You live in an extraordinary time and place. In a matter of seconds, the wages you earn or capital you hold can be turned into steel in a Russian foundry, sent several kilometres down a mine shaft in the Chilean desert, or used to hire Silicon Valley’s brightest minds. Without leaving your home, you can lend money to the Thai government, or to help set up a marketing office in Lagos. These capital flows may be indirect, and may even seem insignificant. Yet with little more than a bank account and an internet connection, the modern UK-based investor has options for capital that would have been unimaginable to even the most powerful 19th century industrialists.
Market operators such as the London Stock Exchange (LSE) like to imply that this diverse cast of international investors and capital seekers is now united in well-regulated and transparent harmony. In many senses, this is true. If it weren’t, international exchanges such as the LSE would have long ceased to operate.
But the financialisation of the global economy has not removed the inherent risk of sending money to the furthest corners of the earth. It never will. That is one of the opportunities of investing: discovering situations where mistrust or fear turns out to be unfounded. The parallels with travel are evident.
Still, the challenge can seem daunting for ordinary investors. So given that we have little to no access to company management, limited air miles, and no team of global political risk analysts and consultants to speak of, how can we better understand the threats posed to investment capital around the world?
The pitfalls associated with investing in a particular country, or providing funds to its government, are legion. They include political risks, which cover everything from social cohesion to external conflict and corruption, as well as fiscal and trading stability, relative wealth, inflation and government spending. The sheer complexity of siphoning this information into any neat geopolitical evaluation makes reliable forecasting a near-impossible task. In reality, it’s often a fudge.
One way of evaluating risk – indeed, the method preferred by hedge funds, banks and many institutional investors – is to use complex modelling.
In essence, this involves turning qualitative judgements into quantitative data points, from which investors can build what is known in the jargon as an ‘equity risk premium’. We will explain more on this, and how a more simple formula can be used to calculate the cost of equity, later.
An example of the way these judgements are made and grouped is shown in the above table, which is a one-month snapshot of the risk ratings for four G7 countries. These have been calculated by the US-based PRS Group, a political risk consultancy which for nearly four decades has quantified country corruption levels on behalf of private and large institutional investors, as well as agencies including the International Monetary Fund and Transparency International.
|Four G7 risk ratings|
|Risk type||Measure (weighting)||France||Germany||Japan||UK|
|Political (i)||Government stability (12)||7.5||7.5||8.5||6|
|Socioeconomic conditions (12)||9||10||10||9|
|Investment profile (12)||9||11||11||11.5|
|Internal conflict (12)||9||9.5||10||9|
|External conflict (12)||10||10.5||9.5||9.5|
|Military in politics (6)||5||6||5||6|
|Religious tensions (6)||4||5||5.5||6|
|Law and order (6)||5||5||5||5|
|Ethnic tensions (6)||2.5||4||5.5||4|
|Democratic accountability (6)||6||6||5||6|
|Bureaucracy quality (4)||3||4||4||4|
|Political risk sub-total||74||83.5||83.5||81|
|Financial (ii)||Foreign debt as % of GDP (10)||6||8||4.5||5|
|Debt service as % of exports (10)||8||9.5||10||9.5|
|Current account as % of exports (15)||12||13.5||14||11|
|Months of import cover liquidity (5)||0||1||5||1.5|
|Exchange rate stability (10)||10||10||9||10|
|Financial risk sub-total||36||42||42.5||37|
|Economic (iii)||GDP per head (5)||5||5||5||5|
|Real annual GDP growth (10)||7||7||6.5||7|
|Annual inflation rate (10)||10||10||10||9.5|
|Budget balance as % of GDP (10)||6||8||5||6|
|Current account as % of GDP (15)||11||14||13||10|
|Economic risk sub-total||39||44||39.5||37.5|
|August 2017 composite||74.5||84.8||82.8||77.8|
|Forecasts||One-year – worst||70.8||81||79.3||72.8|
|One-year – best||76.3||86.8||85||79|
|Five-year – worst||65.3||74.5||73||70|
|Five-year – best||82||89.5||86.8||85|
|Source: PRS Group August estimates|
The group’s methods are not dissimilar to those of credit rating agencies, which guide investors on the risks attached to – and appropriate prices for – government and corporate debt. Once priced, bond yields and credit default swaps (CDS) provide a useful running indicator of sentiment. Loosely speaking, higher bond yields or CDS prices – data for which is easily gleaned from sources including the Investors Chronicle website – tend to reflect the intra-day aggregate shifts in traders’ country risk models. As indicators, they have their uses, and their critics: “We’ve known for some time – and for a variety of reasons – that the credit rating agencies may not be as nimble in adjusting their outlooks as some hope,” suggests PRS chief executive Chris McKee. Typically, his firm makes monthly updates to around a third of the 140 countries it covers, to help clients adjust their bond trading models or equity exposure. Back-testing studies have confirmed that this data has been reliably predictive of risk events.
