not just the status quo and the CA itself but also the ex-post situation, will it be possible to judge the action. Too often we see flawed analyses in which one or the other aspect is forgotten.

And a complicating factor: to a certain extent any analysis of CA that tries to explain it in some other way than just pure self-interest is tricky, because interference in the internal political process of another nation is in-and-of-itself not correct. Don’t do to another, what you wouldn’t like yourself either. Different political system? OK, but aren’t people free to choose their own political system? Oppressive regimes? OK, but isn’t that first and foremost the responsibility of the people in a nation (even when they might suffer dramatically). Yes and no. Yes, in general, but No to the extent that very often the political status quo in a country should be judged in relation to (previous) actions by the CA nations and/or the rest of the international community.

Take for instance the situation in (post) colonial nations in the Developing World. Very often reigning regimes in those nations are not just the result of the domestic political process as a stand-alone set of events, but also directly related to actions by the CA nations and others in the international community in the periods preceding the CA action. Therefore: the linkage between the nations has to be analyzed as well.

And last but not least: this somewhat abstract analysis seems to suggest a large amount of rationality. But people are human. And humans suffer from behavioral tendencies. And these behavioral tendencies do often imply the importance of psychological and popularity-related factors. Some nations or leaders seem to suffer from popularity issues more than others.

Two ‘sad’ examples: China and the US are just like Iran top-of-the-world when it comes to the ‘number of executions per year’ statistic. Now, when analyzing reports in the global media about these nations it is clear that the association of China with economic growth, an active population and friendly restaurant owners all around the world has translated into far less attention for the ‘execution issue’ than in Iran. And with respect to the US it seems that we quite often assume that ‘in the land of the free’ with its ‘solid, legal system’ (not our words but just trying to replicate the thinking of those analyzing) those in death row are there ‘because they deserved it’. Again: we do not judge anything but the statistics and note this strange difference between how we treat various nations.

A second example is related to research work of LMG. In international investments we notice that almost every investor – be it a private or institutional one – suffers from a so-called home bias. The home bias implies an overweight of the home country within investment portfolios. Partly this is the result of currency-related factors (‘internationally you suffer from exchange rate risk, domestically you don’t’), but even when correcting for this we see that there is a home bias. And the overweight of the home country does automatically translate into an underweight elsewhere, because portfolios are in the end always equal to 100% of investments. Now, when analyzing the underweights we see that some countries are more often underweighted and to a larger extent than others. When looking at the four most important Emerging economies for instance – the so-called BRIC nations – we see that Russia suffers by far the most under this foreign bias. Again, even when correcting things for all kinds of ‘fundamentals’ (economic and political indicator differences) this conclusion remains.

Summarizing the reflections above, we can create a matrix. This matrix can be used to judge individual CA cases and derive a more general conclusion when applying it more than once.

From abstract to practical: additional considerations

A lot has of course already been written about the intervention in Libya. Actually, there was lots of talks and speculation about it already before the action. And don’t forget: already back in the 80s did Western forces show Khadafi what they could do when using their military striking power. If we would ask 10 different analysts about their opinion, we would get 10 different answers. And without any kind of matrix it is hard to really capture the ‘how’ and ‘why’ of these differences. After all CA is a sad event, one that often goes hand-in-hand with lots of casualties, innocent victims etc. But we believe that a structured approach, applying our matrix might shed light on differences between analysts and lead to interesting conclusions.

One interesting aspect of most analyses is that – and probably this is logical taking into account the ‘demand’ of the public for factual updates of what is going on with bombings during the last few days, hours or preferably even minutes – there is far more attention given to analysis of the CA Event than to the Status Quo period and the Post-mortem. And that can lead to catastrophe, especially when CA parties do not pay enough attention to the Post-mortem. We believe that what happened in Iraq post-mortem was a clear example of a CA action probably well-prepared as far as the action itself is concerned, but very poorly so when taking into account the longer-term, post-mortem factors. Military leaders cannot be blamed, they are not trained to evaluate longer-term consequences in the post-intervention period. But politicians can be blamed of course. They are the ones who are responsible, with the military just being the operational strike force. But in most countries longer-term analyses are already problematic when it is about the politician’s own country, and that holds even more so when it is about politics in some other nation. Especially so, when domestic popularity factors and election cycles have to be taken into account as well! And that does lead us already to one interesting conclusion:

CA in a country that will require a longer intervention and an even longer complicated post-mortem restructuring phase is almost inevitably not to be advised. Without exception these situations go ‘wrong’ in that the post-mortem is the real killer and not the CA itself.

Therefore: we should incorporate in our analysis the possibility and willingness to work on a ‘smooth’ transition into a solid, stable solution during the post-mortem period. And that is why we incorporate a short-term (ST) and long-term (LT) aspect to that period. For the Status-quo period we do the same thing, because very often longer-term ‘pains’ and ‘complications’ might interfere with shorter-term opportunities. Take for instance in the Libyan case the difference between its shorter-term incorporation within the Western community (be it wholeheartedly or not, and we do not even want to discuss the ‘how’ and ‘why’ at this stage; see more in the part 2 article of this contribution) and its longer-term reputation as financier of ‘terrorism’. We used italics for the word ‘reputation’, because what is considered terrorism by one, is often considered support of freedom fighters by the other. Again: at this stage of the paper we do not want to incorporate our opinion into the analysis. We just want to get a useful framework for analysis in place.

To illustrate the complexity of a CA we highlighted the CA row salmon-colored. Already 12 matrix components to fill in! However, the number of aspects outside the CA period itself is 4 times higher. And that is the problem. We believe that not enough attention is given to the correct incorporation of the period before and after the CA. Flawed analysis before and after provides a perfect guarantee for non-successful interference. Both the Russians and Western Allied Forces know what we mean when presenting the keywords ‘Afghanistan’ and 'Iraq'.

Also: as you see we reserved just one row ‘ST’ for the coercive event itself. The moment the coercive event takes a longer period of time and more or less gradually translates into an occupation during the post-mortem period the more chance-less things will be. Is this important? Yes it is. It automatically means that Western or other powers' talk about interventions in Iran, North Korea and the likes have nothing to do with CA. It is plain war and probably one that in the end can only have losers. ‘Size matters’, but unfortunately this message did not reach many politicians. Or maybe it did reach them, but they are afraid to communicate it to their voters because of the popularity impact. Assuming that no one wants a war with only losers – be it due to lack of differential fighting power between target nation and CA nations or because of some kind of stalemate within the international community that would imply that CA nations are faced with risks and costs not from the target nation but from non-directly-involved outsiders – this will lead us to the conclusion that some nations are just ‘too big’ or ‘complicated’ for a CA.

In those cases one has to follow other strategies to achieve one’s goals. LMG’s plea for a dialogue with nations as Iran is partly based on this conclusion. If you cannot afford the cost of a war – or simply don’t want that for humanitarian or legal reasons – why then not start the dialogue? Especially not, when it is clear that the Middle East powder keg situation might benefit from it!

In the next presentation we will apply our matrix to two cases:

The actual Coercive Action in Libya that is currently taking place

An analysis of the Middle East, based on a ‘what-if’ in case of a bigger-scale actions

Saudi Arabia needs - and will find - a new political strategy: Geopolitical and Financial Market Implications

2011-03-05T16:30:00.000+01:00

Introduction
Fire in the Middle East. What is going on? Recent developments caught most analysts of the region by surprise. The upheaval in Tunisia and Egypt did already lead to new governments. The new government in Egypt was actually forced - already quickly after Mubarak was removed - to go one step further than initially planned. The prime minister who was initially installed by the army had to be replaced by another, because protesters did not accept him. He was too closely associated with the old Mubarak regime.

Libya is in the middle of what looks like a civil war right now. Khadaffi c.s do still hold Tripoli and some of the oil fields/cities close to the capital, but the rebels control other regions. Khadaffi's end is near.

Tripoli: Khadaffi's Last Stronghold?

And in Yemen, Bahrain and Oman things don't remain quiet either. Actually: even Iran and Saudi Arabia (Eastern Shia provinces) are confronted with fierce opposition against the reigning governments.

In two of the four strong Muslim regional powers, Libya and Egypt, existing power structures collapsed. Saudi Arabia and Iran, the two richest of the four, are struggling as well but seem to overcome. By definition this will lead to a new balance of power in the Middle East, one of those regions in the world where it will never be really quiet due to a mixture of complicated (geo)political issues and the presence of oil, gas and other resources.

In a previous contribution we paid a lot of attention to the broader regional balance of power shifts, and how - according to us - Turkey and Iran will be its main beneficiaries with maybe even Israel benefiting. But what about Saudi Arabia? Economically the richest and most important country in the region. One that is used to complicated power struggles. And also the one that according to most Western commentators is critical for the whole world. Many state that problems in Saudi Arabia of a type similar to what went on in Tunisia, Egypt or Libya would translate into a new global financial crisis. But so far, financial indicators and economic indicators expressing investor and producer confidence seem to show far less pessimism among entrepreneurs and investors than what is suggested by political and military leaders. But a recent BBC documentary of about 4 hours of broadcasting called 'The Power of Nightmares' seemed to suggest that the latter groups - including also for the occasion defense entrepreneurs - might have a hidden agenda.If you want to watch the BBC documentary we refer you to our You Tube Channel's Videos - Geopolitics section.

