Why country risk matters – ShareCafe

by Sarah Shaw – Global PM and CIO and Greg Goodsell – Global Equity Strategist

At 4D Infrastructure (4D), we have developed a fully integrated investment process in which country risk is assessed alongside our equity analysis. We do this because we believe that country risk is real, that it can impact equity investment decision-making, and that risk can change – both positively and negatively – over time. .

From the early days of 4D’s business, country risk was a key area that we believed should play an important role in our investment process. As truly global investors, we believe that understanding not only a company’s drivers and risks, but also a country’s drivers and risks, is crucial for investment decisions. How to invest in a company if you are not comfortable with its country of origin or its operation?

In this article, we describe how the valuation of this key variable evolved to where it is today. But first, we want to briefly show why country risk has always been so important to us.

The country risk is real

Country risk is real and evolves over time in both positive and negative directions.

The current war between Russia and Ukraine demonstrates a country risk. Russia has been severely sanctioned by the international community as a result of its actions. At 4D, we have always classified Russia in red.

There has been no greater event exposing country risk than that presented during the Global Financial Crisis (GFC) of 2007-2008. Prior to the recent COVID-19 recession, the GFC was considered the most severe financial crisis since the Great Depression (1929-1939). So, using changes in a country’s Standard and Poor’s (S&P) long-term credit rating as a proxy for changes in country risk, how have the world’s major economies fared during the GFC and since?

Some nations have really struggled, but none more so than Greece, which went from a strong S&P investment grade of “A-/A+” before the GFC to a virtually uninvestable “C” (see chart 1 above). below). However, it is the country risk that is deteriorating rapidly! Fortunately, Greece has shown a gradual recovery since then, although 4D still classifies it as a red jurisdiction, as a number of key metrics remain strained and it has a propensity to tip quickly into political instability (see review of the country in the Annex).

Source: Global Government Bonds

But it is not only major and high-profile macroeconomic events that can have an impact on country risk. Sometimes the deterioration in risk can be a much more subtle, almost creeping and gradual event – ​​a product of a longer-term structural decline. For example, Chart 2 reflects a gradual decline in Japan’s rating over the 21st century, although it remains in the “A” investment category.

Deteriorating national demographics and excessive levels of public debt were important factors in this gradual erosion of Japan’s rating. Similarly, but more rapidly, the deterioration in the UK’s rating shown below reflects its decision to leave the EU, which was prompted by a narrow result of the June 2016 referendum (52% voted to leave, 48% to stay).

At 4D, we currently classify Japan and the UK as green jurisdictions, although the UK has experienced some time in yellow during Brexit.

Source: Global Government Bonds

It is important to note that changes in country risk can also be positive. China’s rating history (see Chart 3 below) very clearly reflects its economic and social growth and progress through the 21st century, with a steady rise in rating since the early 1990s. Green china.

Source: Global Government Bonds

Finally, some things “feel right” and don’t seem to change, as evidenced by Germany’s “AAA” rating history below and the “almost” solid history of the United States. We classify both countries as green.

Source: Global Government Bonds

The 4D approach to country risk

Our approach to country risk assessment is designed to answer a key question: is the country under review an acceptable investment destination?

To kick-start the process and provide perspective on a country during its initial screening, countries receive a Preliminary classbased on their S&P long-term credit rating as follows.

This is a preliminary assessment only. We then complete the 4D country review process, which involves a detailed assessment of the four main country risks below.

Once a country’s review is complete, each country receives a final score using a traffic light system:

  • Green: the country is a relatively attractive investment destination;
  • Yellow: the country remains an acceptable investment destination, but the risk is higher than in green countries. It could be a country improving from a red position, but not yet low risk. Or it could be a country where we believe the risk has increased and is worth monitoring, such as Hong Kong or Italy after the 2018 election;
  • Red: the country is an unacceptable investment destination.

Although each country is rated on the four key risks identified above, the ultimate score does not necessarily represent an equal allocation to each risk. In other words, the ultimate score (if not green) is probably dictated by the weakest link. For example, Russia has been rated red since 2015 despite a fairly strong financial and economic position, due to ongoing political sanctions in Crimea, concerns over governance practices, and the recent Russian invasion of Ukraine.

This final color designation dictates how much of the global fund’s investment portfolio, as a whole, can be allocated to stocks from that particular country. For example, as shown in Table 7 below, stocks of yellow countries as a whole can only represent 25% of the global portfolio. No shares of red countries may be held in the portfolio. These rankings are assessed at both the listing and asset level.

The final color ranking of the country also dictates the market risk premium (MRP) we use to rate that country’s stocks – the lower the country’s rating, the higher the MRP used, meaning country risk is directly reflected in the stock’s ratings.

Finally, detailed country research helps build strategic perspective, identifying relative country strengths and weaknesses, facilitating equity coverage as well as sector and demographic exposure at the portfolio level.

A fully integrated investment process at 4D

Since our country reviews have a direct link to companies’ financial models (via MRP) and lead to strict country portfolio limits, we believe our investment process is fully integrated, risk assessment countries playing an equally important role as our reviews and stock valuations. . We believe this is unique to 4D.

A selection of 4D country risk assessment results

We have been using our country review process since the inception of 4D in 2015. Each relevant country is reviewed at least once a year, but an interim review can also be triggered by a particular event such as Brexit. In 2021, we completed over 30 country reviews, with 70% rated green, 15% yellow and 15% red. Some of the interesting rankings and changes over the past six years are summarized below.

Conclusion

At 4D, we have always viewed country risk as a key factor in stock analysis and portfolio construction. The GFC provided a very real demonstration of country risk in practice. In response to this, we intentionally developed an integrated investment process that included both country and stock analysis, as described above. We believe our investment process is both effective and unique, and has supported our overall performance since its inception.

Included in the Annex is a sampling of some of our 2021 Abbreviated Country Reviews – Austria (Green), Hong Kong (Yellow) and Russia) – which reflect a summarized excerpt from the much more detailed Full Country Reviews.

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[1] The source of this data only reports the US S&P rating for April 2011, which explains the short duration of this chart.

The content of this article represents the opinions of the authors. Authors may hold long or short positions in the securities of various companies discussed in the article. This commentary does not constitute a solicitation of business or investment advice. It is only intended to allow the authors to express their personal opinions on investing and to entertain the reader.

Martin E. Berry