Monday, August 13, 2007

The guidance at the bottom of the pyramid?

(Moussa Keita and Rian Aldridge install a wireless antenna in Bamako)

Being a newcomer to the world of developmental finance C.K. Prahalad's book The Fortune at the Bottom of the Pyramid was very useful in helping me to understand what takes place in under developed markets. I have listed verbatim some of the takeaways I used from the book. I have also tried to adapt some of Prahalad's model to better suit smaller markets. As always I am simply giving my interpretation of the authors work, and I am always open to feedback.

In The Fortune at the Bottom of the Pyramid, C.K. Prahalad proposes that there is a vast, untapped market that exists in developing nations with large populations. Prahalad argues that this market opportunity has remained untapped because multinational corporations have to rethink traditional business models to exploit the opportunity profitably.

“The BOP, as a market, will challenge the dominant logic of MNC managers (the beliefs and values that managers serving the developed markets have been socialized with). For example, the basic economics of the BOP market are based on small unit packages, low margin per unit, high volume, and high return on capital employed. This is different from large unit packs, high margin per unit, high volume, and reasonable return on capital employed.”­ – C.K.Prahalad, The Fortune at the Bottom of the Pyramid.

Prahalad suggests 12 principles to serve as “the building blocks of a philosophy of innovation for BOP markets.” They are listed below:[1]
1) Focus on price performance of products and services
2) Innovation requires hybrid solutions. BOP consumer problems cannot be solved with old technologies
3) As BOP markets are large, solutions that are developed must be scalable and transportable across countries, cultures, and languages
4) All innovations must focus on conserving resources: eliminate, reduce, and recycle
5) Product development must start from a deep understanding of functionality, not just form
6) Process innovations are just as critical in BOP markets as product innovations.
7) Deskilling work is critical
8) Education of customers on product usage is key
9) Products must work in hostile environments
10) Research on interfaces is critical given the nature of the consumer population.
11) Innovations must reach the consumer (both highly dispersed rural market and a highly dense urban market)
12) Paradoxically, the feature and function evolution in BOP markets can be very rapid. Product developers must focus on the broad architecture of the system – the platform – so that new features can be easily incorporated.

When I read these principles of innovation I understood the message but wondered if the model is applicable to countries such as Mali due to their lack of population density. While Prahalad addresses the need to serve the urban market he is mainly addressing the need for MNCs to explore all markets in countries like China so that massive populations may be fully reached. In areas of lesser population density, investment by MNCs is harder to justify but these markets still need to be served. As Prahalad proposes, a fundamental rethink must occur however in the case of smaller countries investment may need to be approached in terms of regional expansion.

Brazil, Russia, India and China (BRIC) are often looked to as examples of the economic potential of emerging markets. However the economies of these countries are not representative of all emerging markets. Each of these countries has large populations; Russia has the fewest people with approximately 141 million[2]. Each of these countries is very large in terms of area; India is the smallest with approximately 3.2 million square kilometers[3]. The average GDP of the BRIC countries is $4.43 trillion; China’s economy is particularly large with a GDP of over $10 trillion[4]. These countries are used as the benchmark for emerging market investment but I believe looking to these markets may blind us to other opportunities.

If investment is made on the basis of returns on extremely high volumes in a dense area, with a relatively large consumer buying power (on aggregate), how do small nations attract investors? In other words, if we condition MNCs and individual investors to use size and returns on size as the acid-test for investment into developing markets we condition them to believe that all sites failing the acid-test are not worthy of investment when this may not be the case. For example Mali exhibited a 5.1% real growth rate in 2006[5] but given as an absolute dollar amount the Malian economy is this growth is fractional when compared to growth in any of the BRIC countries. However looking at a group of West African countries we can see how thinking regionally can help identify opportunities: Mali, Senegal, Cote D’Ivoire, Liberia, Guinea-Bissau, Guinea, Gambia, Burkina Faso, Togo and Benin. The population of these nations combined is approximately 86 million, and has a greater population density than either of Russia or Brazil[6]. I am not trying to suggest that anyone should invest in each of these countries simultaneously but thinking regional helps to identify opportunities, which are otherwise not feasible. Because these markets must be considered in a unique way, opportunity must also be evaluated in a unique way. Factors such as ability to adapt to numerous markets and to provide a high level of price performance are extremely important. Sustainable business practices including human resource development are important to both financial success and to social impact.

The need to identify opportunities in Africa in non-traditional ways caused us to incorporate the ideas put forth by Prahalad with our own ideas of success factors in these markets. Below are the evaluative criteria we have developed for identifying companies that represent potentially profitable opportunities for equity investors.

[1] The Fortune at the Bottom of the Pyramid – C.K. Prahalad, © 2005 Pearson Education, Inc. Wharton School Publishing, Upper Saddle River, NJ 07458
[2] CIA World Fact Book Online
[3] CIA World Fact Book Online
[4] CIA World Fact Book Online
[5] Estimate - CIA World Fact Book Online

[6] CIA World Fact Book Online

Friday, August 3, 2007

Rethinking Traditional Methods of Investing

Hello again, this installment of the uventurecap blog looks at how I came to realize that local market expertise might be a necessary substitute for applied portfolio theory. As always, any feedback or thoughts would be appreciated. As you can see below I think that small companies who are operating, have operated in Africa, might be the bridge to help mitigate risk that is inherent in investing in Africa. Also I would like to apologize that I could not figure out how to use the superscript and subscript that would make reading the equations below easier on the eyes.