Therefore, let's take a closer look at the Saudi situation to see what makes this country so special.

Saudi Arabia: Tale about an ongoing political chess game with changing rules and players
It is of course true that Saudi Arabia is key to the Middle East and the Rest of the World. The country is the second largest oil producer in the world (next to Russia), but by far the largest when it comes to oil reserves. Its reserves are approximately 255 trillion barrels in size. And not just that, these reserves are of better quality than those of most competitors and easier to extract at often lower cost than what competitors can. This ensures the country - whose sovereign wealth fund (part of the Saudi Arabian Monetary Agency) is one of the top-5 institutional investors in the world - an ongoing strategic importance during the next decades. But it is not just oil. Gas wealth in Saudi Arabia should not be ignored either.

Stanford scholar Joshua Teitelbaum's piece 'Saudi Arabia and the New Strategic Landscape' (Middle Eastern Review of International Affairs, September 2010) gives an excellent overview of the various strategic phases the country had to go through. Phases in which both the internal and external political situation complicated the overall picture. Teitelbaum warned already last year that the situation was changing. And as it turned out only months later: he was right. This will lead to a new situation, one in which Saudi Arabia - if it is to maintain its role as Western ally #1 in the region - needs help. Not so much financial help, but a new political and military solution. In other words: a completely redefined domestic and international policy that takes into account regional and global chances. Western governments have been confronted with a situation like this before and back then they made terrible mistakes. That was in the Iranian Revolution when the power of the Shah and his (military) army was strongly overestimated vis-a-vis the moral powers and influence on the poor of Ayatollah Khomeini.

The origins of Saudi Arabia - one of the two countries in the world named after one ruling family, the other being the Hashemite Kingdom of Jordan - go back to a 'deal' between the Al Saud family and the orthodox Sunni Islam preacher Shaikh Muhammad Al-Wahhab back in the 18th century. They merged their political / military interests (The Sauds) with the religious ('spread the orthodox gospel') ones of the Wahhabites. But all through history that was easier said than done.

The Arab peninsula - home of two of the most holy religious Muslim places, Mecca and Medina - was basically one big powder keg in which i) tribal; ii) religous and other political (both domestic and international) factors played an enormous role. The strategic position of the area geopolitically and the presence of oil wealth added to the complexities. So far, helped by its allies, the Saudi leadership has been capable of maintaining its position of power. They have been 'survivors'. True, oil wealth helps when trying to maintain power, but then again Iran's Shah wasn't a poor sucker either.

And although it is always tricky to forecast that things will be 'really different this time 'round' we will nonetheless try to explain why it is different.

Saudi Arabia: maintaining a balance internally
Three factors dominate when looking at the internal power struggle in Saudi Arabia. First of all, the Saud's have to ensure that tribal struggles do not interfere with their authoritarian control over the peninsula. As Teitelbaum explains in his piece (link, see above) they basically did so by giving tribal leaders career chances within the Saudi Arabian National Guard, paying them by using part of the oil money. Result: the Saudi army is definitely not the strongest and best-trained one in the world (result of not necessarily having the best guy at the right place!) but definitely one using the nicest, most modern tools and gimmicks. Saudi Arabian ally #1, the United States of America, understood this part of the Saudi strategy and it is therefore understandable that the US has even been willing to deliver new weaponry to Saudi Arabia when it knew that Israel would not be too happy with it.

Far more complicated were its struggles with religion. When looking at their 'way of life' and 'ideas for the country' the Saudi leadership always comes across as being far less orthodox than the country as a whole. How is that possible?

Over the years the original partnership between the Saud's and the Wahhabites deteriorated as a result of remaining or even growing orthodoxy on the one hand and a gradual tendency to enjoy nicer things of life on the other (the house of Saud and the growing richer and middle classes in the country). Being masters of creating winning partnerships, the Saud's thought they found a great solution: why not give the Wahhabite clerics a strong say in religious and educational affairs, so as to gain their support in other areas (international politics, economics, culture etc). Economically this wasn't too bad too probably, taking into account that the country is also the main destiny of the holy pilgrimage (Hajj) for Muslims.

Sounds tricky, right? Wouldn't that lead to growing groups of youngsters with orthodox ideas that would sooner or later turn against the Saud mainstream ideology? Osama bin-Laden is a nice example of someone who turned orthodox within a country that saw its wealth growing. Normally growing wealth and improved economics work against orthodoxy, but of course - when Wahabbites control schools and religious institutions - that is not something to be sure of.

Over the years, the Saud's worked out a fascinating solution: export the religious zealots and hope that they will not return, either because they like their new evangelist role or because they end as martyrs. Saudi religious fanatics were not just incentivised to work in Afghanistan and other Sunni dominated countries that were at risk, but Imams were also sent abroad to Western countries! Often in combination with mosques paid for by the Saudi royal family as a gift for groups of foreign workers that wanted to give expression to their religious feelings in countries like the UK, the Netherlands, Germany, Belgium, France, Scandinavia, Switzerland etc.

Exporting Orthodoxy to 'Islam Market' of Europe

Tricky strategy of course, since it led to growing tensions in those countries. To a certain extent one cannot totally disconnect the rise of anti-Islam sentiment in those countries (Denmark, the Netherlands, Switzerland, France) from these export activities. But somehow Saudi Arabia's main ally, the United States, was least affected as a result of which this strategy helped in reducing orthodox tensions within the country quite a bit.

But it was not enough: problems with orthodoxy in Saudi Arabia were not just related to struggles between orthodox Sunnis and more moderate ones. The Eastern part of the country - important because of its oil - was mainly occupied by Shia Muslims. Shia muslims were suppressed fiercely. The Saud's were afraid that not doing so would imply giving Iran a stronghold from within. That the poor Shia's were actually asking for rights that in any other country would be considered legitimate was beside the point. Western allies remained silent, hoping that violent actions against the Shia population - of a similar type as what Khadaffi is now practicing against his own population - would be temporary. Reason: now that the Shah was gone and Shia Muslims have proven to be a nasty countervailing power within the Islamic Republic Iran as well as via Hezbollah in Lebanon and through support of Hamas in Palestine, with Syria as a nasty ally, something needed to be done. Iraq and Bahrain, both under Western control, have strong Shia populations but they cannot be given their rights. That was the standard strategy, one that was supported actively by Saudi Arabia. Even recently when in Bahrain - faced by an uprising in line with what we saw earlier in Tunisia and Egypt - Shia protesters were not just faced with police and troops from the country itself, but also by tanks from neighboring Saudi Arabia.

But, OK, Shia Islam is orthodox as well and this was not about simply keeping the orthodoxy out. Remember: within Saudi Arabia the Wahabbite Sunni muslims are also orthodox and they play an important role. What to do with growing groups of non-muslim Western specialists working in the oil and financial industries? Make sure you create strict rules for them in Saudi Arabia (oil specialists) and establish a financial center (Bahrain) outside your own country in a Shia area so as to keep the Wahabbi leaders satisfied. In combination with possibilities for Westerners to walk around in shorts, 'do things you don't do in Saudi Arabia' in Dubai this should suffice. Wouldn't it? To a certain extent it did, but it was a time bomb. And it was especially irritating, that one of the biggest advocates of orthodox gospel from within Sunni ranks - Osama bin-Laden of Al Qaida - started to be more than just an irritation to the US and the Rest of the World.

Challenge 1:
Over the years, the Saud's and their Western allies tried to play with orthodoxy. With respect to the one from within Sunni Islam: give them less important rights or export them. And with respect to Shia: don't give them any rights and fight them fiercely. Obviously this led to sympathy for the orthodox movements, especially because the Western and Saudi moderate or non-Islamic message lacked credibility in the eyes of many Muslims.

The fact that the relatively moderate and charismatic Grand-Imam at the Al-Azar mosque in Cairo, Muhammad Tantawy, died at the age of 81 in 2010 didn't help either. A new moderate Sunni leader would have to establish international influence and charisma first.

The late Grand-Imam Muhammad Tantawy:

His charisma and moderate gospel are deeply missed

Saudi Arabia and its international political challenges
Internationally, the relationship between Saudi Arabia and the UK has always been rather tense. This is directly related to the more positive relationship between the UK and the Hashemite Kingdom of Jordan. The origin of the Hasmemites lies in today's Saudi Arabia and that explains. It was therefore not a big surprise that Saudi Arabia has always betted on the US card. This paid of well ever since the first political partnership was cemented by oil agreements as well. This happened already during the Second World War, when the US wanted to make sure it had alternative oil sources next to its domestic reserve positions.

