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This is part 2 in a series called “Beyond Buffettology”, penned by Australian Equities Portfolio Manager George Kurian.

You can read part 1 here.

2. Politics

In this article, I discuss how Politics at various levels could be the key driver of shareholder returns. While most companies are impacted by country politics to varying degrees as implied in their cost of capital, our focus here is politics as the dominant factor of shareholder returns. Please see the four levels of Political Alpha below.
a.) Country level: The end of Ricardian Comparative Advantage.
“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist” – John Maynard Keynes

One of the most hallowed economic ideas regularly cited by many economists and taught across most top business schools is David Ricardo’s Theory of Comparative Advantage. Stripped to the essentials, this theory postulates that countries should focus on their core competitive advantages and engage in global trade exporting goods and services with relative advantages and vice-versa. For example, it pays for countries with superior terroir like France to export premium wine and import commodities from countries like Australia where commodities are naturally abundant and available at much lower costs. Proponents of this Ricardian model have even extended this original idea to advocate the outsourcing of manufacturing and even some services to lower-wage developing countries. However, what the neo-Ricardians miss is that in modern capitalistic economies, the biggest advantages are not natural, but developed. And who develops these advantages? Countries. How? Politics.

Semiconductors are one industry where the United States have played a foundational role, right from the birth of transistors in 1948, to the current adoption of semiconductors in a wide range of products. However, today we see that some of the most profitable companies in the semiconductor value chain are in far-flung lands like Taiwan and the Netherlands. Did Generalissimo Chiang Kai-shek, while fleeing Mao’s Red Army, stumble on a world leader in semiconductor manufacturing hidden in the Taiwanese Central Mountain range? No. As explained in the majestic Chris Miller’s Chip War, there was no Taiwanese-owned chip manufacturing industry until 1985. Then the Taiwanese government supported the semiconductor industry veteran Morris Chang to set up Taiwan Semiconductor Manufacturing Co (TSMC) with the help of the Dutch major Philips, who provided the intellectual property and some investments in exchange for a 27.5% equity stake in TSMC.

The Netherlands is more than 5,000 miles from Silicon Valley across the Atlantic. How did ASML, a then small unprofitable 1985 Dutch spinoff from Philips, become a compounding machine that beat the returns of most semiconductor stocks in the United States? The answer once again is Politics. In the late 80s and early 90s, Japan was second only to the US in GDP and was the primary competition to the US dominance in semiconductors. Hence, the tiny ASML found itself in a political triangle with the Japanese giants Nikon and Canon for the increasingly ‘nervous’ American affection. The political advantage resulting from its non-threatening size and country context (more likely to get the mager knappe Dutch to go Dutch on Lithography profits than a Japanese Sumo) enabled ASML to get access to some of the most advanced research from the US laboratories, and more importantly allowed ASML to takeover the last major US lithography firm SVG in 2001. This last act cemented the ASML dominance in the lithography market, a dominance which continues to this day.

As seen in the Chart below, since the mid-1990s, ASML has returned more than 20 times and TSMC more than 8 times the total return of the S&P 500. For comparison, the iShares Semiconductor ETF (which has data only from September 2001), has done only about 35% better than the S&P 500.

In the case of ASML and TSMC, the bumper stock returns from the political advantage were not deterministic but path dependent based on continued management execution. However, the crux is that without that initial political advantage, relying simply on good management execution would not have gotten these companies such outsized returns over the semiconductor industry and the S&P 500.

The impact of country politics on stock returns could be more easily seen by inverting the above mentioned ‘political advantage’ argument. Let us think of some of the blue-chip Russian companies that were listed on some of the world’s top stock exchanges. Some investors said, ‘cheapest of the cheap’. Some others including some of the world’s best value investors rushed to embrace these Russians as they couldn’t resist the charm of buying stocks trading at Price-to-earnings ratios of less than five. Some exclaimed in disbelief, “How could we lose anything here?”. Plenty! as they found out to their dismay in February 2022. At that time, all these ‘Russian beauties’ disappeared into the ‘House of Hades’ almost overnight, thanks to the ‘special military operation’ triggering ‘super special’ sanctions on them. Hence, the intuition that country politics sometimes acts like a God who creates or destroys companies.

