Foreign investing has political risk

One of the more curious aspects of portfolio investment, I have always thought, is that its practitioners have no real way of coping with political risk. They can run projections on corporate earnings or economic growth. But political risk -- however material -- cannot be reduced to a number, so it tends to get left out.

After reading “The Fat Tail: The Power of Political Knowledge for Strategic Investing,” I feel nearer to understanding why.

The authors are from Eurasia Group, a political risk consulting firm. They succeed in convincing readers that lack of attention to their subject is a persistent problem. They are less good at making them believe the problem is soluble.

Corporations pay more attention to political risk than fund managers, if only because they tend to be stuck with their investments. Oil and mining companies spend a great deal of time assessing political risk because the resources they extract generally are at the mercy of host governments.

But it is not clear that they are better than anyone else at predicting big events, such as the collapse of the Soviet Union. Indeed, there is a shadow over this topic, in the form of Nassim Taleb’s recent and highly popular book, “The Black Swan.”

Most of the things that matter cannot be predicted, Taleb argues. They are statistical outliers: black swans or, more prosaically, “fat tails.”

Self-styled experts have shown themselves no better at predicting catastrophic events -- the terrorist attacks of Sept. 11, 2001, for example. Instead, they construct elaborate chains of reasoning after the event, then claim that such reasoning will allow us to do better in the future.

It is a serious charge, which “Fat Tail” authors Ian Bremmer and Preston Keat meet head on. Yes, they say, real black swans -- Donald Rumsfeld’s “unknown unknowns” -- are a lost cause. But most political risks are smaller stuff -- corruption, expropriation and the like -- and recur. Their likelihood, if not quantifiable, can at least be assessed and companies can take steps to protect themselves.

Even catastrophes can be handled well. Morgan Stanley’s emergency response to the 9/11 attack allowed its operations to suffer minor disruption, mainly because it drew the right conclusions from the 1993 World Trade Center attack and prepared for disaster by creating a crisis response plan.

Not all the risks the book identifies are so obvious. Take, for instance, regulation. In the aftermath of the Asian crisis in the late 1990s, the U.S. private equity firm Lone Star Funds bought the Korea Exchange Bank for an appropriately small sum.

Stung by this, the South Korean government has recently charged those involved with offenses including stock manipulation and tax evasion. Attempts by Lone Star Funds to sell the bank have been blocked.

Regulatory risk is not confined to emerging nations. The U.S. Sarbanes-Oxley Act of 2002 -- a response to the Enron scandal -- imposed heavy compliance costs on foreign companies, many of which then had to cancel their U.S. share listings at great expense.

A central tenet of “Fat Tail” is that companies and investors pay more attention to economic criteria than to political ones, in spite of the fact that the reverse is true for governments.

The book cites the case of the chief Europe economist of a large Western bank, who assured his executive committee in August 1998 that the risk of Russia’s defaulting on its debts was not significant. Economic analysis showed that the country could meet its obligations but missed the fact that Boris Yeltsin’s regime had good political reasons to default. It did so two days later.

Or take the 2003 study in which Goldman Sachs introduced its notion of BRICs -- Brazil, Russia, India and China -- as the powerhouses of the future. The study made the simplifying assumption that political arrangements in those countries would be roughly unchanged 50 years hence.

Consider how very differently those countries operated 50 years ago. Nobody, as the “Fat Tail” authors remark, gets 50-year political predictions right.

All this is good stuff, but it brings me back to my original point. The issue is not whether the decisions of corporations and portfolio investors are worse for lack of a robust political framework. Of course they are.

It is rather whether such a framework is at hand. The book is a systematic introduction to the topic, but readers are ultimately left short of answers.