And later - as countervailing power against Soviet threats in the Cold War period - the close relationship with the US was expanded further. That the cooperation with the US would indirectly imply a closer relationship with Israel didn't really matter. After all: the Saudi agenda was not about Israel and the Palestines. It was about the domestic power play described above. And as far as international aspects were concerned: the main fears of Saudi Arabia were the Hashemite Kingdom of Jordan and its influence/ambitions on the one hand and the communist/Baath ideologies that were supported by the Soviets during the days of the Cold War on the other (with countries like Iraq and Syria as dangerous strongholds, with - at a certain point in time - risks of communist uprisings in Oman and Yemen also more than real. ''Israel? Who cares! The good relationship with the US and the US's ties with Israel will ensure a satisfactory solution there.'' That was the line of reasoning of the Saud's. One that - of course - didn't make them more popular among orthodox Islamists, be they Wahhabites or Shia.

The rise to regional power of Iran: everything changes
With the Islamic Revolution in Iran (1979) and the consecutive installation of the Islamic Republic the Shia stronghold on the other side of the Persian Gulf became Saudi Arabia's main worry. And not just that of Saudi Arabia. It was also a big worry of the Western world.

Ayatollah's Khamenei and Khomeini;

Two leaders of a growing force in the Middle East: IR Iran

Iran was already a top-5 giant in both oil and gas, and the fact that new coal reserves in the Northwest of the country made the Iranian leaders even more confident, didn't help either. The only chance would be that the orthodox Shia clerics and government in Tehran would mismanage the economy to such an existent that internal upheaval would cost them power internationally. However: the aforementioned continuous actions against Shia populations in Iraq, Bahrain, Lebanon and elsewhere didn't really help. As always they create more cohesion within an attacked group. And economic embargo's are also not effective weapons when you know upfront that they are not very effective, due to a country's existing resource wealth with suppliers elsewhere that don't join the embargo (China for instance).

This has led to a situation in which Saudi Arabia needs to find a new strategic position, one that creates a new international and national strategic balance. As indicated in an earlier article we believe that this challenge is too large for Saudi Arabia and/or the US without new support. Turkey seems to be the regional partner that will have to play a growing role.

Erdogan's Turkey:

Expected to play a growing role within the Middle East

First, because with its size and relatively good relationships with both the Western and Middle Eastern world it can play a natural role as intermediary already. Second, the country is population-rich, militarily strong and part of NATO, but resource-poor. This provides it with a logical possibility for synergy with other Middle Eastern nations. Iran is not really an enemy but a trading partner for Turkey. When looking at the internal new status quo in some of the countries that went through revolutionary upheaval recently (and we include Iraq), it seems out of the question that we can continue to deny orthodox Muslim groups (especially Shiah) their rights. The more we do so, the larger the likelihood that these groups will attract even people who would otherwise opt for a more moderate Islamic alternative or even secular alternative.

When seeing how Saudi Arabia has maintained its power balance with Iran thus far, we can only conclude that Saudi Arabia has to - one way or another - work on some kind of cooperation with the big enemy. Iran is simply too strong (militarily) and rich to consider Iraq-like actions a reasonable alternative. Softer diplomacy seems the only option in the Iran case, but it is not a bad one, as a recent paper by Jentleson and Whytock entitled ''Who 'won' Libya: The Force-Diplomacy Debate and its Implications for Theory and Policy'' indicates. We are pretty confident that the historical track record of the Saud's as survivors will make them understand that. But will Western nations - first and foremost the US - understand this? Recent developments in Libya, that show a quick demise of Khadaffi - after a sequence of different style softer and tougher diplomatic and military actions did already lead to a change for the better in Libyan policies since 2003 - are indicative of the potential of policy change through dialogue. Jentleson and Whytock show that efforts to go further will abandon reciprocity make success less likely. Especially when taking into account that all indicators point out that Iran will be a harder nut to crack than Libya.

Financial and Energy Market Implications
The complicated position in Saudi Arabia and confusion about what is going on in the rest of the Middle East do translate into ongoing uncertainty and volatility in financial markets and the global economy.

What to expect economically in the Middle East?

And with respect to Saudi Arabia: will it imply a collapse of the country, stagnating oil production and a new global crisis? We doubt it. That might be a general feeling in the Western world, based on our belief that without direct Western interference the Middle East can only collapse, but it is not realistic. Of course, less control over Saudi Arabia as oil-richest country in the world will cost Western nations a lot, since oil wealth was actually what led to the strategic partnership with Saudi Arabia in the first place. But it was at the expense of an increasingly unstable status quo between Shia and Sunni Muslim countries and terrorist threats from Al Qaida and the Taliban that could be controlled much better as soon as there is some kind of regional political balance of power between Iran, Saudi Arabia and Turkey in a new status quo that would maybe cost us some direct control in Saudi Arabia but that would lead to trade opportunities with Iran - one of Goldman Sachs Asset Management's Next-11 countries - once we are smart enough to accept them (albeit under certain conditions) in the league of non-rogue nations.

Two of Three Middle Eastern Next-11 giants (TUR, IRN) will

and the Third (EGY) might benefit in the longer run

Turkey - another Next-11 country - is already benefiting economically from that (Iran is now good for approximately 20 percent of Turkish export/import (combined)) and the world could be next.

At the moment the oil surpluses of Saudi Arabia don't bring much, other than the fuel and new monetary assets added to their wealth funds. You cannot export more in other areas: the country is simply not populous enough. On the contrary, regional economic growth - with populous countries Egypt, Turkey and Iran being the prime areas of development - and less 'control costs' related to Western presence would lead to a less volatile equilibrium in the longer run. One with relatively lower energy prices (less nervousness translates into more moderate price rises) - which is also in our interest - and broader economic development. That is not just in the interest of the Western world, but also of Saudi Arabia. We are confident that the Saudi's and Iranians are pragmatic enough, but will Western investors and governments understand it too?

In the short run volatility in global financial markets will remain high, which implies that volatility related instruments are definitely of interest to investors, with oil and gas prices most likely not at their peak yet (oil price levels of USD 200 are not impossible). Economically, in the longer term this will lead to interesting chances to buy in Turkey at a discount, because current valuation levels there do already incorporate the energy-poorness of the country itself, but not yet its growing regional importance, and later - when opting for a new strategy along these lines - definitely in Iran. Selected Egyptian stocks might become interesting as well, albeit that one should follow a strict deep value strategy which bets on firms that can sell their produce regionally.

The Middle East: Liberalism? No! Islamic Renaissance? Not Really! Demise of Postcolonialism? Yes!

2011-02-23T15:18:00.000+01:00

INTRODUCTION

Sometimes it is good to be busy with other things. To be involved in business dealings that have nothing - or not much - to do with the turmoil in the Middle East. It is clear that we are in the middle of a period that will be labeled as a 'historical' or maybe even 'decisive' one years later, when historians and political scientists will write their analytical books about this period.

The Middle East; A Change is Gonna Come, One Way or Another. No Matter What we Do.

But at the moment we are in the middle of a media circus. TV stations, Radio stations, Social Media...they all try to bring the latest news. With the definition of news resembling that of gossip more and more. No matter if you are talking about CNN, Al Jazeera, or any of the other official news sources: in the end they all have a business model linked to the amount of followers and even more important: the amount of advertisers.

Aren't the Social Media different? Yes, to a certain extent. But unfortunately they have become a huge collection of good, less good and despicable stories, comments with the distribution over these 3 categories unfortunately not being 'normal', but skewed to the latter. The bulk is shouting, screaming and/or politically induced without much depth.

That is why we were ex-post happy that we had to go through a situation in which most of our firm's senior people were focused on something different, but unfortunately oh so similar because it dealt with plain economics.

ECONOMIC AGENDA

What is going on in the Middle East is not so much a religious agenda in itself, although - as we will explain below - the way things played out has indirectly provided religious groups with tremendous momentum. The region is still relatively homogeneous in this respect with the vast majority of people involved being Muslims. True, their might be differences in their level of orthodoxy, or in their categorization as either Shia or Sunni. But was that what led to the explosion of revolutionary resistance?

In a recent speech for followers in Iran, president Ahmedinejad even claimed an Iranian indirect positive signaling effect by saying that it was all spurred by the great example of the Iranian Revolution back in 1979. We doubt strongly that this is the real story. And his forecast that it will spread into Europe and North America seems even more far-fetched if not ridiculous. He is of course following his own political agenda there.

But of course. This is also the time of foreign politicians all around the world screaming and shouting that they know what to do about the Middle East. Or that they have always warned the dictators for this result. The only big nations that seem relatively quiet in terms of comments and statements are the Chinese and the Russians. But aren't they always when it comes to criticizing foreign authoritarian regimes? And for well-understood reasons.

