Managing Geopolitical Risk

A 7 Steps Method to War Time Risk Management

Muddling through troubled times

I have had quite a few discussions lately with other investors and writers about geopolitical risk. Especially about China, and Taiwan, but also looking at the onset of the Ukraine-Russia war in the rearview.

From those discussions started to form in my mind a more definitive version of the method I have been using for managing geopolitical risk.

This is especially important for me as a large part of my portfolio was and is invested in non-Western jurisdictions. But as we will discuss, I think that for the next decade, this method will apply equally well and be needed for investments in Western markets as well.

Photo by Gaël Gaborel - OrbisTerrae on Unsplash

The return of history

There was a long period of time when investors could simply ignore global politics and power games. The archetypal example of an investor using this method is none other than Warren Buffet.

From 1945 to the 2010s, America has simply been an extraordinarily stable and safe jurisdiction. Buffett famously said, “never bet against America”. For the quasi-integrality of his investing career, this was sound advice.

You WERE better off investing in companies like Coca-Cola and other staples of the American economy than anywhere else. Most important to these was how safe from the rest of the world's turbulence these companies were.

You might have gone through the Cuban Missile Crisis, the Vietnam war, the fall of the Berlin wall, and none of those mattered to Coca-Cola earnings. If anything, the collapse of the Soviet Union and the opening of China were the last straw that made American companies great. Now they could both have a solid base home AND make tons of money and growth in formerly out-of-reach markets.

In that world, it made little sense to even try to invest abroad.

Of course, today, most of the growth of Western companies is dependent on sales to the rest of the world. And most of their supply chain is global. And their production is done in Asia. And the raw materials come from somewhere else.

So, silently, this safety advantage has completely disappeared.

Would tomorrow a China-USA conflict erupt over Taiwan, do you really think Coca-Cola, Ford or Apple stocks will be a safe haven? Was German chemical giant BASF safe from a war in Ukraine? How about UK or French utilities?

So I would argue that very few companies are now fully safe from deglobalization and international tensions. The world is flat and no one is safe. Not even good old Coca-Cola, GE or GM.

Step 1: Being paid for the risk

I went on this tangent about (de)globalization because currently, most Western and even more US corporations are still priced as inherently safer than the rest of the world. But this is hardly justified considering the new political, geopolitical and economic reality.

To top international risk, domestic politics are not helping either. Western jurisdiction used to have a strong rule of law and be overall pro-business.

The Western political discourse is now dominated by promoting inefficient energy sources, universal income, taxation and welfare, crony capitalism, tech monopolies, and central banks printing money by the trillions.

For the most recent example, let’s just give a look at UK bonds. This is not how a safe jurisdiction behaves. This is low-tiers emerging market material.

Name is Bond, Junk Bond

So the first step in investing should be getting a proper reward or margin of safety compared to the risk. In this game, which do you prefer:

• Shell: A Western oil company whose own CEO is asking for more taxes, actively squandering the money away from its core competency, collapsing oil & gas reserves, de facto forced by Dutch courts to cut production by half in 8 years, giving 3.75% dividend yield. P/E of 5.9

• Petrobras: A Brazilian oil company with local political risk, distributing a 51% (!!!!!) dividend yield and expanding production as fast as it can. P/E of 2.9

• CNOOC: A Chinese oil company with geopolitical risk but strong state backing at home, also expanding production and reserves as fast as it can, giving away a 14% dividend yield (which I cover more in-depth here). P/E of 3.7

I cannot imagine why Shell, which is essentially doomed as an oil company, should be valued at a twice higher ratio than Petrobras or CNOOC.

Is it the ridiculously low dividend yield? The hostile judiciary telling it to self-destroy its business? The mal-investment in low or negative ROIC ventures like windmills? Or the inept management asking for shareholders’ profit to be taxed away?

This is not to say that CNOOC shares could not be sanctioned like Gazprom was. Or that Petrobras is fully safe from the mess a Lula-controlled Brazil would be.

But at the very least, these companies give you some margin of safety:

• their valuation is already at rock bottom.

• dividend yield range from good to comically high.

• they are growing production and expanding, instead of actively committing seppuku.

So the first rule in managing an increasingly risky world is to ask to be paid for your capital. And I have a preference for a 10% or more dividend yield. It shows a will to actually give money, instead of wasting it on ideology or corruption. It might change in the future, but I am at least getting paid for taking that risk. Smart share repurchases can be ok as well, but harder to find.

Step 2: Diversification

This should be obvious, but so few people actually do it. So let's look at what bad excuses could be at work.

Some of the bad reasons to not diversify the geopolitical risks:

1. Investing only at home: it worked since 1945, but it will not anymore with the Western market and currencies reacting as if they are now emerging markets (see UK bonds and the pound value).

2. Investing only in the West. As the Dutch court ruling telling Shell to suicide as an oil company shows, rule of law is in decline everywhere. The only question is if you are being paid for this risk (see step1).

3. Getting enamored with one destination. No matter how much you love the Russian, Polish, Brazilian, or Chinese markets’ valuation, don’t put all your eggs in one of them. It is unlikely that ALL of those going simultaneously into a civil war or invade their neighbors. It IS likely one or two will screw up.

4. Pretend geopolitics does not matter because it hasn’t really for decades. Tell me again how Russia is irrelevant to your specialized, small German manufacturer selling only to the EU and USA, who sees its electricity price go up 10x in one year…

Just diversify. You’ll thank me later.

