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Investing in Stocks with Geopolitical Risk

Value investor with a deep passion for understanding and a desire to improve results over time.


Fundamental Analysis Includes Geopolitics

Fundamental stock valuation is the holy grail of value investing. After all,

  1. a stock is just a little slice of a company, and you own that company when you own that stock; and
  2. all of the cash flows that company ever generates represent what a company can possibly give back to owners of said company

Still, there are tons of stocks that don't really seem to work this way, especially over shorter time horizons. What gives? One potential answer is geopolitical risk, a particular type of danger to your portfolio that needs to be included in any fundamental analysis. Imagine Hitler 2.0 invading a European country (perhaps this isn't so tough to imagine!) and how that might affect businesses in Europe. Now imagine how businesses that aren't in Europe might be affected by such an event, and you start to have an idea of how to think about geopolitical risk as it pertains to your portfolio.


Geopolitical Risk Can Effect Fundamentals

The example above, of a military action that affects stock prices directly, is a good place to start. While the untold human suffering that goes along with war is rightly given the lion's share of attention, economic damage can have even worse, far-reaching consequences that last decades. In the shorter term, prices can swing wildly for commodities that are needed for military defense, and companies that offer recreational services might take a rough back seat for the foreseeable future. This direct, obvious connection isn't just me being trite; it's actually really good to slow your brain down to think through what all this will mean for each of the GICS sectors.

Keep in mind that the actual economics of the companies you own may be shifting, and stocks you're considering buying? You're going to want to do a fresh valuation, integrating any new geopolitical risk into the future potential cash you can expect to generate. Clearly, the economics of the business at the price the stock's selling today might not seem so good, given the new information you have. Think carefully here, since not all price fluctuations are going to be so obvious. Supply chains will be disrupted, likely exacerbating inflation, and lots of different industries you might not initially expect will be affected.

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Vicious Cycle

Assuming you've vetted a stock and you see that there are great fundamentals behind the underlying business, you still might be wrong about the stock's future prices because of a funny thing that happens to a business when its stock stays low for a long time. In other words, even a great bargain can be a poor bet for you. How is this possible?

It's because the market capitalization of a company actually matters a great deal when it comes to credit markets. If a company wants to borrow money, they'll often use stock as collateral, and if the stock isn't worth as much as it used to be, the business is unlikely to be able to borrow money so easily. This can turn into a vicious cycle, where the fundamentals are ultimately destroyed by a perpetually low stock price, and then the perpetually low stock price gets even lower as the fundamentals deteriorate.

Even under normal circumstances, you might see a stock trading well below its intrinsic value for several years, but when you add in significant geopolitical risk, the vicious cycle can really take on a life of its own. Be careful out there!

Call Mr. Market's Bluff

The market will typically weight how likely it thinks a particular risk is to a company, and it will price the stock accordingly. This weighting relies on the wisdom of the crowd, and it can be a pretty good guess some of the time. It's the lousy guesses you're going to be most interested in as a contrarian value investor, of course.

Ask yourself whether the disruptions the market is "pricing in" (taking into consideration) the risk at hand, or whether they're overly pessimistic at the moment. Keep in mind that entire industries can stay more pessimistic for long periods of time, sometimes longer than a decade! This often leads to multiple contraction. Your job is to determine when the contraction is about to revert, so you can gain from the market's undervaluation as well as from the business fundamentals.

Be a Lifetime Learner

Keeping in mind that fundamental analysis needs to incorporate your view on geopolitical risk, it pays to stay at least peripherally informed on world events. Make sure you study history so that you will have the proper contexts for events as they unfold. Understanding the cultures of the nations at play is a must, since a cultural norm in one place might look very, very different from the norms in another place.

In an interconnected world, driven ever-closer by globalization (in spite of a global pandemic!), we are seeing one country affect the actions, prosperity, or politics of another country. Ultimately, this affects businesses within those nations, and it's crucial for us as investors to understand how this complicated machinery works. Be a lifetime learner; never stop seeking to understand how the world works. Stay curious, and ask yourself new questions about the businesses you're studying every day.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith

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