Europe and the US - the former colonial powers - still mainly treat the Middle East as an energy-rich colony. It is amazing how they seem to believe that a simple switch of leadership support - away from the dictators that were once their friends - and a consecutive embrace of the revolutionary resistance and a demand for human rights, democracy etc might enable them to maintain some kind of status quo.

Economic Exploitation with Postcolonialist Tendencies:

But was it really smart business thinking?

But that is the problem with the Western agenda. No way it will involve a real demand for democracy in the Middle East. Democracy! Think about free elections in Iraq or Bahrain: two countries where the Shia majority will wipe away opposition and gain control. Next step? Of course, a new government that will be congratulated quickly by Iran not just in words but also through economic support.

And what about Egypt? Aren't democratic changes possible there? Maybe, but as far as we can see the Muslim Brotherhood will remain a forbidden albeit well organized huge force in the country. But actually: now that there is less media attention for Egypt - it all went to Libya where Khadaffi is in big trouble - we see a subtle change. For the first time in more than 30 years Iranian navy vessels are allowed to travel through the Suez canal. In other words: the new leadership is milder towards Iran than Mubarak was. And there is of course nothing wrong with that. One is not to be convicted until proven guilty. And whatever 'proof' Westerners or others can come up with concerning Iran, there are at least an equal amount of cases showing the guilt of others, including these same nations. Actually, in terms of prophylactic measures there are dozens of countries who have done far more than Iran, but they somehow get away with it. The ayatollahs have a huge popularity problem. Similar to what Russians always have.

China can get away with almost everything, notwithstanding the fact that the Chinese leaders suppress any form of resistance probably in a far more radical way than the average Muslim leader in the Middle East (maybe with Khadaffi as exception when listening to his speech yesterday) would even think of. But is there much focus on China other than excitement over its economic possibilities? Not really.

The excitement over Libya is large. Far more than there was about Tunisia, Egypt, Bahrain. Reason: this is a big business country. Oil- and gas-rich. Khadaffi who moved from being a big enemy of not just us in the West during his period of Green, Islamic Socialism has moved to a position as friend of the West since 2003. The economic link with Italy improved to levels that can be considered 'warm and friendly' with dozens of firms and corporations on both sides of the Mediterranean benefiting and a substantial percentage of Italian energy needs being taken care of by Libya. But business relations with other European nations and the US improved as well. It is therefore pathetic to see how herds of Western politicians try to portray 'anger and ignorance' when being confronted with weapon deliveries to Libya or atrocities committed by Khaddafi. As if they did not know!

And now that the end is near... Is he facing his final curtain?

The Libyans paid of their debts in Lockerbie didn't they? That is the line of reasoning most foreign governments and corporations followed. And they are rich (both financially and in energy resources), and can therefore now be seen as a friendly nation. And not just that: Khadaffi's role and influence in Africa could help protect Western interests there at a time in which China is expanding its powers on the Black Continent through huge investments.

But Khadaffi is now finding out the hard way that there are no friends in international politics when you go too far. Just like Mubarak did. And he and his regime did so during the last 40 years. Triggered by the international freedom sparks, resistance started and spread over the country from Benghazi via Tobruk to Tripoli...he and his sons cannot escape (or was the freaky, almost surreal speech yesterday shot from a film studio in Venezuela already?). It is indicative of his going too far - losing track of reality - that some of his foreign representatives (ambassadors etc) and his second man, an important army general (General Younis)- were among the first to switch sides.

THE BANKRUPTCY OF THE 'OLD' MIDDLE EAST POLICY OF THE WEST

And that is one of the problems for the Western world. You can say a lot about Muslim resistance. Call them terrorists or whatever. But you have to give them credit. Just as much as they were against certain things 30-40 years ago, they are against them now. Irrespective of the alleged dangerous powers of their enemies and irrespective of their wealth.

The power of religious 'business models' - be they Islamic, Judaic, Christian or whatever - is their stability and well-understood deeper intentions with in most cases a focus on social work for the poor and lower middle classes. Khomeini used it when leading the revolt against the Shah in Iran from his exile in France. And all around the Middle East we will see that those who only followed economic interests will now have a problem there. They have lost credibility compared to religious opponents. Not that these guys didn't follow certain economic interests as part of their bigger goal, but at least there goal was about so much more (when seen from the perspective of the lower classes in society).

And that has not so much to do with a new Islamic Renaissance as it has with the demise of Post-Colonialist economic opportunism. Was the period that we left behind us to the advantage of those that followed the opportunistic model? Either foreign influencers, or the local authoritarians?

Not an Islamic Renaissance, but the demise of Postcolonialism

Well, the corrupt leaders in the Middle Eastern countries involved will have to wait and see. Will they be able to get their hands on what they stole? Switzerland's actions against Mubarak and his bank accounts are just the beginning. Tunisia asking Saudi Arabia for the arrest of Ben Ali is another and there is more to follow. The well-known visible cases might get away with things when it comes to imprisonment, legal cases etc while probably having more of a tougher case if they want to reach their wealth. Although...think about the leadership in Iraq! On the other hand, the less visible opportunistic followers that were part of reigning families or one way or another associating with them are in big trouble physically, but might have a bigger chance to save parts of their stolen wealth.

And what about the foreign influencers? Directly and indirectly - through their oil and gas companies - Western nations will probably not really be held responsible like they were in their regular former colonies. They had on the one hand a good time, but on the other it is also clear that the continued nervousness in the Middle East (partly because of the dependence on natural resources and partly because of the geo-political problems related to Israel, the Palestinians, Iraq, Afghanistan and Iran) has resulted in higher energy prices, increased volatility of those energy prices and 'terrorism related costs' both related to local presence in the region and damage outside the region.

An alternative model in which it would have been understood that the current stand in the Middle East after the fall of the colonial empires did resemble postcolonialism and in which those countries would have been given more freedom to grow in their own way, with us dealing with them through trade and business relations, i.e. from a distance instead of through direct presence in the region, might have led to less skewed income distributions, more domestic economic growth, and slightly lower oil and gas prices and accompanying volatility.

CONCLUSION

So; what is the 'value' of the excess oil and gas reserve revenues that went to the West via oil and gas companies during the last 50 or more years minus all the costs related to local presence, volatility, higher prices in recent years when we have less control over these nations and lost economic trade in countries that were basically seen as exploitable commodity fields?

We believe that it is incredibly small if not negative. And that is when purely focusing on the economic numbers. When adding the moral costs related to doing to your neighbor (post-colonial occupation) what you would not like yourself) it is definitely a negative.

And it is exactly that combination - financial and moral costs - that will hopefully lead to a new start in the Middle East. The right reaction should be a loosening of control and Western influence. But the first reactions by politicians on both sides of the Atlantic seem to indicate that we will probably get some kind of more subtle form of the same. And we would not exclude that Turkey might play a growing role in that process as 'Real Politiker' (German word) extrapolating their current pragmatic stand that has led to economic growth (sigh, again) and growing influence. But it will of course be more of the same with different main actors on the local stages as new country leadership.And that is at least something. A new leadership that remembers how the former leaders went too far.

But through the influence of China, Russia, Iran, India the geo-political situation (and the economic one now that energy prices have made local Sovereign Wealth Funds in the Middle East forces to reckon with in international capital markets) ensures a better equilibrium. And that is good, not just for the world politically, but also for all of us economically.

But of course, the economic benefits will only be enjoyed in the longer run. The local people in the Middle East - who deserve our deepest respect - will one way or the other first have to go through a period of continued hardship. One in which they have to build - and not rebuild since they never got there in the first place - a new concept of a Nation.

And financial markets? As you know we believe in the longer term prospects of the Africa - Middle East region. Did recent developments change that? Not at all. If anything, we can expect a more egalitarian society within the countries of the Middle East with our energy hunger remaining unchanged. This does translate more into buying opportunities in various North African and Middle Eastern countries than in reasons to stay away for a longer period of time. But obviously, we need to closely watch the political situation and advise those who are invested in the region to sell part of their holdings when they have a profit. If not, stay. Not in the region yet?: wait along the sidelines: your buying opportunities will come during 2011-12

Xenophobia and its impact on our International Risk Perception: An Example

2011-01-02T13:18:00.000+01:00

Introduction: our difficult relationship with Statistics

The most rewarding thing of specializing in a specific field that is defined internationally instead of domestically is that your world gets smaller. Or should I say: our scope and outlook gets bigger? Not sure, but we believe that we are lucky. International investment consultancy focusing on Emerging Countries and Asset Allocation enables you to analyze different countries, travel to them and meet people from those countries.

One of the most appreciated aspects of this internationalization of scope is that you find out that in the end we are all human and that the differences between us are far smaller than the similarities. Don't get us wrong, we are not idealists. Not at all. But by combining the qualitative, (inter-) human experience with quantitative and statistical rigor we feel that we are capable of uncovering a lot of ridiculous fears, theses, anecdotes, dogmas and things that are just plain wrong.

