Until recently, sovereign wealth funds (SWF) were cast as villains, pools of capital controlled by foreign governments pursuing agendas other than maximizing investment returns. That perception has softened after SWFs helped recapitalize several major Western banks during the financial crisis. The emergence of SWFs controlled by a number of emerging nations marks a clear shift in the global economic order. We recently spoke with Yiannis G. Mostrous, who, with Elliott H. Gue and David Dittman, co-authored "The Rise of the State: Profitable Investing and Geopolitics in the 21st Century" (FT Press). Mostrous explains how the growing influence of SWFs will impact the global economy and how individual investors can profit by following their key investment themes.
Shepherd: What is the main premise of the book?
Mostrous: The book’s main idea is that governments of influential states will play a greater role in the world’s economic and financial activities. Furthermore, the rise of emerging economies will lead to a more balanced world where the dominance of the West, led by the US, will subside. This should set the stage for an increasingly polycentric approach to geopolitical and economic issues.
The end of Western economic dominance is almost a certainty, though it won’t happen overnight. But what’s more interesting is the new reality that will emerge. Developed-world economies are in a precarious condition after the credit crisis of 2008-09. This instability and the extreme measures required to counteract the crisis have hurt government balance sheets. Governments have made long-term commitments to their citizens, and a paradigm of entitlement has gripped these societies. This will prove a difficult burden to shed.
Add to this an aging Western population and the retirement of the “Baby Boomers” that have been America’s growth engine for decades. Western governments will have bigger domestic issues to deal with, rather than worrying about their global economic dominance.
The good news is that Western investors can profit from the power shift. This book should give them the tools to do just that.
Shepherd: Does this shift in power mean governments will play a greater role in the free market?
Mostrous: Yes. Today’s rising economic powers are led by governments that traditionally have been deeply involved in financial and economic matters--practitioners of what many have called “state capitalism.”
As these economies are still in a transformative period, and given that their citizens are accustomed to high levels of state involvement in their economic life, this movement will become even more powerful.
Shepherd: Do SWFs use their cash as a foreign policy tool or merely for investment purposes?
Mostrous: SWFs have been vilified by a lot of people as a Trojan Horse wheeled out to breach the walls of the Western financial system. There may be some truth to this accusation, but although several SWFs rank among the world’s top institutional investors, as a group they still represent a relatively small slice of total invested assets.
Furthermore, the credit crisis proved that SWFs can also help to stabilize the global financial system. SWFs provided significant capital to Western institutions at critical moments during the crisis. They also were among the most aggressive global investors in the early days of the recovery.
Given that SWFs have a different mandate than other sovereign money-handling entities, investment returns are paramount to them. While foreign reserves have historically invested in sovereign fixed-income notes to intervene in the foreign exchange market, SWFs typically take a longer-term approach. International equities, commodities, and private fixed-income securities are all used to achieve the long-run strategic and financial goals of a sovereign nation.
Shepherd: How can investors benefit from the new political and economic realities described in the book?
Mostrous: There are two main ways for investors to benefit from this transformation. The first is to invest in the same areas as SWFs. This means buying the same things that the emerging markets need, such as technology or natural resources. The second strategy is to invest in the countries that sponsor these funds. SWFs and other government-related money managers allocate a portion of their funds to investments that will ultimately benefit their domestic economies. Once these benefits begin to accrue, these economies will be able to sustain strong growth for longer periods.
Shepherd: What are some of the investment themes you’ve identified?
Mostrous: Energy is one of the main themes, especially coal and natural gas. Oil also features prominently in the book, and we strive to provide our readers with a historical perspective on energy markets.
We also don’t subscribe to the prevailing wisdom regarding alternative energy. We argue against the widespread delusion that alternative forms of energy are destined to replace oil, natural gas and coal in the short- to intermediate-term.
We also have an interesting take on investing in water, and not just in the traditional sense of buying utility companies. We have identified the three main trends in water investing as well as one unconventional trend that doesn’t involve potable water--namely fisheries. Fisheries represent a stealth growth industry, especially because fish remains one of the basic foods in Asia, a region whose economies and population are growing strongly.
Transportation and health care are another two investment themes. We devote a lot of the book to trains, which are becoming one of the fastest-growing infrastructure segments in the emerging world, particularly in Asia.
On healthcare, we examine how an aging, but more prosperous, population in emerging economies will spend its money. Add to this the efforts to provide universal healthcare in China, and it’s easy to see the magnitude of the opportunity.
Shepherd: Tell us about some of the specific long-term stock recommendations in the book.
Mostrous: Generic pharmaceutical companies will remain relevant for a long time and one that every investor should own is India’s Dr. Reddy’s Laboratories (RDY). The company also develops and manufactures pharmaceutical active ingredients used to produce other drugs as well as proprietary branded products. Dr. Reddy’s has an inexpensive workforce operating 16 production facilities in India, providing it with a significant cost advantage. Geographic convenience also plays a role in the company’s strength, as Dr. Reddy’s is experiencing rapid growth in Asian markets.
In regards to water-related investments, the book highlights an interesting Chinese utility company. Beijing Enterprises Water Group (Hong Kong: 0371) has two water-treatment plants and 24 sewage-treatment plants. It boasts water-processing capacity of 1,885,000 tons per day, sewage processing capacity of 1,735,000 tons per day and water-supply volume of 150,000 tons per day.
Kentucky-based Ashland (ASH) is a global specialty chemicals company with 20 percent of its sales derived from the water industry. In addition, about one-third of the company’s revenue is generated outside the US. Ashland manufactures a wide variety of chemical components critical to manufacturing and water-infrastructure development.
Shepherd: What about energy?
Mostrous: We like coal. Investors should note that although countries such as China and India will continue to pursue natural gas, nuclear, and other sources of electric power, coal remains the cheap choice and will still be the largest source of power 20 years from now.
US-based coal mining giant Peabody Energy Corp (BTU) is a good stock to own for the long term. The company has shifted its operational focus from the US to Australia and, to a lesser extent, other regions within Asia.
By 2014, through a series of major mine expansions, Peabody believes it can expand its thermal capacity to 13.7 to 15.5 million metric tons, and its net coal capacity to around 11 to 13.7 million metric tons. That would represent production growth of 77 and 117 percent, respectively.
We also think that the long-term growth story for natural gas remains strong, as it has three powerful advantages over oil: It’s more widely available, it’s cheaper, and it’s environmentally friendly. Investors should look to Enterprise Products Partners LP (EPD), one of the largest operators of natural gas processing and fractionation facilities in the US.
Oil will remain an important resource for years to come, as the end of “easy oil” is now a reality. Output from the large, cheap-to-produce fields that have been the mainstays of global production for decades is declining. Producers are turning to more expensive and difficult fields. Replacing easy oil production with hard-to-produce crude spells higher prices and myriad opportunities for investors.
Weatherford International (WFT) remains an underappreciated operator. The company is best known as a provider of services related to mature oilfields. It’s a relatively small player but is expanding rapidly in key international markets.
Traditionally, Weatherford has had a strong presence in North America, particularly Canada, where aging oil fields have been a proving ground for technologies that squeeze oil from older fields.Disclosure: No positions