I had an astute reader ask me over the weekend if I could reconcile my apparent interest in loss leading investments with my recent critique of SWFs investing for altruistic reasons. Good question — I think this warrants a bit of explanation on my part.
First off, if you’ve just tuned in, back in October I offered a friendly critique of a conference in which the organizers wanted to recruit SWFs to “save capitalism” from the depredations of short-termism:
“For example, one of the presenters specifically suggested that SWFs could be important in “transferring technology” to the developing world or “creating jobs”. This individual even went so far as to suggest that SWFs should be willing to give up some financial returns in order to achieve these social objectives…So I guess this is where my views diverge somewhat from those of the organizers. I do concede that the idea that SWFs can help “save capitalism” from the depredations of short-termism is tantalizing. After all, these funds (in many cases) have intergenerational time horizons that grant them a unique ability to consider risk factors not priced in today’s short-term markets (but which will no doubt be priced in the long-term). However, I’m not sure now is the right time to ask the SWFs to do this, nor are the SWFs’ employees necessarily the people that need convincing…”
Subsequently, I offered on Friday the following ‘take-away’ from the Malaysian government funds roundtable:
“I couldn’t help but think that there may be a place for SWFs to make “loss leading” investments in emerging and frontier economies in order to open doors and create opportunities for future return generating investments. In other words, because SWFs have a long-term focus…longer than any other institutional investors…perhaps it is in their interest to, say, invest in some African countries under the assumption that they will lose money now but will gain knowledge and contacts which will, down the road, lead to very attractive investment opportunities and financial returns. I’m not sure if funds have given any thought to this, but it seems like a potentially interesting long-term strategy, especially since the investment business appears to be so dominated by relationships and mutual trust.”
I can see how my critique of the former would make my interest in the latter a bit confusing. Still, at least to my eyes, the points are actually quite different and mutually exclusive. I don’t see the concept of a “loss leader” as being similar to the concept of creating a new form of capitalism or directly participating in development (even if it may have development as a positive externality). At its core, it’s a management concept about dominating a market through small, loss making investments (in the short run) in order to generate large profits (in the future). I’ll make it simple for you and let Investopedia define the term:
“A business strategy in which a business offers a product or service at a price that is not profitable for the sake of offering another product/service at a greater profit or to attract new customers. This is a common practice when a business first enters a market; a loss leader introduces new customers to a service or product in the hope of building a customer base and securing future recurring revenue.”
For SWFs looking to frontier economies, adopting this type of strategy could be a way to “gain customers” (i.e. generate new and potentially important investment opportunities) in a new market. How? By investing in the region, the fund can solidify trust among local business elites, secure local knowledge and partners, and gain favor among local politicians, among other things. All these factors have significant value in frontier economies.
So, in my view, loss leading investments are not altruistic and can have a place in boosting long-term risk adjusted returns. In theory though, a discounted cash flow analysis using a loss leading investment strategy should still be attractive purely on a commercial basis. While this investment approach might have positive externalities, it frames the investment decision in clear terms for the SWF (i.e. profit motive), which is one of the touchstones of good investment governance.