The accuracy of this kind of risk modelling may be about to improve further. At PRS, early tests have suggested that artificial intelligence and machine learning tools can extrapolate political risk data sets with clarity. “We can now take our scores and project trends and patterns out one year with an accuracy rate of 90 per cent,” says Mr McKee. Apparently, not only can computer algorithms grapple with the real-time unravelling of world history; they are now flirting with geopolitical pre-cognition.
Yet whatever the quant models suggest, the future is unknowable, and the responsibility of country risk management ultimately falls to the investor. Nonetheless, there are ways of approximating risk for equities, which is the best any investor can ever hope for.
In financial markets, the equity risk premium for any given country can be calculated in a few steps, typically with reference to the US, which as the world’s dominant financial actor is seen as having the least risky market.
To do this, we first need to work out a five-year discounted cash flow rate for the US stock market, by compounding its implied yield alongside the country’s forecast GDP growth. In the case of the US, this is currently 5.96 per cent (if you add a crude 3 per cent GDP annual growth target to the 2.96 per cent yield expected from dividends and buy-backs). Then, we add the spread between the selected country’s CDS and the cost of insuring against US debt default. Together, this gives the cost of equity. Third, select a risk-free rate. This will usually be some point on the extended yield curve for US Treasury bonds, and in our example in the table is based on the 10-year T-bond. That currently yields 2.307 per cent, which should be deducted from the cost of equity, to finally arrive at the total equity risk premium.
|Country risk premiums|
|Country||Total required equity return (COE)*||Country risk premium (CDS spread over US)**||Total equity risk premium^||Country CAPE (Star Capital)||Cheapness rank||Premium rank||Spliced scores||Overall value/risk premium||Cheaper and lower risk|
|USA (Russell 3000)||5.96%||-||3.65%||29.5||15||13||14||15||11|
|*Calculated as a five-year discounted cash-flow rate for the US (3 per cent annual GDP growth, plus 2.96 per cent dividend and buy-back yield), plus the country risk premium.**NA results indicate CDS spread lower than the US. ^Calculated as total required equity return (cost of equity), minus the risk free rate (10-year US Treasury yield of 2.307 per cent. Sources: Capital IQ, Star Capital, Investors Chronicle, as of 9 Nov 2017|
The table above, cribbed from my colleague James Norrington’s research into the cheapest global markets, offers one interpretation: that G7 and E7 countries with relatively higher equity risk premiums are also relatively good value. That method, which highlights Brazil, Turkey, Russia, South Africa and Italy as the best value equity markets, bases its test of cheapness on Robert Shiller’s cyclically-adjusted price-earnings (CAPE) ratio, and probably downplays the risks inherent within the cheapest markets.
Placing a higher weighting on risk – in other words, focusing on markets whose equity risk premiums and CDS spreads are lower, more reliable and therefore ‘higher ranking’ – instead reveals the UK, South Korea and Russia to be the best priced against their backward-focused CAPE ratios. Although Germany and Canada score highly on this measure, this is largely because their CDS spreads over US bonds is negative, thereby giving slightly unreliable total equity risk premiums.
