OLIGARCHS & THE COST OF CAPITAL (*)

" ...there is a natural aristocracy among men" — John Adams

Agustin Mackinlay | @agumack

Would you like to be an aristocrat? Or an oligarch? What's the difference? And what does it have to do with the cost of capital? Let's start with a few definitions. Inequalities of all sorts —arising from wealth, birth, talent, education, beauty, strength, energy, eloquence— create élites. Ancient Greeks considered it a natural phenomenon: κατά φύσιv. In this sense, the term ‘aristocracy’ refers to influence rather than to formal titles or ancestry. And that's fine! The talents and the energy of a Steve Jobs, a Jimmy Wales, a Jack Ma or a Sheryl Sandberg are assets that societies do well to protect, nurture and reward.

French magazine Le Figaro runs a cover story about the ‘true power of aristocrats’; meanwhile, the weekend edition of the Financial Times refers to American politicians and their clever use of Instagram and other social networks to gain votes and influence. All of this is perfectly natural. Aristocrats will always seek more influence. Ambition knows no bounds. But even a natural aristocracy, if left to its own devices, can degenerate into an oligarchy—the rule by a few persons concentrating wealth and political power in their own hands. The surest sign that an oligarchy runs a country is the lack of judicial independence and central bank independence. It's called 'institutional capture'. Judicial independence is hard to measure—it encompasses the quality of judges' training, the stability of their tenure, their salary, and the degree to which precedents act as a formal source of law.

The two surveys that I use here are conducted by Canada's Fraser Institute [see] and by the WEF as part of its World Competitiveness Index [see]. My friend José-Luis Espert, an Argentinean economist who will run for president later this year, has documented the corrupt links between politicians, trade union leaders and crony capitalists [1]. The flip side of this ‘soft oligarchy’ is all too apparent—unstable property rights that shrink the size of credit markets, as the supply of credit naturally contracts. In Argentina, where interest rates are 50%, the value of local-currency denominated outstanding bonds is a ridiculously low 8% of GDP. It is 5% in Russia, a country where oligarchs run high. Venezuelan oligarchs are known as ‘boligarcas’, a reference to the so-called ‘Bolivarian’ regime; they have stolen more than $300bn—and the country is in ruins. In Iran, according to Reuters, the good ayatollahs control around $100bn in assets, thanks to their overwhelming influence in courts of justice. These are all high-cost-of-capital countries.

Good billionaires, bad billionaires 
Ruchir Sharma, Morgan Stanley director of Emerging Markets, has coined the terms ‘good billionaires’ and ‘bad billionaires’ [2]. The former tend to show up in productive and innovative industries such as technology, telecoms, retail, e-commerce, manufacturing, and pharmaceuticals. These are industries that need to compete, often on a global scale, and therefore need to remain competitive. And competition leads to lower prices for consumers. Bad billionaires are found in politically connected industries such as construction, real estate, oil and gas, gambling, metals. Competition in these sectors is often focused on securing access to a greater share of the national wealth in natural resources, not on growing the wealth in fresh, innovative ways.

Bad billionaires spend a lot of time trying to win over regulators and politicians, by bribery if necessary. Accordingly, they tend to earn monopoly profits while driving up prices. “Bad billionaires thrive on corruption”, writes Mr. Sharma. These distinctions roughly match our definition of aristocrats and oligarchs. Milking Bloomberg’s data on billionaires, Mr. Sharma has arrived at the following rule of thumb: if billionaires’ fortunes are more than 5 percentage points above the world average, that is threatening from the political risk point of view.

Financial markets and oligarchies
In terms of financial markets, there are some interesting conclusions. The most obvious point refers to the carry trade, a strategy in which an investor borrows money at low interest rates in order to invest in an asset that is likely to provide a higher return. Given the yield gap between low-risk currencies and the currencies of ‘oligarchic’ countries, the carry trade will always act as a magnet. Nassim Taleb, an acclaimed author on randomness and risk, has a warning for carry-traders: it’s like “picking up pennies in front of a steamroller”—an investment strategy that has a high probability to yield a small return (pennies), and a small probability of a very large loss (steamroller).

My advice, if you want to act a as a carry-trader, is to closely watch what I have called the ‘Global Dollar Liquidity’: it’s OK to pick up pennies when liquidity is abundant—but the steamroller is bound to crush you as soon as the music stops. Just ask investors in the Argentinean peso and the Turkish lira. In terms of valuation, make sure to adjust the Capital Asset Pricing Model to reflect the higher risk of ‘oligarchies’. Aswath Damodaran, the ‘Lionel Messi of Finance’ has some valuable suggestions here. I’ll come back to that point in another article. Finally, watch out for currency mismatches between debt and assets—another irresistible temptation for corporates, but one that must be factored in into your valuation.

(*) Originally published in LinkedIn on March 7, 2019.
 
[1] José-Luis Espert. La Argentina devorada. Buenos Aires: Galerno, 2017 [video].

[2] Ruchir Sharma. The Rise and Fall of Nations. Forces of Change in the Post-Crisis World. New York: W.W. Norton, 2016.
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