How to Lie With Statistics: Sad common practice innate to most of us

Sometimes these stories are 'innocent' in nature and just make you smile. Like the one in which it is shown that far more than half of the people in the world believe that they are great car drivers. And within the male group an enormous percentage believes they are better drivers than both their neighbor or more in general: women.

Now: taking into account that most men are not living next to female neighbors that provided them with this first hand empirical knowledge, even a little bit of statistical knowledge would already lead us to the conclusion that this cannot be true. And of course, the majority believing that they are better than the average can only be right when they define it as a question that is not about the number of drivers but about some kind of driver rating. In the latter case it could be possible that the bulk of people is slightly better than the average with the remaining minority being terrible and a danger on the road (i.e. far less good than the average rating). But that is not how people interpret it. Most of the time they just refer to the number of drivers, making it clear that their application of statistics is more than flawed.

This is corroborated by the fact that most people immediately reconsider flying by plane after a plane accident somewhere in the world, with quite a few canceling their flights and/or ask for government committees to analyze what happened. The next moment they are happy to jump into the car, exposing themselves to a statistically far bigger danger. Even on days when the daily number of car deaths exceeds that of the number of victims in the plane crash that day.

And it is even worse with 'international' statistics

The moment that we move international things get worse. In a previous entry we talked about the strange 'home' and 'foreign' biases in investments. The 'home bias' was well documented for a long time already, implying that people overweight their investments in the domestic market because of a combination of currency reasons and risk considerations. The other man's grass is not greener, but things at home seem safer. Isn't it true that we do know more about what is going on at home? To some extent yes, but how sure are we that this extra knowledge is 'priced' and that it will give us extra return or lower risk? Most of us don't know and don't care: with respect to things happening at home we feel more safe. Period.

The 'foreign' bias is part of a body of research that entered the academic investment world more recently. It is related to us emotionally feeling different about all kinds of factors related to risk, return, fear, justice et cetera when comparing different places in the world outside our own country.

Conclusion of the research: the larger the cultural difference and/or the bigger the 'fear' (correctly so or incorrectly so, that is not even important), the larger the 'foreign bias'. I.e. the bigger the underweight in our investment portfolios for those regions.

And: the impact of this flawed international factor extends far beyond investments. Even in a period of 'Globalization' the good old xenophobic monster is still alive and kicking. Sometimes we believe that it might actually have grown. Why? Well, if something is totally foreign and strange and you know nothing about it, didn't see it on TV et cetera, it is just plain exotic isn't it? It is only when we start to build knowledge in the terribly flawed way that is second nature to most humans - i.e. including flawed applications of statistics - that we end up with strange 'foreign biases'.

That is what we thought of when finding the attached link below in a Twitter message by one of our information sources.

Government-spread xenophobia

Xenophobia: Everyone is a foreigner somewhere. Nothing wrong with that, as long as you don't translate it into being an ignorant idiot that left his or her statistical knowledge and eye for details at home.

The US Embassy in Slovenia came up with the following list (see URL link at the bottom of this article) for US citizens traveling to Slovenia. Some of you might think, those people in the Embassy know what they are talking about. I don't doubt that this is what they talk about. But is it based on unbiased knowledge? Definitely not. When looking at crime statistics on a global scale it is true that Eastern Europe is not Vatican City, but then again there are dozens of places in the US that aren't exactly nice spots to visit either.

But in all cases it is still true that the car trip to get at your destination from the airport is probably of similar danger...and we would almost be inclined to say: no matter where you are, when not knowing much about the place you are visiting. I still remember the time when people traveling to Miami had to be told how to get to South Beach from Miami International Airport. 'Don't take the wrong turn or you might end up in dangerous territory where Hispanic gangs rule'. Actually, one of our principals recalls that something like that ended up in the assassination of a German tourist exactly at a time when our principal was there to do a presentation at a seminar at the Fontainebleau Hilton at South Beach.

Did or do we translate that into the idea to create warning pages in German on some kind of new website project of LMG, on a page entitled 'Risks in the US'? Not at all: to be honest, when reading what happened to the German traveler our principal felt that the guy was kinda asking for trouble, being plain ignorant. Same in Washington DC. Not sure how things are these days, but we recall that years ago when doing a presentation there we ended up driving past Capitol Hill in the direction of Baltimore finding ourselves in a neighborhood that looked different. And when we say 'different' we mean different not in a negative way. True, it was a deprived part of town, but different has to be interpreted as us understanding that we probably should not be there at that time looking the way we did and with the things we were carrying. A similar connotation as the one we would have in certain parts of Amsterdam, Rotterdam, Utrecht here in the Netherlands. Again: it is also a matter of adjusting. Our principal would not be scared to go there, just that he would dress appropriately, act differently etc.

Aha! Now we are getting somewhere. So when it is in our own country, we often immediately sense or understand where we should not go or how we should act. What about international?

Aren't governments right with pages like the attached one about Slovenia? No, read through it and see that it is a general text. Not a text telling us where not to go, what not to do etc. In our own country we do not say that we should not live there because of the danger in neighborhood X of city Y or because yesterday this or that plain was hijacked or a bank robbed some 500 miles away. Internationally we loose track of nuance and generalize. Scary that this is official policy. And believe us, this is definitely not something only American government officials in embassies and consulates do albeit that they are above-average sensitive to it. You can already see that in the approach of many Americans to international investing. Institutional investors in the US still define asset class allocations as either domestic or international. Not some kind of geographical distinction that enables you to fill in nuance. Nope: it is either 'domestic' (read: safe) or 'international' (read: scary). The moment you act like this, you are asking for trouble.

Other countries are sensitive to the same problems, with all of those non-cosmopolitans traveling abroad and believing that they should not adjust adding additional fuel to the problem. Be sure that every sub-urbian American tourist will adjust when visiting the wrong parts of Chicago, LA, Miami, Washington, New York, Detroit, Philadelphia or Atlanta. Or even better: they would probably not go there and definitely not talking loudly suggesting it is their prerogative to be who they are with shorts, colorful shirt and camera in front of them. They are not crazy! Who would want to be dead! But whereas in our own country we translate news about victims ending their life this way (or when they are lucky just ending their relationship with their wallet and golden watch!) as 'Was the idiot asking for it?', we often translate it into outrage about foreign countries and foreigners when it is about some other country. And the more different the country, the larger the probability of ending in trouble with the unadjusted behavior and the larger the probability of us translating it into country fear and an increased foreign bias.

And voila: half of the problems with Eastern Europe and the Middle East are explained. Eastern Europe and the Middle East are areas where still quite a few Westerners go to and that somehow are culturally reasonably different. Result: the biggest probability (and now we are talking real statistics) of ending up in trouble when not applying true rational cosmopolitan savviness. Governments can do a great job preparing their people for this kind of experience. And people themselves can do even more: learn how to read Statistics as if they are the same stuff as what you experience nationally. The world is your oyster, there aren't two oysters: a criminal one abroad and a safe one locally.

It is therefore that we had to smile, but at the same time shake our head reading the attached page from the US Embassy in Slovenia. So just plain wrong! But one of the good things of the US is that they do at least write these things down, register and record so that sooner or later we can test and proof how ridiculous this all was. In many other nations government opaqueness ensures that international anecdotes and folklore can continue almost forever. See for instance the recent suggested changes to press laws for both national and international journalists in Hungary. But then again: seeing this incredibly poor page, we had to think of something else. Something we wrote earlier as well.

What has Wikileaks to do with Xenophobia?

When seeing this stuff, it confirmed our fears that it is not Julian Assange that we have to fear. Or the deeper information content of Wikileaks. It is good that there is a certain level of transparency and those scattered, fragmented cables were of a level that was so questionable that - if this were supposed to be an important source of information in International Politics - we are just plain lucky that we did not yet experience a Third World War. Thank God at the higher levels people are smarter. It reminded us of those Chess Pundits that are always present at matches about the World Championship. While the Grandmasters playing the match for the big title (with chess knowledge 1000 times bigger than that of the audience) think for 10-20 or more minutes before doing their next moves in complicated positions most pundits know what to play within a few seconds or at best minutes.

Beati Paupera Spiritu as the Roman Bible says. Lucky are those who enjoy the 'benefit' of a simple mind. And then we are back in our standard LMG story about a world that is not black or white but shades of gray. People don't like gray. At home the blanket covering their world is transparent so that they don't fear an excess number of gray situations. But when abroad most of us - knowingly or unknowingly - translate our ignorance into covering that world with an opaque blanket. Result: less things seem white, what is gray turns black and what is black turns even blacker.

And that is what we learned from the Wiki cables. A big sequence of simple minded blanket fragments translating the world outside our own nation into a caricature.

Anti American?