Country politics could also provide an across-the-board cyclical upturn in equities. Recent examples where the author had firsthand experience would be the Brazilian market in 2016 and the Indian Market in 2014. The exceptional returns achieved by both were triggered by political factors – The impeachment of a Brazilian President and the arrival of a new market-friendly Indian Prime Minister. Moreover, from a portfolio perspective, these returns from country politics are precious as they provide excellent portfolio diversification. This is because a country’s political cycles are not directly correlated with the global economic cycles.

In the Australian market, we could see another country political dynamics at play in Treasury Wine (ASX: TWE). If we value TWE using traditional value investing principles, we can see that it is fairly valued. However, what is missing is the 169.3% tariff China introduced in 2020 on TWE’s high-end Penfold wines decimating Treasury’s China sales. The new Australian Government is now lobbying the Chinese counterparts to revoke these tariffs. If the tariffs are revoked or even reduced, Treasury stock would suddenly look undervalued at the current price. Once again, it is not the Treasury CEO, but the political lobbying that provides the treasure for shareholders.

Finally, yet another Country’s alpha angle is evident with the Lithium stocks on the ASX. This is because of the US Inflation Reduction Act, which nominates commodities and processed minerals from Australia (and a small circle of American friends) as de facto US source of supply for Electric Vehicle rebates. This means protection on the downside for scalable lithium production names like Pilbara (ASX: PLS) and Mineral Resources (ASX: MIN) as they become prized candidates for takeovers even in the worst-case scenario of extended commodity price falls.

b.) Compliance level:
“Interests, not people, are represented in Sacramento. Sacramento is the marketplace of California where grape growers and sardine fishermen, morticians and osteopaths bid for allotments of state power” – attributed to Mc Williams, lawyer and journalist, in James Richardson’s Willie Brown.

As in the Politics world above, in the Compliance world also it is a mistake to think that Regulators are omniscient, omnipotent, and infallible. Below are some scenarios where shareholders’ value is created or destructed by politics at the Compliance/Regulatory level.

Regulator, what Regulator? Sometimes no regulation is Hobson’s choice for Shareholders. A case in point is the Container Corporation of India (NSE: CONCOR) which is a cargo haulage company majority-owned by the Government of India. However, Indian Railways, another government entity controls the master key to profitability for CONCOR, as Railways sets the haulage pricing for CONCOR. Historically, haulage price changes have been as random as it gets with no rhyme or reason from CONCOR’s point of view. For many years, this was a puzzle in the back of my mind. Why can’t the government create a pricing and timing mechanism for haulage price changes, which would materially improve the shareholder value (and the government’s value) due to the reduction in uncertainty? The puzzle remained unsolved for years until I met an expert in Mumbai, and the conversation went something like this:

Expert: No, they cannot do it.

Author: Why? Why do they act contrary to self-interest?

Expert: Railways do not know the haulage rates ahead of time.

Author: Sounds like there is a coordination problem

Expert: No, not coordination but a knowledge problem. Cross-subsidy problem.

Author: Passenger train subsidy?

Expert: Yes, that is done on an ad hoc basis every year.

Author (soliloquy): Aha! Anything that depends on a political variable invariably becomes a random variable.

As is often noted in military intelligence, evaluating one’s opponent using one’s assumptions and interests usually leads to false conclusions. 

Compliant but openly Complaisant to ‘other’ interests. This is true of the antitrust regimes in most countries. For example, Sprint and T-Mobile were prevented from merging for years by soft signalling from the Democrat led Federal Communication Commission, and not to mention the powerful US Department of Justice itself. However, once the Presidential elections affected a ‘regime change’, the merger was done without much opposition from the same regulatory authorities. The arguments for and against the merger, the racehorses, all remained the same. However, the change of Jockeys sealed the deal and created shareholder value.