One clarification to these rankings is that there are no ‘risk-free’ environments. For example, it could be argued that the low equity risk premiums assigned to the UK and the South Korea are more a function of the historical perception of those countries within financial markets – and less a comment on the very real near-term and present threats facing investments in either economy. Furthermore, it is debatable if the large contingent of international businesses that make up the UK stock market can be classed as ‘UK equities’. The risks of investing in Diageo (DGE) have little to do with any one country’s growth profile or political risk. Ditto the natural resources sector, to which London’s equity market is heavily weighted.
Then again, when it comes to assessing the ‘country risk’ to investment capital, energy and mining stocks are especially seasoned travellers. The large diversified miners – and many of their smaller challengers – treat every nation and jurisdiction as ripe for exploration and extraction. Yet they frequently run the whole gamut of risks, from corruption and bribery to the political hazards of permitting, labour, royalties and tax, in addition to the task of managing cost in jurisdictions with high inflation or unpredictable monetary policy.
Unfortunately, the requirement for low-cost, high-quality assets often forces large resources groups into jurisdictions with higher historic rates of corruption, and barriers to doing business. On this measure of risk, the geographies to which Anglo American (AAL) and Glencore (GLEN) are exposed pose far greater risks than the assets owned by BHP Billiton (BLT) and Rio Tinto (RIO), as Investec’s estimates for the stocks’ risk-weighted net present value indicate in the chart on page 23.
Some company boards will sanction projects that offer not just scale, but near-guaranteed profitability at rock-bottom commodity prices. For example, Randgold Resources (RRS) – whose operations in the Democratic Republic of Congo, Mali and Cote D’Ivoire would be considered high-risk by most investors – does not give the green light to a new project until the gold miner’s management can be confident of an internal rate of return of at least 20 per cent, at a gold price of just $1,000 an ounce.
This strategy – disconnecting broader country risks from operational specifics – is also a good starting point for ordinary investors. An adventurous yet considered approach can bring its rewards. Over the past two-and-a-half years, London’s mining sector has provided two examples of companies whose subsequent gargantuan stock reratings were at least partly masked by perceptions of country-specific risks (see chart above right).
The first is the copper producer KAZ Minerals (KAZ), which at several points in 2015 and 2016 looked to be heading toward an equity wipeout. At issue was not just the parlous state of the copper market, or disappointing production results, but residual concerns over corruption in the Kazakh mining industry stemming from the chequered history of peer ENRC, the company sold to former KAZ owner Kazakhmys in 2013 just months after it became the focus of a Serious Fraud Office criminal probe.
With so much reliant on a smooth ramp-up in output – and with the company spending billions of dollars to develop the Bozshakol and Aktogay projects – the odds were stacked against KAZ. Investors were clearly concerned that any slippage in commissioning could precipitate a fight for the assets between the company’s complex web of backers and debtors.
Equally worrying was the state of the Kazakh economy. For two years, with exports hit by lower commodity prices and sanctions against its top trading partner, Russia, the country’s central bank had spent tens of billions of dollars to prop up the value of the tenge, the national currency. In 2015, with CDS prices on government debt spiking, and fears of a countrywide default escalating, the tenge was allowed to float freely, resulting in a 23 per cent collapse in its value and an immediate leap in inflation.
The conventional measures of country risk – questions over corruption as well as socioeconomic and fiscal stability – all suggested that Kazakhstan should be avoided. Yet the converse was equally arguable: the country’s reliance on its resource sector meant authorities had little choice but to prop up the industry, supporting stocks such as KAZ. Past problems at ENRC also created extra impetus for the copper miner’s advisers and management to raise corporate governance standards and the collective focus on project execution.
At the risk of stating the obvious, a country’s political, economic and social risks inevitably impact companies’ ability to operate in that country. It would be irresponsible to suggest, for example, that any business based in Venezuela is not severely threatened by the broader economy’s current dysfunction. But in less perilous situations, it is also important to avoid drawing too close a link between broad-brush ‘country-risk’ assumptions, and the risks specifically posed to any one company.
