Finance Understanding political risk: three fundamental truths First things first: what exactly is political risk, and how does it differ from other risks that investors face? At its most basic, political risk is the risk of change: the possibility that a given government (municipal, regional or national) will upset “business as usual” and force companies to do business differently than the way in which they’ve done business before. Sometimes those changes will be intentional and legal (Ottawa imposing a one-time tax on bank profits, for example). Sometimes they will be imposed by other countries (trade tariffs between the U.S. and China). And sometimes they will be denounced by the rest of the world (Russia invading Ukraine). Either way, political change can have a profound effect on how a given business makes money. And obviously, anything that affects how a business makes money can have a significant impact on the valuation which others give to that business and, therefore, the price that investment has in your portfolio. Any investor looking to understand political risk and its impact needs to accept three fundamental truths about it: 1. Politics are unpredictable One of the things that makes political risk so challenging for investors is that change (whatever form it takes) is difficult to measure and predict. Unlike numbers on a balance sheet, politics is an inherently subjective topic. Often, it requires a deep knowledge of the historical background of a given country, on-the-ground contacts to provide local perspective, and a good deal of “what if?” thinking to understand the potential impact of political changes on a given business − and even then, those impacts are often only obvious in hindsight. On top of that, governments are notoriously fickle about the changes that they impose upon the business world. Rumours may circulate for months (or even years) that a government will introduce changes to the tax code, for example. And, while many analysts, pundits and commentators will try to predict the likelihood of such change, there’s really no way to know for sure whether these will actually happen (or what investors should do about them) until such changes actually become law. 2. Political risk is often driven by investor emotion Make no mistake: political change can have a real and lasting impact on a given business (ask anyone in Ukraine or Russia). But as much as that’s true, the real risk of political change is often more emotional than it is practical. Think about it this way: investors often react more strongly to deviations from the status quo than do businesses. And to some extent, that’s understandable: it can be difficult to really understand the long-term impact of political change in a country when you’re watching events from halfway around the world. Investors also tend to extrapolate current political crises far into the future, and often don’t account for the ability of businesses to adapt to political change over time. As a result, stock markets can frequently overreact to political events and drive the price of politically affected stocks up or down far beyond any rational measure. 3. Political risk often creates investment opportunity You know the old saying about how crisis and opportunity go hand in hand. That’s certainly true regarding crises brought on by political change. Even with the most acute forms of political upheaval (such as what we’re witnessing in Eastern Europe), there will be opportunities for businesses that arise out of the crisis. It takes time (often years or even decades) for such opportunities to become obvious. But make no mistake, eventually these will become clear. Veteran investors have long known that scouring the world for such politically driven opportunities can be a very good way tomake money. Such an approach is definitely not for everybody, however. It requires a strong stomach for volatility, and a willingness to spend the necessary time and effort to fully research the political and business background behind a given opportunity and, let’s face it, some snowbirds simply have better things to do. That said, if you’re a seasoned, experienced investor who’s serious about looking for off-the-beaten-track ideas, there’s no denying that emotional market reactions to political risk can often make for tremendous investment profits. CSANews | SPRING 2022 | 29
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