We could also see a similar dynamic in play in Australia, this time in the destruction of shareholder value. Back in June 2018, APA Group (ASX: APA) received a $13bn takeover offer from a Hong Kong Kong-based consortium. However, the then treasurer, in close consultation with the Foreign Investment Review Board (FIRB) rejected the takeover vaguely dubbing it ‘contrary to the national interest.’ The takeover offer was at A$11. Now more than 5 years later, shares are below A$8.50!

Compliant but secretly Complaisant to ‘other’ interests. Back in 2014, I got bullish on a Malaysian utility called Tenaga (KLSE: TENAGA). The thesis was that Malaysia wanted to adopt the Western model of regulation and give the independent regulator the ability to set tariffs. This would have ushered an end to the government’s track record of long fallow periods with zero tariff hikes, punctured by giant random spikes. However, while doing the research, I came across Ruchir Sharma’s Breakout Nations, which admonished:

The issue in Malaysia is execution: the country has become famous for presenting grand schemes that don’t get built, and for announcing new ‘growth corridors’ that appear only on paper.

As a Bayesian investor, I should have heeded this warning seriously. Unfortunately, my reasoning went like this: The Energy Commission (regulator), has published nearly one-hundred-page documents on the details of the proposed regulations. Will this time be different? Could they bluff this big? Indeed, the events proved they could, and worse they could have even bluffed much bigger (the 1MDB scandal had not hit the papers yet then). Tenaga stock which had hit MYR 15 by the end of 2014, now after nearly a decade is still under MYR 10. Hence, we can see once again that politics (i.e., regulator subservient to corrupt political masters) decimated any other value created by the company management in a decade.

Sometimes one could see multiple strands of compliance politics in the same country. An example is the regulation of Brazilian Electricity vs. Water sectors. While Brazilian electricity companies are regulated at the Federal level by ANEEL, the water companies are regulated by the state governments. While all the water companies claim to be regulated by independent state boards, those same boards are nominated by the state governments who are in the business of winning elections with populism. Hence, one could see that Brazilian water stocks trade at much lower valuations than electric stocks, a classic sign of shareholder value destruction facilitated by Politics.

The battle of Compliance factions. The author once had a meeting with an airport regulator, in a country that we won’t name. The regulator wanted to know my opinion on the merits of the Single-Till vs. Dual-Till airport regulatory model. In the former, both Aeronautical and non-Aeronautical revenues are regulated to a pre-determined return on investment. In the latter only Aeronautical revenues are regulated, and the upside from other revenue streams like Duty-Free and Retail could be captured by the airport operator. However, during the discussion I realized that there was no consensus even within the regulatory committee as their single-till group supported the ‘lowest customer cost’ argument, and their dual-till group supported the ‘airport development incentives’ argument. Hence, while investors prefer airports with dual-till structures due to their higher growth potential, the final regulation choice that would decide the shareholder returns will be political, depending on the strength of the pro-growth or pro-cost compliance factions.
Compliant with bureaucracy and incompetency. Finally, we should note that shareholder value (for the short to medium term) is also created by compliance in letter but not in spirit. The ongoing crisis at Thames Water and some other British water companies is an example. Water companies are ideal candidates for Leveraged Buyouts, as their revenues are predictable. However, the regulator should have better focussed on the serviceability of the debt in rising interest rate environments, limited the dividend payments in good times, and made sure companies are not reducing maintenance capex to avoid the current spectre of sewage being dumped into Britain’s rivers. Hence, we can see that regulatory incompetency to detect and counter short term political decision making at UK water companies, has juiced the shareholder returns for many years, unfortunately at the expense of public health and wealth.
We will continue part 2 in another instalment, in which we will discuss the other 2 C’s of Political Alpha.

Written by George Kurian, CFA
Australian Equities Portolio Manager
Oracle Investment Management

Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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