Friday, April 11, 2008

How to Cash In on Sovereign Wealth Funds

The early 21st century is being marked by the rise of a new player on the financial landscape: the Sovereign Wealth Fund, or "SWF". Nations with large surpluses of dollars from petroleum exports or manufacturing - think China, Dubai and Abu Dhabi - are no longer content to park their dollar reserves in bonds that offer paltry returns below the rate of inflation. Instead, they are using an increasing portion of their reserves to create Sovereign Wealth Funds, pools of money which use the money endowed to them to make investments in stocks and other assets with the potential to provide substantial returns over the long term.

So, why should you care? The most important reason that you should care about this development is that understanding how sovereign wealth funds are investing their money can help you to you can position yourself to benefit from their buying spree. At the most basic level, sovereign wealth funds provide investors with reason to be at least moderately bullish because purchases of equities by these funds will help to prop up stock prices in coming years as streams of money that previously flooded into bonds in recent years adds to demand for stocks.

The Housing Boom that China (Partially) Built

Before we begin projecting into the future, we should probably review the recent past. Although the recent boom and bust in house prices was largely attributed to moves by the Federal Reserve, that was not the only factor that contributed to low mortgage rates. Mortgage rates were also kept low by low yields on US government bonds, which compete with mortgages for fixed-income investment dollars. Many of those fixed-income investment dollars originated in China, but Saudi Arabia, Dubai and Abu Dhabi also parked much of their dollar reserves in treasury bonds; all of which helped to keep treasury yields, as well as residential mortgage rates, low. These low mortgage rates contributed to the real estate boom of recent years. However, the recent drop in the dollar, along with the dropping value of those treasury bills, has prompted sovereign wealth funds to look beyond fixed-income investments to investments in other asset classes, including equities.

Why Shares, Rather than Companies?

Sovereign wealth funds have good reason to buy shares in US companies rather than attempt to buy US companies outright. A takeover of a US company by a foreign company tends to raise protectionist ire, as we saw recently with the attempted CNOOC takeover of Unical, or with the attempt by Dubai Ports World to purchase a domestic manager of US ports. In both cases these takeovers where opposed in the media and in the US congress. Recent purchases by sovereign wealth funds of shares in US companies such as Citigroup, AMD, and Nasdaq Stock Market Inc., on the other hand, does not inflame protectionist sentiment.

This is good news for investors because the effect of sovereign wealth funds taking minority stakes in US companies is to bid up the prices of many companies that are components of the Standard and Poor's 500 and other stock indices. Because many individual investors have the lion's share of their retirement funds parked in index funds, this will benefit individual investors far more than a SWF buying spree in which companies are bought out entirely. A buyout of an individual company has little effect on a stock index, and shuts out individual investors from participating in a company's success in the future.

So, you can sit back and benefit from this trend without lifting a finger. But if you really want to benefit from the rise of sovereign wealth funds, you have some great opportunities to do so. In this post, we’ll look at a company that is working with a specific sovereign wealth fund to manage its purchases, and make the case for buying shares in that company.

Beijing via Baltimore

In late 2006, the National Council for Social Security Fund (SSF) of the People’s Republic of China selected T Rowe Price to manage its investments in US stocks. This creates a steady inflow of capital into the Baltimore, Maryland-based operator of mutual funds and provider of investment management services at a time when other asset managers are dealing with a slowdown in mutual fund purchases by consumers. T Rowe Price was a well-managed company and a good long-term investment before it was selected to manage capital for China’s sovereign wealth fund, but this additional business makes it an even better investment.

In my next post, I will discuss another strategy to cashing in on the actions of sovereign wealth funds: buying shares in the companies that these funds are buying.

Thoughts on Visiting Palm Springs

I recently visited Palm Springs, California, on vacation. I have to admit that I was shocked by the extent to which the current real-estate crisis is impacting this area. I live in western Washington State, where house prices have held up pretty well in the last year compared to the rest of the country; so I was not prepared for what I would see when I visited Palm Springs: A real-estate market in serious trouble.

For the first few days of our vacation, my wife and I stayed in a rented timeshare in Indio, just outside of Palm Springs. This timeshare was newly built, and was part of a development that included a golf course and some very recently built houses. Upon entering this development, I could not help but notice a large sign that read: "New Single-Story Homes from the Low $200s". Something looked strange about the sign, so I slowed down to take a closer look; at which point I noticed that the "2" in "$200s" was a sticker that was starting to peel, revealing a "3" beneath it. That the developer was dropping their asking prices was no surprise, but that they would drop their prices by so much, and use such a tacky sticker to change their advertising was a bit of a shock. And even at these lower prices, the neighborhood looked to be about 30% vacant.

The next shock came when I noticed several billboards carrying the following stern warning: Stealing Copper Pipes Will Land You Behind Bars. I had read about problems with theft of copper pipes from vacant new-construction houses in various national newspapers, but this was the first time that I had visited an area where copper theft was enough of a problem to warrant billboards to warn against it. This is certainly a sign of the times, demonstrating how the confluence of rising commodity prices and falling house prices have combined to create a situation where the copper in a house is the most valuable (and certainly the most liquid) part of that house.

The final detail that I noticed in Palm Springs was just how many of the retail spaces were vacant. In some cases you would see vacant storefronts or restaurants on major streets next to thriving businesses; in other cases I found entire new construction strip mall developments without a single tennant. This demonstrates that what started as a downturn in housing is rippling into a a downturn consumer spending and commercial real estate, at least in areas as hard-hit as Palm Springs.