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

RETHINKING
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 OECD.org, both US and Mali GDP figures given were calculated using the expenditure method.