For that matter, this is why I do not invest more in Brazil ( I own ELP and PBR). This looks like the best market in the world currently: only local risk, not international risks, a commodity-based currency, and crazy high dividends.

But I will keep it at max 30% of my portfolio …. this is still Brazil (no offense to any potential brazilian reader).

Step 3: Everybody lie

The thing I see again and again leading to poor risk management is echo chambers. At no time is it more spectacular than with the perception of Russia. You are either pro or anti but seemingly cannot listen to both positions.

Or (gasp!) have your own nuanced opinion.

It is absolutely impossible to understand a situation if you are not listening to both sides.

The idea is NOT to find who says the truth. This is not about picking a side and deciding who’s right.

As a rule of thumb, it is safe to assume BOTH sides are lying.

Discerning the truth in international politics is more about figuring out how and why they lie than who is saying the truth.

Step 4: Expand your mind

What usually kills you in investing is what you didn’t even know you didn’t know. The unknown unknowns.

To find blind spots or facts omitted from a narrative, you should:

• NEVER read about a speech or declaration in a news article. Read the transcript yourself in full.

• Never rely on analysts from only one “side” or that all agree with each other. (see step 3: echo chambers)

• Try to find primary data, not comments on them.

• Look at maps, especially old or historical maps, and learn the relevant geography to build a multilayer mental model (geography, natural resources, industries, infrastructures, ethnicity, cultures, languages, religion, old borders, voting patterns, age pyramid, ecosystems, agriculture, population distribution, etc…)

• Read about history. Learn the perspective and national myths of multiple nations.

• Read about humanities, not mind-numbing news. Political systems, economic theories, philosophy, and theology. Realize how limited a culture’s ideas and values are compared to the full human experience.

Step 5: Stay mentally flexible

The Russian admirers could not imagine Putin would invade Ukraine. So they were completely blind to the Russian government telling explicitly they were done with diplomacy from late December 2021 onward.

Any negative news or prediction had to be “Western propaganda”.

I have seen investors I admire trying for months to defend their devastating financial losses. The truth is they were so sure about “Western propaganda” that they did not listen to Russia itself telling it themselves weeks in advance.

Pretending it was unpredictable was also a way to brush off their very real personal responsibility for listening blindly to an echo chamber.

I used to think Gazprom paid me well enough for the risk when I owned some shares. And frankly, it did.

Besides, I felt the risk was very small. (Boy, was I wrong on that one).

But when I saw the sudden and brutal change of tone from the Russian administration, I changed my mind. I sold everything at a nice profit almost 2 months ahead of time.

If the situation (diplomatic posturing) changed, so did my opinion.

Staying informed + Staying flexible = good data + processing them properly.

These are the new rules of the game. Or maybe it’s the old rules as well, but forgetting them is more dangerous then ever.

Step 6: Be aware of your own bias

After the invasion of Ukraine, there were tons of “Hahaha, you deserve it, you evil Putin apologists. Who is stupid and greedy enough to trust Russia or Russian companies?”.

The funny thing is, most of these commentators also held opinions like:

• The sanctions are devastating Russia’s economy.

• The Russian army is entirely destroyed after a few weeks.

• Russia is running out of tanks and missiles.

• Russia will collapse soon.

• China cannot afford to support Putin.

• China might look to take over Siberia.

• China is learning a lesson about the futility to pressure Taiwan.

• Green energy solved dependency on fossil fuels.

• Inflation is transitory.

I would be very curious to see how their portfolio is doing with the inflation and energy crisis.

Most of the investors who avoided the Russian debacle were not better informed. They were just lucky to have (for a while) the “right” bias.

Step 7: Respect luck

You will not always be right.

This is your fault.

You will sometimes be right.

It is most likely luck, NOT talent or intelligence.

This mindset serves me well to make proper analyses. Staying humble is a key psychological component to achieving steps 4, 5, and 6.

It is by expecting to be wrong you might get it right. Such is the paradox of any high level of reasoning.

Bonus step: an example of applying this mental model

Of course, the obvious next risk is Taiwan. So I can walk you through how to apply this model step by step:

Step1: Be paid for the risk

So only Chinese or China-exposed companies at an absurdly low price should be considered.

Step 2: Diversification

No more than 30% of Chinese or China-exposed companies. I might be breaking this rule with commodities at large, but this is more of a “global great depression/WW3” risk. Not too sure how to diversify away from that one…

Step 3+4: Trust nobody + unknown unknowns

What if both the USA and China actually want war? What if the Taiwanese people want reunification? What if the war starts in Korea? What if China attacks India? Or used Pakistan as a proxy?

Most of these ideas will be wrong. But I would be a fool to not even think about it and consider these scenarios.

Step 5: Stay mentally flexible

Currently, I expect China to not attack Taiwan for years, for supply and logistical reasons, as well as military abilities. But if I see them stockpiling more oil, metals and selling international assets, I will change my mind.

Step 6: Be aware of your own bias

What I am missing? What element of communist China I am misjudging as a Christian European? What part of Chinese or Western propaganda I don’t even know is propaganda?

Step 7: Respect luck

I was right, and ahead of time with Ukraine. Maybe I will not be about Taiwan. Maybe I am missing a completely different risk somewhere else.

I must remember that I will achieve steps 3 to 6 by not congratulating myself for my past successes.