Take Ferrexpo (FXPO), the Ukraine-based iron ore pellet miner and manufacturer, which has been one of London’s best-performing shares over the past two years. At the risk of sounding hyperbolic, MBA instructors should use the company’s turnaround as a textbook case study in effective crisis management, which occurred despite, not because of country risks.
In August 2015, Ferrexpo warned of the “fragile state of the Ukrainian economy”, flagging potential problems in the country’s banking sector. Reforms aimed at consolidating and weaning the financial services sector off state bailouts had thrown a number of lenders’ futures into jeopardy. Those lenders included F&C, which held $175m of Ferrexpo’s cash and which was subsequently forced into liquidation in December 2015, all but wiping out the miner’s capital position. By February 2016, the miner had just $36m of cash on hand, and with $203m of debts due in the following 12 months, auditors were forced to raise “material uncertainties” over the possibility of their repayment. What’s more, the ongoing crisis in Crimea – though hundreds of miles away from Ferrexpo’s asset base in Poltava – added to the gloomy investment outlook for Ukraine writ large.
But given that this was not a crisis of Ferrexpo’s making, and because the company was still able to turn a slim profit with iron ore prices at multi-year lows, there was a way out. The miner hacked away at outgoings, reducing capital expenditure to the bare minimum needed to sustain operations and unit cash costs to a decade low of $27.70 a tonne. At the same time, sales teams secured a larger volume of orders of higher-grade pellets, which command a premium and helped push 2016 net cash flows up to $332m. And while a weakened hryvnia and strengthened iron ore price certainly aided the turnaround, the main accolades go to the quality of the asset base and management team. Any investor who assumed – as we erroneously did – that Ferrexpo’s collapse was probable or even desirable to creditors, missed out on one of the best investment opportunities in the London-listed share universe in the past three years.
This month presented a fresh example of how the country risk calculus may be changing. On 3 November, EnPlus Group (ENPL) sold $1.5bn of its shares in London, as part of the largest initial public offering by a Russian company in years. The energy and aluminium giant, controlled by billionaire oligarch and Vladimir Putin confidant Oleg Deripaska, was seen by many commentators as a litmus test of investor appetite for Russia. The country remains subject to international sanctions, which followed the annexation of Crimea and military campaign in Ukraine in 2014, and many investors are still averse to any censure from US authorities that might stem from a hazardous Russian connection. Unsurprisingly – according to Star Capital, and as shown in our country risk premium chart – Russian stocks remain very cheap on a CAPE basis.
Mr Deripaska and his advisers have clearly noted global investors’ desperate hunt for value and yield, a relative paucity of sufficiently large assets, and connected the dots. For their part, investors have been asked to swallow the 38 pages of risk factors outlined in EnPlus’ prospectus, and make a judgement on whether the company’s largely unavoidable links to sanctioned Russian banks present an existential risk to their capital. Given precedents for this kind of relationship already exist in London, there should be little surprise that funds such as AnAn, the Qatar Investment Authority and US Capital are reported to have bought into a company valued at $8bn and which is on course to generate free cash flow of $600m in 2017.
EnPlus also tells us something else about country risk: that appetite for a supposedly risky jurisdiction can increase if the asset is big enough. Inversely, this explains Aim investors’ collective loss of faith in supposedly high-growth Chinese stocks – Naibu, Asian Citrus, Aquatic Foods Group and Sorbic among them – several of which seem to have proved too small to regulate. Conversely, a ‘too big to fail’ attitude to country risk may also help to explain why some investors, and the higher-ups at several global exchanges, are apparently undaunted by the prospect of a Saudi Aramco initial public offering, despite the obvious corporate governance hurdles of floating 5 per cent of a state-owned enterprise.
The premise of a country-specific equity risk premium is for a company’s stock price to reflect the higher theoretical risks that so-called developing markets pose to investment capital, relative to ‘developed’ markets. While the latter group is never really ‘risk-free’, sometimes the warnings attached to the former are apposite. And sometimes the best test for an investor is the same for a traveller: go out and see the world for yourself. Just prepare before you set off.