Housekeeping
Like always, it goes without saying that what I write in these posts is not financial advice. Also the opinions here are solely my own and they don’t represent the views or opinions of any company I might be affiliated with at the time of writing.
Just wanted to take one paragraph to say that I’m not going to pretend that I understand anything about military strategy or that I’m an expert in geopolitics. It’s natural to be worried about your savings/investments and if they might be affected by the conflict. If that’s your situation, like it is mine, I would consider it a luxury compared to the people in Ukraine whose current worry is whether they and their country will survive the day. Or the civilians in Russia who now have to worry about their livelihood in a battered economy due to a war they most likely do not support. As for your investments, many of the principles I’ve discussed in past posts continue to apply even in today’s situation, so the information is already there for you to find if the conflict keeps you up at night.
Now, on to the boring stuff!
The Circle of Competence
“The first rule is you must not fool yourself. And you are the easiest one to fool.” - Richard Feynman
The Circle of Competence is a simple concept to grasp, and its relevance in investing is underrated. Your circle of competence encompasses those businesses or asset classes that you truly understand, with all the complexities and nuances inherent to them. Having this level of understanding helps you to critically analyze the merits of each investment based on their fundamentals while accounting for the most important details that others would miss.
The Key Points
If you’re unsure whether it’s within your circle, then it’s not within your circle. Don’t fool yourself. You know when you don’t know, and marginal knowledge is even worse than zero knowledge. The red zone is where you will fuck up the most.
You should also be keenly aware of where the edges of your circle are. This is great because it allows you to actively target areas for expanding the circle.
Focus on what is important AND knowable. There are many irrelevant variables. But even among the important variables there are some which are simply unknowable, such as what interest rates are going to be in 10 years, or whether a pariah state will launch a nuclear missile at a major population center. As much as variables like these would affect the value of any investment, they’re simply unpredictable for the vast majority of people, so it’s a waste of time to base your decisions off of them.
How to Develop your Circle
If you want to understand how a particular business works you either have to read extensively about it (books, articles, industry publications, company annual reports, etc.), talk with people that work in that industry, and/or obtain experience working in that industry. With patience, over time, knowledge will compound and give you a clearer picture.
Your circle doesn’t have to be huge. Many investors focus on relatively few businesses that they know quite well, giving them an edge. As long as you stay honest with yourself about whether something is within your circle, you will have plenty of opportunities to pounce on.
A Humbling Example
Early in 2021, I invested in AstraZeneca (LON:AZN). I think one of the main trends of the next 20 years will be the deterioration of demographics in developed economies, resulting in increased consumption of medical drugs and treatments. AstraZeneca has a well structured portfolio of patents which are not yet close to expiry, across key medical areas, and with a very balanced distribution of business across North America, Europe, and Emerging Markets. Management has done a fantastic job during the past decade bringing the company back to life, increasing revenues, boosting margins, and placing the firm in a position of strength. Importantly, sentiment around the company was negative at the time due to criticisms of the AstraZeneca vaccine and the company’s beef against the EU, which in my opinion created an ideal environment to buy. So I did a valuation of the company and bought the stock.
A couple of months ago I was going through the company’s latest quarterly report reading through the updates on their trials for different drugs, and it suddenly hit me. I have no fucking clue what to look for when analyzing whether a drug will be successful. Like, zero clue. Not even kidding. I can tell you the financial effect of patent expiries and the pros and cons of their sales strategies in different markets, but when it comes to what makes a drug succeed or fail I am a complete donkey.
I guess that back when I bought the stock I convinced myself that I really didn’t need to have detailed knowledge of this factor, so I fooled myself. I had a small gain in the investment, but once I realized I messed up in my analysis I immediately sold without looking back. Any future profit I made would have been a result of pure dumb luck. Investing is already quite hard for me to rely on luck like that. Lesson learned.
The Point of No Return?
“See the world as it is, not as you wish it would be.” - Emily Lockhart
Financial Warfare
You probably heard about the barrage of sanctions that “the West” has imposed on some Russian institutions.
The significance of these sanctions is enormous. The world order is changing right in front of our eyes. Among the most important ones:
The Central Bank of Russia’s foreign exchange reserves were frozen. While the central bank does hold ~20% of their reserves in physical gold and ~13% of their reserves in Chinese yuan (not frozen), the rest of their reserves in US dollars, euros, Japanese yen, British pounds, are by all intents and purposes, gone. Poof. Disappeared.
Russian banks were shut off from the corresponding banking system for US dollar transactions. As a reminder, the US dollar accounts for 50% of of global trade invoices.
7 Russian banks were disconnected from SWIFT, the global messaging network for international payments. Although it’s important to note that Sberbank and Gazprombank were not included in these particular sanctions. Europe still needs to buy Russian energy.
MSCI and FTSE Russell, two of the largest index providers, are excluding Russian assets from their indices, effectively pushing passive funds that track these indices to divest their Russian holdings. JP Morgan has also followed suit.
This is, without exaggerating, financial warfare. The effect on Russia’s economy has been, and will continue to be, devastating. Just look at the Russian ruble.
Some European banks, such as Raiffeisen, SocGen, and Unicredit, have sizable Russian exposure, although small relative to their total exposure, so risk of any widespread banking crisis appears to be small.
The Implications
There will be losses, and there will be bankruptcies, but it’s to-be-determined whether any of these are large enough to generate cracks in the system.
However, these sanctions send a clear message. Even if some sanctions turn out to be ineffective (some by design), the message is a strong one. Take the wrong step and you’re out of the Western financial system. And by all intents and purposes, the Western financial system is the global financial system. Not to mention the effect of private companies withdrawing from your country and reducing the quality of life of regular citizens. A quick glance of what is happening in Russia and the significance of this is more than evident.
Investors, being smart and risk-averse as they are, will be more attentive to these geopolitical risks moving forward. Now, obviously not many investors are fishing for juicy investments in Iran, North Korea, or Venezuela. So we turn to China. Again.
We’ve seen some of these exogenous risks here already, such as regulatory risk this past year with China’s tech companies, for example. The KWEB ETF is a good proxy for this sentiment:
Do I think China was/is thinking of invading Taiwan? No, I don’t. I don’t think they were seriously thinking of doing it before, and I don’t think Russia’s invasion has convinced them that this is the right time to do it. The Chinese government is many things. Stupid is not one of them. That’s not the point.
The point is that there’s still a chance, in my opinion extremely small, that it could happen. There’s also still a small chance that the Chinese government could nationalize, ban, or otherwise neuter any private company operating in the country. The fact that the probability is more than zero means that it will be accounted for by investors when they price these assets. Said more clearly: Chinese stocks may have a permanent discount to what they would be worth if they weren’t based in China.
Fundamentals are the most important aspect to consider when evaluating an investment. Unfortunately, in today’s environment and in the foreseeable future, investors will be much more careful and conservative when pricing investments in jurisdictions on less-than-friendly terms with the West.
Under normal circumstances, the value of the business drives the share price in the long-term. However, it might be worth recognizing that these are not normal circumstances, and that we may not return to normal for a long time. I could definitely do without the headache of having to worry about these geopolitical factors.
It’s something I will think about deeply during the coming months. But like I said at the beginning, I don’t understand military strategy and I’m not an expert in geopolitics. Nevertheless, it’s well worth pondering whether investing in China now requires geopolitics to be in my circle of competence.
Thank you very much for reading! Hope you enjoyed and that the concepts I discussed are at least a tiny bit helpful! Until next time!