We are fully aware that quite a few of the examples we were able to use during the last three quarters of a year to stress our point about the world being shades of gray and not black-white were related to the US. Are we Anti-American? Not at all, when looking at the developed world as basically three blocks - North America, Europe and Asia-Pacific - we actually believe that Europe is the sickest man of all three. And be sure that there will be plenty of examples, albeit probably more economic in nature and less political, in which we will illustrate this. But to some extent our role as researchers and commentators when translating news into more in-depth pieces of evidence and/or quantitative factors that find a place into our valuation or risk systems is a bit like that of stand-up comedians. The bulk of news flows in sequences consisting of different types of news. Sometimes this or that country is in the spotlight. Sector distributions over time differ too when it comes to information flow et cetera.

International M&A Market: Even in the US now a two-way street

Actually: when reading the economic news in US media, if anything, we have a feeling that LMG is far more optimistic about positive dynamics in the US society than many Americans themselves. And that is in a way also the result of what one could label natural behavioral flaws mixed with Xenophobia. At a time when the world is recovering from a big crisis, people tend to extrapolate (now negative) trends too long. Just like they will extrapolate the next recovery too long. New for Americans is that they are not the sole catalyst of the world anymore. China and other Emerging Countries are now important as well, economically. And that leads to the introduction of some xenophobic tendencies into the analyses of even good economists and policy makers who previously got used to thinking mainly domestically and/or of a world led by the US economic machinery with Europe in a comfortable second place. We believe that M&A opportunities within the US are popping up in numbers that almost grow by the day. It is just that people have to get used to investors with big pockets now being foreign entrepreneurs as well. And when we say foreign we mean truly foreign. I.e. not an Irish firm buying an enterprise in Boston, or Carlos Slim from Mexico buying stakes in firms in El Paso, Texas. Nope, we are talking about Asian firms or even Middle East Wealth Funds buying substantial stakes in large stockmarket-listed entities on Wall Street.

Dozens of text books have been written about this topic. International M&A's. Most good texts published by US publishers. But when reading them it became clear that it was still mainly understood as US firms or private individuals buying stakes abroad. Be happy that in a period of crisis things are now a two-way street!

ATTACHMENT

What is scary here? Official Link to US Embassy Website (Slovenia)

http://slovenia.usembassy.gov/security_tips.html

I am sure that those who live in Slovenia or have visited the country will be smiling now. Of course: there is always a few examples who did experience bad luck OR (but they won't admit) who did something silly. You can react but be warned: we will apply proper statistics when using your input in (re)defining our judgment.

Happy Holidays!

2010-12-24T17:39:00.000+01:00

The LMG Emerge team wishes you a fantastic holiday season and a great 2011

Thanks for your support!

Erik, Andre, Eloise, Noah and Erika

How to Not Find the Right Investment Advisers - Reflections about Madoff and Deserts

2010-12-21T14:32:00.000+01:00

It happens all the time, and it will happen again.

The end-of-year period around Xmas is a good one for a reflective note. This was the year of the big Bernie Madoff scam. Why do even intelligent people continue to fall for Pyramid scams? Answer: because the Investment Game is not a simple one. Performance analysis of good investments in either individual stocks or bonds or mutual fund strategies is a profession. But yet, and that is the sad thing for professionals in the financial industry: unlike in the medical profession, too many amateurs believe they can do it. Would you consider doing some complicated surgery yourself? Nope. Would you consider putting all your money in 'that fantastic investment strategy that brings you 30-40 percent per annum guaranteed?'. Too many people do the latter.

Even Bernie Madoff didn't get away with things. Sooner or later all Pyramids collapse.

But OK, this story has been told so often. And we won't go into details here. Pyramid games stand a chance because of a mixture of 2 things:

Investors are still very sensitive to 'form' instead of 'content'. In our last entries to this blog we talked about that, quoting academic research that confirmed investors' sensitivity to form-related factors like Age of the Adviser, Power Dressing, Size of his/her Portfolio, Look and Feel of the Office etc.
Performance analysis is a complicated thing. You need to look at Return, Risk (in several dimensions), compare things with the right peer group and analyze sensitivity to market factors.

It is definitely true that the bulk of investors reduce point 2 to an analysis of historical return graphs. So if someone made a relatively high return over the last couple of years, he has to be good!!

Sure? I don't think so. Our database of good, licensed investors contains some 1,000 providers with on average about 10 strategies each. That is 10,000 individual financial products that passed our first tests. Now let us assume that - like in so many fields - for every reasonable or good professional there are 10 crooks out there.

That would lead to a sample of 10,000 potential 'scam' or 'lousy' investment advisers. Of course: the bulk of them is just plain mediocre, but still....Quite a few of them will be professionals or amateurs that somehow have the charisma to have others follow them, even when performance is not of the highest quality after correction for risk.

If we assume that a dollar return of 10% per annum for stocks is 'average' over a longer period of time (looking into our database with information covering the last 100 or so years we see that this is not a bad assumption) and a volatility of standard deviation of 40% we know from Statistics that 2/3rds of all managers will score returns between -30% and plus 50%. This implies that 1/3rd is either totally lousy, bringing in returns of less than -30% per annum, or fantastic: scoring more than 50% per annum.

Result: the group with returns less than -30% will shut up. The group with returns above +50% per annum will make sure people know. They are the champs. Fantastic!

This means that after one year, there are 10,000/6 = 1667 (rounded) managers with more than 50% return. Now, obviously average returns are not 10% each year. But let's assume that on average it is a fair estimate to assume that the group of managers scoring fantastic returns of more than 50 percent per annum will be bigger in good years and less good in bad years. But OK, in the mixture of good and bad those with some buffer due to good performance in the (recent) past will get away with things in less good years, won't they? You can't win in every year.

Now, continuing the math assuming for simplicity sake that we can use the average return as our basis for all consecutive years, we can find out that after 5 years we are left with one manager who scored returns of more than 50 percent in every year !!! That is a cumulative total return equal to 1.50^5-1 = 659.4 percent (rounded). Far more than 5 x 50%, due to the compounded return effect.

We are not using any knowledge about expertise etc here. Just a simple characteristic of statistical data. And since we did not use knowledge about expertise but just statistics, it is equally well possible that our 'good' manager will be in the minus 30% group in year 6 as it is that he is in the positive group. So another 50% annual return is just as likely every year as a -30%. Random statistics is a neat game that in the end will reverse toward the mean.

If everyone were just investing with his/her own money and not in a situation in which he/she could impress others there is nothing wrong with this. But it is tricky in a situation in which investors follow gurus. A lot of those 'scam' guys will be considered stars simply because of their good historical returns in combination with charisma and non-investment-related 'form' factors.

Voila: that explains the opportunities out there for the Madoffs of this world. Not just the opportunity to attract investment money without solid strategy, but even worse: also the opportunity to rob the system by extracting amounts from the system that were never earned. Or: other possibility in Pyramid games, to trigger excitement further by using some of the new inflows of the growing group of followers to pay out some dividend to the smaller first group, so that you create 'disciples' who help spread the gospel ('They really did it! These guys are fantastic!').

But things get even more scary.

This morning the financial newspaper reported that the Dutch regulator did fine an investor for stock price orchestration. During a period of 1.5 years he did more than 500 transactions (buying one share on each occasion) in one relatively unknown and illiquid stock and almost 1,000 in another. His total costs of buying these 1,500 shares was marginal.

But the costs to society could be huge. Idea? Think of this. In a time in which people are already disappointed or dissatisfied with the behavior of the big, boring banks who always advise those same group of stocks that anyone can think of (large and mid caps, blue chips etc) this guy came up with two unknown shares!! ''Waw, he dug so deep to get all this unknown information!' You can almost hear people get enthusiastic.

So, at the beginning of his buy rounds (i.e. before buying one share) he - with at that time still not so much followers - reports that he bought those stocks for his strategy. In the reports on his website he will then start to follow the shares and the portfolio performance. What will happen? Remember that the stocks are unknown and illiquid.

A combination of two things:

Even his small individual transactions on the buy side will sooner or later lead to upward share pressure.
Sooner or later actions by 'followers' will start to appear, thereby increasing things further.

And that is the time when our friend reaches guru status. He will maybe get to a point where some followers want him to invest for them. Find new stars!

As you understand the reason why everyone, including the star manager, in this case are fooling themselves is quite simple. In an illiquid market you make your own price. So the positive return looks nice, but the moment you want to use it to get out, negative price pressure will make it very difficult to really benefit from the price increase. This was not a price increase 'carried' by positive firm news other than the increased trading which we created ourselves in the first place. It provides the manager and his followers of the first hour with an opportunity to exit. Simply make sure that gradually but slowly you become a bit more opaque. Tell them a bit less about what is going on, i.e. use part of the liquidity for your own exit from the desert.

I am not saying anything more. But do you now understand why there are so many unknown 'advisers' with fantastic Penny Stocks advises? Be careful, enjoy a well-deserved great Holiday Season and make sure that one way or another you get your performance analysis right! And let us make sure that regulators around the world get sufficient power to fight scams like this one. Powers in terms of fighting them ex-post, and powers in terms of demanding more transparency up-front.