Rob Tudhope

To use portfolio theory I began with a top down approach. I wanted to analyze the risk associated with investing in Mali. Ideally, I would have liked to identify risk as a function of variance and establish a correlation between the Malian economy and North American economic growth. Had I been able to do so, I could have drawn conclusions about the effect that investing in Mali would have on a well diversified North American portfolio. Note that portfolio risk would be defined as follows:

σp2 = wna2σna2 + wm2σm2 + 2wNAwMρna,mσnaσm

where: σp2 = portfolio variance
wna = weight of the well diversified North American Asset (market portfolio)
wm = weight of the investment in a Malian asset (company)
σna2 = variance of returns of the North American asset
σm2 = variance of returns of the Malian asset
σna = standard deviation of returns of the North American asset
σm = standard deviation of returns of the Malian asset
ρna,m = correlation of the Malian asset

Correlation between the Malian economy and the North American economy could be calculated by comparing GDP growth figures over time and standard deviation of growth of both economies could be easily calculated from historical data. However, Mali has no equity exchange market like the Toronto Stock Exchange or the New York Stock Exchange so comparing returns and correlations on equity investments is more difficult. To do so I would have to develop a risk premium for equity investments into Mali and assume that returns would be similar to a proxy for North American equity returns (S&P 500). After the creation of this risk premium my plan was to use the relationship between North American economic growth and equity returns as a predictor of expected returns in Mali. Normally the risk premium necessary to justify investing in a foreign market is determined by analysis of market data (of which none exists for Mali) or by a team of economists, financial analysts and political scientists. I do not possess the knowledge, or expertise to fill in for a team of experts so I had to settle for simply using GDP volatility as a proxy for equity returns. For the assumption that Malian equity returns would in the same way, relative to GDP growth, as North American equity returns to be valid, both economies would have to demonstrate some similarities. Therefore, my next step was to examine the Malian economy and its drivers.

My first step was to check Standard & Poor’s rating of Mali as a borrower. With a B rating investment in Mali appeared to be below investment grade. To better understand the risks associated with investing in Mali, my next step was to research drivers of the Malian economy.

According to the country report on Mali in the OECD’s African Economic Outlook:
“Mali’s economic growth outlook remains favourable.” After recording a 6 per cent growth rate in real gross domestic product (GDP) in 2005, growth in 2006 is estimated at 5 per cent and is expected to be around 4.7 per cent per year in 2007 and 2008. This expansion would be due mainly to higher output in the mining sector and a big increase in food-crop production. The good prospects are also explained by a rising domestic demand helped by private and public investment, especially in 2006.” – OECD 2007

While the Malian economy appears to be in an expansionary state I found it difficult to fairly compare this growth with growth figures in North America. Firstly, Mali’s economy is significantly smaller than that of a developed country: US GDP in 2006 was ≈ US$12.7 trillion, whereas Mali GDP in 2006 was ≈ US$13.8 billion[2]. Secondly, developed countries have a number of industries that contribute to their productive capacity. Mali, on the other hand, is heavily reliant on mining (particularly gold), cotton production and farming. In each of these industries prices are set in a market where Mali is a price taker and as such has almost no power relative to buyers in terms of price setting. Thirdly, Mali’s ability to participate in trade is determined by its access to ports of neighboring countries. In 2004 social crisis in Cote D’Ivoire limited Mali’s access to ports, and reduced the amount of exported goods. Because Mali is land locked and it’s major trading partners are outside Africa i.e. China, port access is particularly important. While rehabilitation of road systems has begun, with particular attention being given to routes leading to major ports such as Dakar, Nouakchott, and Conakry, access to ports still presents a significant impediment to trade.

These dissimilarities between the infrastructure and drivers of Mali’s economy and those of a developed nation do not disqualify Mali as a location for potential investment. However, drawing meaningful comparisons about the Malian economy in terms of traditional metrics could easily lead to false conclusions.
I originally hoped to argue the merits of investing in Mali, in terms of portfolio theory, based on the low correlation between the performance of North American and Malian investments. Ironically the causes of this low correlation made it impossible for me to argue their benefits in a traditional sense. I found my problem with investing in a developing market was symptomatic of doing business in a developing market and is the case for many businesses I had to come up with a market specific solution. Eventually the solution became obvious; instead of marketing investment in African companies, which is difficult to explain and even harder to quantify, it is easier to sell the market expertise of a Canadian company, Adapted Consulting. I came to the conclusion that investors will be much more responsive to the prospect of investing in a Canadian company who has intimate market knowledge of an otherwise inaccessible niche market, as compared with the prospect of investing in small companies in small economies in foreign markets.
[1] Data and factual information concerning Mali are taken from the OECD’s African Economic Outlook (2004,2005,2006,2007 – Mali) unless otherwise stated.
[2] Data gathered from, both US and Mali GDP figures given were calculated using the expenditure method.