Frequent readers of our blog posts and research papers likely are well acquainted with our underlying philosophy that commodity prices alone do not provide a compelling rationale for investing in real asset businesses. Instead, as a result of decomposing the returns of individual real assets businesses, we have found that these stocks often exhibit a broader range of return drivers. One such driver is political risk.
Where there is risk, there is often opportunity
While the term "risk" may evoke a feeling of discomfort among some investors, we believe assessing political risk requires a nuanced approach—one that combines caution and optimism. This reminds us of a poignant phrase that reverberated throughout John F. Kennedy's 1960 campaign for the U.S. Presidency:
"The Chinese use two brush strokes to write the word, 'crisis'. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger—but recognize the opportunity."
Although the specific Chinese linguistic reference may be more symbolic than linguistically accurate, the essence of the phrase endures as a reminder to acknowledge the inherent dangers in crises while maintaining a keen eye for the potential opportunities they present. We believe this wisdom extends to the realm of political risk. To demonstrate this point, we provide an illustrative example.
Ecopetrol and Factor Exposure
The stock of Colombia-based oil company Ecopetrol has experienced a significant selloff due to political risk arising from Colombia's tumultuous 2022 presidential election. Two prominent candidates were vying for the presidency—one with liberal leanings and one with more conservative inclinations. The market's concerns surrounding the liberal candidate's policies stemmed from fears that he might lead Colombia toward a situation resembling a Venezuela-like Banana Republic. Although we think this is a valid concern to consider in any emerging market, we don't feel it is a high probability risk in Colombia. Political risk remains a blind spot for equity markets and the source of a systematic market expectations error that, more often than not for emerging markets, tends to resolve itself in favor of the less hysterical outcome.
As illustrated in the above chart, early in the campaign, when voter polls revealed that the conservative candidate enjoyed improving support, the stock of Ecopetrol mainly traded in line with oil prices. Our analysis, which included reviewing the factor1 drivers of equity performance, found that, during this period, the primary driver of equity returns was sectoral (Oil, Gas, and Consumable Fuels) exposure. As the conservative candidate's prospects faded, sectoral factor exposure became less important and the significance of country factor exposure increased. The country factor broadly represents the collective market participants' forward-looking political risk assessment (danger or opportunity).
The need for a runoff election made the market question the potential future and the country factor popped, resulting in a temporary price reprieve. As the outcome of the runoff election became apparent, with the liberal candidate poised for victory, the stock sold off again and the country factor collapsed, driving Ecopetrol's downward price action.
During the period examined from February to July, factors accounted for 91% of the stock's movement, and idiosyncratic company variables explained only 9% of its movement. Notably, we found that approximately 50% of the factor explanation was driven by Colombia country exposure, and 28% stemmed from shifts in the value of the Colombian peso (a derivative of the market's political risk sentiment). Essentially, the stock experienced a sharp decline devoid of any direct correlation with the company's operational performance: It fell because Colombia had a touchy election with a liberal candidate that won. In summary, the stock decline could be attributed to Political risk rather than any intrinsic factors related to the company. The critical question is, did the market correctly price political risk? We think not.
Strong rhetoric, weak military support, and legislative constraints
Upon reviewing the political landscape in Colombia and consulting our extensive network of political risk experts, we determined that Colombia's new liberal President lacks support within the military, which would be an essential prerequisite for the kind of regime change many market participants were concerned with, significantly reducing the probability of this worst case scenario in any forward-looking political risks assessment. Additionally, since being elected, it has become clear that he has limited control of the Senate and the Chamber of Representatives and his coalition partners, therefore, he has had to make significant concessions to his proposed policies.
As always, with political risk, one needs to remember that the preferences of a politician are not, as Marko Papic noted in his excellent book, Geopolitical Alpha, diagnostic variables because they are options subject to external constraints. This means that although the Colombian President has a significant liberal agenda, his actions are constrained. In essence, his preferences are just that; they are not a realistic policy agenda given the Colombian political landscape. What he has accomplished has thus far been limited to additional taxes on the oil and natural gas industry rather than implementing drastic measures.
But even there, we find the situation intriguing. Tax rates could reach a maximum of 50%, but within the current oil/economic context, Ecopetrol’s taxes over the next two years are projected to be a mere 5% higher than the company's current tax levy. We do not support tax increases, as we believe they're value disruptive for shareholders. However, the market is not treating this tax increase consistently with increases in so-called politically risk-safe jurisdictions. We're not making the case that Latin America is a higher quality or less politically risky jurisdiction than European countries or the U.S. but, some of Ecopetrol's international peers have significant relative valuation premiums despite experiencing worse tax issues.
Consider a few examples illustrating striking inconsistencies in how the market perceives government taxation. The U.K. implemented up to 35% energy profit levies until 2028 last year. In Ireland, governments implemented a 75% tax on profits. This is consistent with the Norwegian government taxes. We think EQNR is worth around $42 a share at the moment with that level of taxation. All else being equal (which we do not claim is the case), if EQNR were taxed at the maximum Colombian level, it would be worth $84 a share, and if it paid the top U.S. corporate tax rate it would be worth more like $140 a share.
In our view, situations like Ecopetrol often present the enterprising investor with asymmetric and contrarian investment opportunities that can generate strong risk-adjusted returns due to the market's systematic mispricing of political risk. By delving into such situations, we can identify investment prospects with substantial potential for significant idiosyncratic returns.
For more on this subject, we encourage you to explore our Thought Piece Real Asset Equities: More Than Just Inflationary Hedges. In this paper, we provide our perspective on the merits of considering factors beyond commodity prices when evaluating real asset equities.
1We decomposed results utilizing Omega Point and the Axioma Worldwide 4 Medium Horizon Risk Model. At the level we focus on the factors were: global markets factor, a basket of style factors, the sector exposure factor (Oil, Gas & Consumable Fuels), country factor (Columbia) and currency factor (Colombian Peso).