Even a little bit of liquidity can become expensive in the desert. But after it dries up you probably still die a terrible death. Better not to go into the desert in the first place, unless you ensure yourself of sufficient REAL liquidity.

Flawed Investor Behavior; A Random Walk Down Today's Financial Newspaper

2010-12-18T15:38:00.000+01:00

Introduction

After reading the newspaper this morning, I decided to write this reflective piece about private investors (and maybe for that sake: also those professional investors who do not qualify as 'Best-of-Breed'). It felt like a Random Walk Down the Newspaper (slightly modifying the title of a famous investment book) which explained quite a bit about a lot of problems investors are facing today. The interesting part of it is that different components of what we write below are not from one big, major article in that newspaper but they are linked to different articles. Some that were investments-related and others that aren't.

It was already known and documented in tons of articles including scientific books like Prof Burton Malkiel's A Random Walk Down Wall Street that it is very difficult (even for professional investors) to beat the market index structurally and consistently. But it is also true that around this average there is some sub-categorization in groups going on. The US Defined Contribution market that allows individuals to take care of their own pensions is a fantastic pool of information about the investment style and performance of private investors. More information about that style will follow below. What is important now, as a basic premise, is that studies seem to conclude that (whereas private investors always - at parties, on their websites or in their well-known discussions with friends, family and neighbors - proudly present their own investment successes) the group as a whole underperformed. This implies that - so as to reach the average net return for the market as a whole - there are others who outperform. And I am not talking about those with non-diversified, 'lucky' one-shot portfolios then. No, I mean outperformance over a couple of years, with stable risk profile and realistic returns. There are best-of-breed grandmaster investors who create well-structured portfolios of outperforming products so as to achieve this result.

Burton Malkiel: Wall Street's Randomness Makes the Investment Game Complicated.

LMG: But that doesn't imply non-existence of a sub-group of grandmasters and a sub-group of under performers.

Early Adopter Bias

One of the problems is that different asset classes and products outperform at different times. So long-term investment success is about getting the averages right. Not about going all the way with one or the other temporary success. And that was exactly one of the main problems. Today, Hollands financial newspaper quoted a scientific study by scientists from the universities of Groningen and Maastricht who surveyed a representative group of Dutch investors. Compared to investors in most countries on this planet, Dutch investors are reasonably educated, reasonably cosmopolitan in their orientation, reasonably exposed to (international) investment news, acting in a market with reasonable cost levels, quite well regulated etc. We do therefore not believe that the bias is typically Dutch. Result of the study: private investors - even relatively experienced ones - had a tendency to be so-called early adopters . Normally it is good to be not too late in a cycle, but being an early adopter with a new product is not the same as riding the tide and being an early adopter in a new cycle for an existing security within a well-known traditional asset class.

EarlyAdopter: Testing the waters before the others dare to do so.

Receiving awe for it: but was the water safe?

There is a kind of early adopter premium which brings them awe and admiration from other investors. However, very often these new products are structured products created by financial institutions in an effort to transfer risks from the bank or insurer's balance sheet to the buying investor. Or products especially created to fulfill the needs / new demand for a 'hot' niche in which case performance and quality are of lesser importance than having something to sell. 'Turbos', 'Teak wood funds', 'Trackers', 'Guarantee Products', 'Shipping Ventures with positive tax treatment', 'Green Funds' you name it. There is so much. Most of the time the early adopter investors do not even completely understand what they are buying. And almost always these innovative products are added to portfolios that from the start weren't even neatly structured or diversified as far as standard, traditional asset classes are concerned. And in almost all cases these products are offered by parties that did not establish themselves a reputation as 'Best-of-Breed' in this new asset category, but simply offered it being the bank or insurance firm with which the investor had a relationship already. You could even say that to some extent they were misusing their fiduciary relationship. But then again: looking at the early adopter premium one could also say that these investors wanted to be fooled because they derived non-monetary gains from buying these products.

Is it therefore surprising that both these products and the buying investors were underperforming? Not really.

Fiduciary Problems

But why did these investors buy those products? Partly because of the non-monetary utility derived from being able to receive awe from other private investors. 'Waw, you are so good at this stuff. I didn't even know that this product existed!' or 'It is such a complicated product. Amazing that you already understand it!' and similar lines are a kind of bonus to the admired early adopter. And in an industry in which performance analysis and keeping track of performance over time are already underdeveloped when it comes to most professional product providers and their institutional clients, it is not a surprise that the admired early adopters get away with things the moment those products do not deliver. Solution: you simply stop talking about it, and instead spread the gospel about some other product that you were successful with and/or think to be successful with in the future. The trend followers will do what they always do: follow.

But, OK, what about the early adopters themselves? They are not crazy, are they? Why did they and do they continue to buy these products? In another article in the same newspaper we got our answer. Stefanie Tzioti of the Erasmus University Rotterdam received her Ph.D for a very interesting piece of research. What she did in her experiments was the following: she provided the participants in her experiments with choices between i) types of wine; ii) investments in stocks or bonds; iii) this or that mobile phone offer. In the first part of the research participants could make the choice themselves, based on a concise information package about the choices. In the next stage of the research they were offered additional help by advisers. They did not only receive the additional information, but were also shown pictures of the advisers and some information about them.

Result: the power dressing guy with the big car (or better phrased 'right car'; there was also something going on like specific brands of cars, watches being more expensive but 'wrong'!) was more often believed than his more casual 'guy-next-door' colleague. This is something banks and other financial firms know quite well. No matter how lousy their back office situation (compare news yesterday about insurer Aegon who some 10 years ago acquired Scottish Equitable in the UK and continued to be sluggish about a known back office problem to such an extent that there are now more than 200,000 (!) clients that cannot be traced due to problems with addresses) or the actual quality of a financial product, in the end they still seem to be capable to impress their clients with their size, wealthy looking front and branch offices and power dressed sales staff (with or without long legs; male or female). In other words: fiduciary relationships were often more about 'form' than about 'content'.

There were however other factors at stake as well. 'Age' was also a positive factor, and so was 'content'. So, genuine, non-power dressed people of a certain age with great content were able to compensate their non-power dressing disadvantage. But still: it was clear but sad that 'content' seemed to be everything but the most important of these factors.

Power Dressing instead of Power Results: Form matters at least as much as Content

The Definition of Risk

Risk is a far more complex and less-understood concept than Return. But both are of equal importance when it comes to creating a good investment portfolio. Risk is a derivative concept of a return distribution. But there are types of risk: we can use 'volatility' which is basically the standard deviation of the return distribution. We can also look at 'beta' or market risk which analyzes how much - on average - a security will go up or down when the market index goes up or down one percent. We can also look at 'Value-at-Risk', 'Downside Risk' et cetera. There are a lot of indicators. And even if you incorporate them in a structural manner in your decision making process, so that you can analyze risk and return in some integrated fashion you are not there yet.

There is a difference between Risk at the security level and Risk at the portfolio level. It was Dr Harry Markowitz (Nobel Prize Laureate 1990) who taught us about this difference when he developed his work on Modern Portfolio Theory in the 1950s (followed by equally important work by another Nobel prize Laureate Bill Sharpe in the early 1960s). When going from the individual security level to the overall portfolio level things change because of a new dimension that is now added to the investment problem: 'correlation'. 'What is the relationship between the various components within your portfolio?' Over the last 10 years I have worked with Dr Markowitz on a new asset allocation framework based on i) a more efficient integration of bottom-up, security and asset class level information and top-down market information (including correlation analysis); and ii) some of the basic principles laid down in his earlier work. Prof Kritzman of MIT performed a series of tests that confirmed the value of this new approach. The approach was not really rocket science, just a careful integration of all factors involved when taking investment decisions and its results are therefore more indicative of the problems others have with the treatment of risk.

Harry Markowitz, often misunderstood or misinterpreted: No Power Dressing, but Enormous Content when it comes to Risk.

But back to the difficult relationship between private investors and the concept of risk.

Investors are not just relatively bad in getting their partial or individual security risk calculus right, they are even worse when it comes to getting the correlations and portfolio structuring right. To some extent this is understandable. In an earlier piece that we wrote for the first issue of UK asset allocation journal Portfolio Institutional, we explained that regime shifts imply shifts in correlations and not just that: in different regimes return patterns seem to change as well. That complicates things tremendously.

We had to think about these aspects when reading yet another article in today's financial newspaper, again totally coincidental that it ended up in the same issue. But it illustrates the intensity of the problem and its many different faces. It was a piece about private investors and their visions about markets in 2011 and beyond. It was based on a survey by a prestigious Dutch, independent market bureau. The pool of participants was a representative group of private investors with portfolios in excess of Euro 50,000 each. That 50,000 cut-off rate is important, because it is the hurdle rate applied by the Dutch regulator to distinguish between those private investors that are small (and who therefore need to be protected) and those that are big enough to assume that they can shop around and know what they are doing. An important distinction of course for providers of investment solutions, because for minimum investments below 50k you need a hard-to-get private investor market license and above 50k you don't.

