Country Risk

When managing a global portfolio it’s important to have a handle on the risks inherent in the places we’re investing our funds. The approach most investors take is similar to the approach with which they assess individual stocks: Do I recognize the name and how does it make me feel? This really isn’t adequate, especially when it comes to emerging markets. As with smaller individual stocks, which many investors overlook, there are good businesses operating in smaller countries that actually score well on country risk metrics. These countries are often simply overlooked because of their size.

On the other hand, just as there are some major companies with questionable quality, there are also some major countries where the risk is greater than investors realize. It’s good to have a handle on the relevant metrics and also to see how they change over time.

It’s also interesting to see how our own country stacks up against other international markets. We tend to have a bias towards that with which we are familiar. We often consider other countries with far less risk than our own to be uninvestable, while having the vast majority of our assets invested here where the risks are often greater. (Also read SA Foie Gras.) If the specifics of the analysis aren’t of interest, scroll down to the last two paragraphs and see how South Africa fares – some food for thought.

How do we quantify country risk?

The first issue we need to address is how to make an accurate assessment of country risk. Most investors approach this as they do with every other aspect of investment: Stories and predictions. What does the economic growth outlook look like, what industries are growing and which countries feature prominently, etc. Our approach is somewhat different. We focus on the preconditions that make for a favourable economic and investment environment, rather than unknowable predictions of the future.

For us, the most important factors when considering country investment risk are respect for property rights, and investment freedom. The Heritage Foundation generates such scores for countries, which are described as follows:

1. Property Rights

“The property rights component is an assessment of the ability of individuals to accumulate private property, secured by clear laws that are fully enforced by the state. It measures the degree to which a country’s laws protect private property rights and the degree to which its government enforces those laws. It also assesses the likelihood that private property will be expropriated and analyzes the independence of the judiciary, the existence of corruption within the judiciary, and the ability of individuals and businesses to enforce contracts.”

2. Investment Freedom

“In an economically free country, there would be no constraints on the flow of investment capital. Individuals and firms would be allowed to move their resources into and out of specific activities both internally and across the country’s borders without restriction.”

Using the Heritage Foundation’s scores for these two variables, we generate our own composite and rank countries accordingly.

Secondary Factors

While our primary assessment of country risk is based on respect for property rights and investment freedom, there are a number of secondary factors that we also take into consideration. We consider scores for business freedom (how easy is it to start and run a business?) as well as labour freedom (how onerous is labour regulation?). We also look at the size of a country’s economy (larger economies are inherently less vulnerable), their inflation rate (avoid hyperinflationary environments) and their debt picture.

Finally, we consider measures of income inequality (e.g. GINI coefficient) and poverty. Countries with income disparity and poverty are more prone to civil unrest.

How do we manage country risk?

Based on our assessment of both primary and secondary risk factors, we establish upper limits to individual country exposure. Essentially we classify countries as Tier 1 – 4. Tier 1 is most investable, and Tier 4 is uninvestable. We set higher limits for more investable countries, whilst also giving consideration for the size of the markets. While United States and New Zealand may both be classified as tier 1, our exposure to New Zealand is necessarily limited by the size of the opportunity set. We also set overall tier limits so that we don’t overexpose ourselves to low tier countries in aggregate.

Note that we don’t set exposure targets like most investment managers do. This is because we aren’t benchmark cognizant. We set upper limits and then maximize exposure to our best investment ideas (specific stocks) within these constraints. If we don’t have good ideas in a certain country, we don’t invest there. Most investment managers set geographic exposure targets. This means that they must maintain significant exposures to the United States, Japan, UK, etc., irrespective of where their best investment ideas are. This is suboptimal in our view.

Results by Primary Score (0-100)

Countries with GDP greater than USD 150bn:

Results by GDP

Top 30 Countries by GDP:

So how does South Africa stack up?

Since most of our investors are South African, we should consider where South Africa ranks both in terms of primary factors and secondary. This has obvious implications for the domestic/offshore exposure debate. We’ve long argued that the traditional local/foreign exposure paradigm borrowed from the US/Europe makes no sense for local investors. Our economy is less than 1% of the world and we face far greater risks than 1^st world countries.

Categorizing the world between South Africa and Offshore and placing these two options as equals is ludicrous.

South Africa ranks 43^rd of 55 countries with GDP greater than USD 150bn, on property rights and investment freedom. This isn’t surprising given our government’s policies regarding land expropriation, capital controls and the endemic corruption we face.

Further, on secondary measures, we’re a small economy which scores relatively poorly in terms of business and labour freedom. We have the highest income inequality score of any country in the world. 55% of our population lives below the poverty line. Do we see civil unrest in our country? Our debt is also growing rapidly. The only bright spot is that our inflation is under control, for now.

Invest by merit, not familiarity

I don’t want to paint a picture only of doom and gloom. Brazil, Russia, India and China score roughly the same as us (though they are larger economies with less inequality and poverty). Many consider these countries  to be viable investment destinations. But we need to be realistic when we compare South Africa to other investment destinations and when deciding how much to invest “offshore”. For a global investor, the reality is that South Africa is a borderline investment destination.

If I suggested that you invest half your money in Brazil or Thailand or Mexico or Turkey or Poland or Hungary or Chile – you’d call me crazy. Yet these are mostly bigger economies than South Africa. They all score better on the primary and most of the secondary country risk metrics. Then there are more developed economies like Taiwan, Norway, Israel, Australia, Canada, Sweden, Hong Kong and Singapore. Not to mention the giants of United States, Europe and Japan. These are all unquestionably superior investment environments.

As global investors, we should consider the scope of investment opportunities and the inherent risks when making offshore allocation decisions. It’s high time we abandon the traditional local/offshore allocation models. Our local investments should compete against the global opportunity set on merit, not familiarity, for a place in our portfolios.