Monday, 28 July 2008

Book Review: How the West Grew Rich by Nathan Rosenberg & L.E. Birdzell, Jr

Exactly how have Canada, the USA, the UK and other western countries grown so rich in comparison with the rest of the world? Is it just a matter of luck for if that is the case, inevitably luck runs out and we will lose our edge. This book published over twenty years ago (in 1986) still rings fresh and topical, particularly during the present credit crunch and worsening economic conditions.

And the answer folks, based on my understanding of the book and the fact that I have been convinced by its argument, is that while we cannot relax, we can have confidence that our material well being will not collapse and dissipate like a house of cards.

Another happy and positive message of the book is that we need not feel guilty or morally deficient about the manner in which the wealth has been generated. It is not the result of exploitation of labour, slavery, imperialism or colonialism.

This book is not, however, a polemic or a manifesto. It is a work of scientific research by two scholars, who start with all the suggested explanations and look for evidence to accept or reject individual forces at play. There are many footnotes and an extensive bibliography but they don't get in the way. Very often they are delightful sidelines.

Most interesting is the authors' demonstration of the interplay and interdependence of the many causal factors of growth - none is individually sufficient and all are necessary: science, technology, resources, political freedom, commercial freedom, laws, pluralism, property rights, flexibility of institutions, new forms of corporate organization, the list goes on and on. The primary drivers of growth have evolved over time and today, Rosenberg and Birdzell maintain that innovation is the key. For a book written before the explosion of the Internet, that conclusion seems very accurate and prescient.

The authors' style avoids hyperbole, bombast and breathless drama. There is no mystery or coyness, the conclusions are stated up front. But the story is exceedingly well laid out and I got much intellectual pleasure from seeing how all the parts fit together. It is a book for the curious layman (though I also notice it referenced admiringly in another very serious economic book I am reading now by Richard Lipsey).

One thing that is dated is the recurring discussion of Marxian economic analysis, always to show how wrong it is. The Berlin Wall has fallen since the book's publication and nobody even refers to Marx or takes him seriously anymore, and such discussion seems weird.

  • "... the West has created a powerful system for economic growth, of a sort which could keep generating growth and even substantive advances in material welfare for decades after the spirit had burned out of it." (page 8)
  • "... the West's system of economic growth offered its largest financial rewards to innovators who improved the life-style not of the wealthy few, but of the less wealthy many." (p.27)
  • "Sometimes the success of an innovation means the end of an entire industry, entailing large capital losses as well as the loss to their employees of their human capital of training and experience." (p.30)
  • "... there is no reason to believe that the expansion of knowledge has any inherent limits, so that the growth of technology is especially appealing as an explanation of the persistence of Western economic growth." (p.262)
  • "In a constantly changing world, it is not necessarily a rational investment strategy for employees to invest both their careers (their human capital) and their personal savings in the same enterprise." (p.316)
Surprises and Not-so-Trivial Trivia
  • the accumulation of capital actually contributed very little to the growth that has generated all our wealth - i.e. there isn't much capital in capitalism! success is all about innovation and starting small with little capital
  • famines in France - one of the more advanced regions of the world - were frequent up to the 18th century
  • sieges in the Middle Ages often failed because the besiegers often starved before the besieged
  • the three-masted sailing ship, double-entry book-keeping and the skills of clockmakers were key ingredients to economic growth in the past
  • the Magna Carta principle that property should be protected from arbitrary expropriation by the government arose as an accident of a power struggle between elites of the time, the king and the nobles, though it has been hugely important as a protection for everyone since to retain the benefit of their ingenuity and labours
Lessons and Take-aways
  • our material prosperity is robust, i.e. let's not despair folks, the market will come back sooner or later; one can view the current turmoil as getting rid of the bad stuff, a process the book describes as being as important as the creation of the new
  • our material prosperity is not guaranteed or inevitable; many successful elements play a part and they must be defended against the corrupt, the misguided, the power hungry
  • fast growth can be sustained through innovation in the creation of new products and services; the past of hundreds of years ago or even a only a hundred years ago was not like the present;
  • small companies are the drivers of growth and the winners of the future; many will get launched and fail but a few will succeed spectacularly; big old companies are destined to eventually fade away despite their seemingly unassailable power and prosperity today
This book is a classic, a valuable source of understanding how our current material well-being came about. Its lessons are still very current.

My rating 5 stars out of 5.

Wednesday, 23 July 2008

Adding Infrastructure as a Separate Holding in a Portfolio?

Back in June, when I posted about the Canada Pension Plan Investment Board's investing approach, I discovered that it has significant holdings of infrastructure investments to provide inflation protection and portfolio diversification. Infrastructure consists of physical structures that support society - airports, seaports, water systems, electricity grids, toll roads, gas distribution, telecommunications networks, schools, hospitals, prisons.

So I asked myself why and how I as an individual investor should add infrastructure as another component of my portfolio.