This is therefore the group of private investors who supposedly knows what they are talking about. Here are some of the most remarkable results of the survey:

Private investors in the Netherlands are currently considering the US market as the most risky one. Only the African market was considered to be of 'similar or higher risk level'.
The bulk of investors is not convinced that the crisis is over. Only 21 percent is willing to reduce the size of their savings account and invest more in equities. So even with today's relatively low interest rates, fear is still there. And market momentum of the last few weeks is the result of actions by a few (when it comes to private investors) and institutional investors. But in the latter group pension plans were relatively quiet due to problems with coverage ratios.
The so-called Home Bias is immense. Almost all investors over-invest first and foremost in their home country (in this case the Netherlands), and within the foreign component of their portfolio Europe is highly overrepresented.
Emerging Markets are popular when it comes to talking about them. But when looking at portfolio allocations, either current or planned, private investors are far less enthusiastic than the big banks who advise them. Only 13 percent indicates that they want to invest more in China during the next 6 months versus 24 percent who want to expand their Dutch holdings when interest rates remain low. And when replacing China by some lesser known or smaller, less spectacularly growing Emerging Market things are even worse.

A more than remarkable result. Whatever will happen in the world, if anything, the US market is not going to be the most risky one. And definitely not something comparable to Africa. And actually - with us being positive about the long-run prospects of Africa - don't forget to integrate return and risk at both the individual security and portfolio level when taking decisions. The Home Bias is an indication of cultural and news intensity related mistakes most investors seem to make all the time: 'if I know a market better, because I live in or close to it my risk is lower'. They forget that their investment outcome is a function of the quality of their information vis-a-vis other participants in the investment game. When there is far more information available about a specific market, this does not translate automatically into lower risk and/or higher returns. It is about differential information vis-a-vis the competitors in the market place. And then I even forget to what extent available data is really information. Most investors don't really understand that distinction, thereby mistakenly interpreting their excess data for the home market as priced information.

Basically: what is very clear from this feedback is that investors extrapolate. The uncertainty about the US is nothing more or less but an extrapolation of Global Crisis related factors ('didn't it all start in the US with the sub-prime crisis and bank problems?') and fluctuations in the Dollar-Euro exchange rate. But if you want, you can hedge currency risks, and when looking beyond the financial sector the US economy is so much more. In market value it is still more than 30 percent of the world. And well-diversified in terms of industry distribution. No way that this market will be riskier than the not-so-well-diversified economies of Africa with all their political risk and corruption as a not-so-welcome add-on. OK, less risk will translate into lower return, but that is another story.

The relationship between private investors and the concept of 'risk' remains a troubled one.

Extrapolation/Trend followers Bias

When analyzing studies about the behavior of private investors (and actually the not-so-good institutional investors as well), it becomes clear that they are trend followers while at the same time being early adopters (see above).

When it comes to existing products, they want to buy after receiving confirmation that something is doing well. Some want more confirmation, others less. But all wait for confirmation signals. That explains why it is so much easier to sell Morningstar Five and Four Star Funds. It also explains why stocks with a good looking share price development over the last year experience continued 'momentum'. But sooner or later this trend following translates into 'buying expensive'. If you wait for confirmation, you actually skip the security in its cheapest phases. Nothing wrong with one or two confirmations, but when combining this with the risk analysis in the previous paragraph it becomes clear that the bulk of people wait for a lot more confirmation. They will start thinking about something after that something had a fantastic ride already. And then obviously, with the chance of disappointments going up the more expensive you bought, sooner or later it translates into buying high, selling low.

The Private Investor Trendfollowing Cycle

Evaluation

Is it therefore - when just browsing through today's newspaper - strange that tons of investors under perform? Not at all. Is it strange that what we wrote here for private investors does also apply to dozens of institutional advisers and / or large financial institutions offering products to private investors and/or not-so-well-informed institutions? Again: not at all. In the end the bulk of people - even professionals - is a private person as well. With all the flaws that come with it. And it is therefore not surprising that Behavioral Finance has gained so much in importance during the last 20 years.

But the academics were wrong to translate this into the conclusion that there are no grandmasters in this game. You can conclude that they are hard to find, sure. But the same applies to any competitive sport, because that is what investing is. There are always far more lousy amateurs than excelling stars. Investment performance of investment managers has to be disentangled into several components

Skill
Market
Peer Group
Other Relevant Factors

before you can distinguish between those that most likely did something 'special' and those that were just plain 'lucky'. That does not only apply to finding the best advisers. It also applies to your own portfolio performance. But as long as there is no structural, state-of-the-art performance analysis available investors and not-so-good advisers will often be trend followers with all the flaws written about above. And in the mean time the true investment grand masters will continue to struggle with ways how to distinguish themselves from the poor and mediocre. And even when they do show the value of their 'content', they still have to fight against the power dressed marketing managers of huge financial institutions with great front offices and branches all around the world.

When looking at the possibilities of approaches like our 'Best-of-Breed' concept for manager selection and our cooperation with UK database provider Camradata (one of the largest institutional databases of performance of investment procucts vis-a-vis their peer group), we believe that increased transparency requirements, the role of the internet in general and the increased speed and depth of information dissemination will help things to improve. And that is good news for both private and institutional investors. But there is still a long way to go.

Geo-political and economic shifts in Russia-Western Europe relations create opportunities in Emerging Europe

2010-12-09T11:30:00.000+01:00

Introduction

We start this note with a picture of one of the most important elements of the European Infrastructure: the pipelines that connect Russia with Western Europe. With gasoline prices in Europe hitting record levels again, we felt that it was good to use the attached article (see below) from the excellent Frontier Markets blog for this note.

It is of course not totally coincidental that we wrote our previous entry on Gazprom, the Russian energy powerhouse, and one on our Facebook page on the fact that Russia was awarded the World Championships Football in 2018. Add to that the fact that the country will also organize the 2014 Winter Olympics in Sotchi and you know that a lot of good infrastructure dynamics will be going on during the next 3-5 years and beyond. Another indication is the fact that Sotchi will be on the calendar soon as a new spot on the Formula 1 car racing map. Gossip even states that it was Vladimir Putin himself who translated his personal love for motorsports into sponsoring by the Russian state after Russian driver Petrov's great performance in the last race of this season in Abu Dhabi. It was to quite some extent Petrov's driving that ensured that Vettel and not Alonso took back home the world championship.

Eastern Europe = Central Europe

Dynamics characterized by one thing: sufficient money to create an infrastructure boom in Russia. If you add to that ongoing tensions in the Middle East and European suspicions about Asian domination, it is not totally impossible that old geopolitical enemies will find each other: Western Europe / EU and Russia. OK, this will not be a marriage of passionate love, but it will be one of two parties who need each other. They might even continue to live separately. Or at least meet each other often at neutral territory. And that neutral territory between them is Central Europe, often called Eastern Europe in the past.

Eastern Europe consists of three parts according to the Frontier Markets blog:

A central core consisting of Poland, Czech Republic and Slovakia where the banking system is already developing and proximity to Western Europe has already translated to some substantial integration. Budget deficits and debts are still worrying (and so are Polish actions against the second pension pillar), but all in all - helped by substantial investments from Western European parties - these countries are already transitioning. Large infrastructure investments go hand-in-hand with positive stimulus derived from industries like logistics and transportation (just drive through Europe and it seems that all trucks are from these countries!) and Polish workers flocking labor markets in Western Europe offering their services for far less than their Western European counterparts, followed by a weekend drive back to their country where they are then relatively rich citizens who have something to spend.
The Baltic States. Still struggling with the aftermath of the Global Crisis, but we believe that there are some indications that the fact that these states (especially Lithuania and Latvia) have invested heavily in education over the last 10-20 years will translate into opportunities in IT, Banking and other industries heavily dependent on higher education. The proximity to markets in Scandinavia - where labor costs are high - has already led to the first large foreign direct investments by corporations from Sweden and Finland active in these sectors.
The Balkans (including Hungary and the Ukraine). Still struggling and trying to ignite positive fire. But take a look at our map. The likelihood of these - now cheap - countries not benefiting from an increased interest in increased West-East lateral business and political contact in Europe is highly unlikely. The fact that they are mainly financed by now expensive loans from abroad a problem? Well, might be in the short run, but then again: taking into account their relative size compared to Western Europe and Russia we do not believe that this will be a big problem. Short-run tension will - as so often - translate into low valuations and low valuations are basically something that makes those countries interesting in the longer run for those who have a longer run agenda.

And we believe that the longer run agenda in Europe will be one of increased interest of Western Europe in Emerging Eastern / Central Europe. And the other way round? The Russians know about their linkage with Western Europe and interest in German exports. LMG believes that quite a few of the Eastern European negatives and low valuations do therefore translate into opportunities for Emerging Markets investors.

Click here to see the original Frontier Market Blog article on Eastern Europe