C&B Notes

Details, Details, Details

A requirement of a concentrated portfolio like ours is that the rule of law is sufficient (i.e. we feel like outside capital will be treated fairly) in the places in which we invest. The typical developed, emerging, and frontier market categorizations loosely address this issue, but this distinction is a blunt instrument. Our approach requires a more refined, ground-up assessment of geopolitical and legal conditions of each market, and new research hints more closely at the subtleties that we believe are important to our decision-making process on this front.

MSCI’s definitions have to do with markets themselves, with institutions, and with investors’ access to them.  Economic development matters but is less important — as can be seen by MSCI’s continued classification of South Korea as an “emerging” market.  Another aspect is corporate governance.  Markets where minority investors lack protections are, correctly, deemed less developed.  But corporate governance comes in far more than two varieties, and it tends to overlap with broader political governance.

Fascinating new research by J.P. Smith at EcStrat consultancy has produced a new taxonomy which divides investment markets into nine different governance regimes.  They make a very useful guide to investing.  In order, they are:

1. Liberal — a grouping that includes almost exclusively anglophone countries, from the U.S. and the U.K. through Australasia to South Africa.  They have transparent markets, with high levels of free float and a high ratio of market cap to GDP, and a separation of ownership and control, which tends to be widely spread.  They have a domestic base of investment institutions, which prioritize returns over other objectives, giving rise to what Hyman Minsky termed “money market capitalism”.

2. Coordinated — a grouping almost exclusively drawn from the EU.  They differ from liberal countries in having a lower ratio of market cap to GDP, with banks providing more capital than equity markets, and control residing with large blocks of shareholders.

3. Network — Japan and Taiwan are the only examples: they are similar to coordinated economies, but companies tend to gain most finance from other companies or banks within their networks, which are defined either by supply relationships, or by families.

4. Hierarchical — a group that includes much of Latin America, and southern and Southeast Asia but also European countries such as Italy, Spain, and Portugal. Control tends to be exerted by a few dominant families.  They have relatively low free float, and controlling families in practice have relatively few checks on their action.  As they are based in politically hierarchical societies, significant changes in governance tend to require a political crisis.

5. State-guided — a group that ranges from Singapore through Malaysia and the UAE to Pakistan.  The government itself tends to take a direct role in allocating capital and in corporate decisions, while equity markets tend to be small and hard for foreign investors to access.

6. Authoritarian — China, Russia, Saudi Arabia and a few others.  State-controlled companies dominate, in economies that are often based around commodities.  There is some transparency but it is low, and there is “rent-seeking” by politicians and corporate executives alike.

7. Dependent — a category that includes the Czech Republic, Hungary, Kenya and Argentina; these are countries with relatively small markets, that tend to be dominated by foreign owners.  The problem, in the event of a crisis, is that the foreign owners become obvious targets for politicians.

8: Autarkic — EcStrat lists Venezuela, Cuba, Iran and North Korea; this sounds more like George W Bush’s “Axis of Evil” that does little to appeal to foreign investors.

8. Disrupted — disaster zones such as Syria and Libya, while EcStrat controversially adds Nigeria.

Most will recognize that this list makes a deal of sense, and many of the countries grouped together naturally belong to each other in the minds of many investors.  Countries can move between different regimes over time, and indeed there is a natural progression, along with the possibility of regression.

Referenced In This Post