Effective Investments

The most effective investments … are investments in politics.

– Boris Berezovsky

Am I seriously quoting the late Russian oligarch about investments in politics? After all, Berezovky brazenly manipulated political outcomes in Russia for personal gain.  Am I implying that investors do the same? Not exactly… While it is certainly not possible for a typical investor to manipulate the political landscape on such a grand scale, it is possible to achieve superior returns by taking the time to understand politics in order to anticipate developments that affect all financial markets.

Consider an investment in the common stock of a company. Which is the bigger driver of price movement in the stock, the quality of the company or overall economic conditions in the country? Obviously, it is important to pick a company with a great business model and a solid management team. However, all the companies in the U.S. are affected by the overall course of the ship, in this case, the economy of the United States, or in the age of globalization, the economy of the whole world. Even the best run companies suffer in recessions, though not as badly as mediocre ones. On the other hand, even mediocre companies may deliver good investment returns during economic expansions. The capital asset pricing model (CAPM) considers overall market risk to be the most important determinant of the total return of investments, quantifying the relationship between overall economic conditions, and returns on individual investments. If the R2 number in the CAPM is greater than 50%, then the majority of any investment return is due to its systematic risk, which in turn is driven by overall economic conditions. Most U.S. stocks have CAPM R2 values well over 50%, which means that the overall economic conditions in the U.S. are the primary driver of stock returns.

The great importance of overall economic conditions in driving investment success is underscored in my research on hedge funds. It turns out that hedge fund managers who demonstrate the ability to profit from directional positions driven by overall economic conditions deliver superior risk-adjusted future returns.

Now let’s consider what drives overall economic risks. There is a consensus among economists that overall long term economic growth is greatly influenced by the quality of economic, political and social institutions in a country. These institutions are established and maintained through a political process; hence it is possible to get an idea about overall economic growth by considering political developments in a country.

Political decisions may also have profound short term effects, especially with regard to fiscal and monetary policy (for example, see the previous post “True Economic Growth vs. a Pyramid Scheme”). If political and social institutions drive a country’s long term growth prospects then political developments influence the growth and success of its companies (and therefore your portfolio).

For example, political wrangling over European bailouts has profound effects on financial markets. I recall the exasperation of my investments students in picking U.S. stocks in the Fall of 2011. They came to realize that all of their research with regard to individual companies mattered little when compared to political developments in Europe. And they were tasked with investing in American companies!

As an example of the power of politics to shape investment prospects I will freely indulge in a favorite activity of economists – prognostication. I conjectured in the previous post (see “True Economic Growth vs. a Pyramid Scheme”), the U.S. growth rate will likely be hampered in the future by the accumulated debt from years of stimulating the economy through government spending, as its current debt to GDP ratio stands at about 100%. In contrast, China’s debt to GDP ratio is a mere 23%, granting them ample room to increase its GDP numbers through government spending, if the government decides to do so. Furthermore, the total household debt to GDP ratio in China is currently below 30% compared to more than 80% in the U.S. This means that the Chinese economy also has a massive growth potential if households decide to take on a bit more debt. Currently, however, China does not have a social security-type safety net. Households save a lot because they must rely upon their savings for insurance and retirement purposes.

Here’s where the political and investment prognostication kicks in. What if China were to implement a program that works as a social insurance for retirement income and medical care? Such a political development would spur household consumption – the consumer would buy more and save less. Economic growth would be increasingly driven by the consumer as is typical in developed countries. A politically savvy and prescient investor could be well compensated for his “investment” in politics by investing in the Chinese market index and/or in consumer goods companies with exposure to the Chinese market. The return on said investments would likely dwarf that from just picking good companies. Just as Berezovky said, most effective investments are in politics.