The Why's?
Potential Portfolio Diversification
The possibility that infrastructure could reduce my overall portfolio volatility and/or improve returns through having its returns uncorrelated with other holdings seems to have some merit. In the April 2008 presentation Global Infrastructure - A "New" Alternative Asset Class by Edward Keating of Lazard Asset Management LLC, chart 20 shows the up and down 3-year rolling correlation of infrastructure with global equities and with global bonds. The low correlations (say 0.3 or less) from around 2000 to 2003 would have been quite worthwhile. Since 2004, the correlations have been climbing to 0.4 or higher, meaning much less portfolio diversification benefit.

In the May/June 2007 issue of the Journal of Indexes, Tony Rochte's Infrastructure article shows on page 3 the correlations from 2002-06 for infrastructure against a number of asset classes like US equities, non-US equities, commodities, US bonds and US T-bills. The equities correlations are high while the rest are low. The time series isn't very long so the strength of the conclusion is weak.

Rochte goes on to show that a portfolio with infrastructure as a separate asset would have done better than one without in his study period, especially during the time of market decline in 2000-02. Maybe now would be a good time to do the numbers again to see if the relationship repeats itself.

Overall, there seems to be a fair diversification benefit.

Potential Higher Risk-Adjusted Returns
This aspect is a puzzle since both the above materials (Lazard chart 19 and Rochte page 2) show that the risk-adjusted returns for infrastructure, as calculated in a higher Sharpe ratio, are significantly higher than other equities. One would expect that market forces would bring the return-risk ratio into line with other types of investments.

Ways to Invest - ETFs, Funds and Companies
There appears to be about 70 to 100 major infrastructure companies around the world, many of whose shares can be bought in North America, whether they are based here or abroad. The easiest way to find them is to look at the composition of various infrastructure indices (and these indices seem to be proliferating as the infrastructure fad is growing):
- FTSE Macquarie Global Infrastructure Indices (MGII) (heaviest weighting in utilities)
- S&P Global Infrastructure
- Dow Jones Brookfield Global Infrastructure Indices (new since July 2008)
- NMX Infrastructure Indices (focus on companies with a perceived monopoly)

There are already a number of mutual funds, most as usual actively managed, and we can be sure the bandwagon will get more and more crowded as the investment industry looks for the "next big thing" after the sub-prime meltdown following the tech meltdown (I think of this as bubble rotation). A few examples: Renaissance Investments Global Infrastructure Fund (Canada), First American Global Infrastructure Fund (USA), Caninfrastructure Mutual Fund (India). One company, the Macquarie Infrastructure Company (NYSE: MIC), is a large diversified conglomerate that operates in several different infrastructure businesses and almost looks like a fund itself.

There are two main passively-managed ETFs aligned to one of the above indices available through US markets:
IGF - iShares S&P Global Infrastructure Fund (guess which index it tracks) - MER of 0.48%
GII - SPDR FTSE/Macquarie Global Infrastructure 100 - MER 0.6% and 80% weighting in utilities

An actively-managed closed-end fund has popped up in Canada - the Macquarie NexGen Infrastructure Corporation (class A shares are traded on the TSX under symbol MNF). It's performance has so far (since March 2007 inception) been disappointing - down 21% vs the benchmark minus 3.4%.

Last October, Roger Nusbaum wrote about MIC, GII and a number of infrastructure companies in Infrastructure Funds Flub Stress Test on His Correlating Infrastructure on Seeking Alpha is also worth reading.

The Criticism
A sobering and well-argued counter-argument to treating infrastructure as the next must-have part of a portfolio is The Skilled Investor's post The Birth of Yet Another Darn Asset Class - Infrastructure.

Bottom line for me:
- I do own, at lower MER cost ranging from 0.07% to 0.17% (in VIT, VGK, VPL and XIU) vs the higher MERs of the index ETfs, all or virtually all of the main publicly traded infrastructure companies;
- thus I get the diversifying effect of those companies, only it is hidden within my existing holdings
- I already have enough headaches balancing my overall portfolio across my various accounts - regular, RRSP/RRIF, LIRA - without adding another holding

Some people may wish to play the greater fool game of musical chairs and ride the likely infrastructure fad in hopes it becomes the next bubble and try to sell out in time but for now I'll look at other things to improve my portfolio.

Sunday, 13 July 2008

Speculate on Federal Party Election Prospects

For those who are passionate about politics and are willing to put their money where their mind is, you can put money down on the Conservatives or the Liberals to win the next federal election at the Intrade Prediction Market. Looks like you stand to make a lot more on the Liberals - right now their chances appear to be only 40% while the Conservatives are up around 60%. It's interesting that the Conservative chances have risen with bumps along the way by about 10% since the bidding started back in December 2006.

Unlike polls, this is the result of real people betting their own money. Prediction markets do quite well in their predictions and they stir up a lot of enjoyable controversy. If you think the market predictions are wrong, go make yourself some money! Too bad they don't reveal "insider trading" on the website. ;-)

Want to Know Who I Am?

The secret, if ever it was one, is out. In today's (Saturday, July 12th) Globe and Mail on page B14 of the Report on Business, Tony Martin published the interview he did with me about my investment approach in his Me and My Money column. The article is a good summary of my strategy but I'm not quite 56!

Tony invites people to contact him to be profiled (see his email at the bottom of the article) so I look forward to reading about other bloggers.

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