I spent much of this past week travelling around some of my old haunts in Central Europe. One night, I popped into a bar and I saw a group of three bulky, ominous-looking figures sitting in the back. It was a scene straight out of the Godfather, with three Don Corleone-like figures smoking fat cigars, throwing back shots of whiskey, celebrating a business deal that they had consummated that day. As I ambled closer to take in the scene, I suddenly recognized one of them. He had been a junior colleague at an investment bank I had worked at about 15 years ago, and later an analyst at a U.S. hedge fund that had blown up after the Russian market meltdown in 1998. Over that time period, he had fashioned himself into something very different from an aspiring Wall Street analyst. He told me that he had retired in his mid-30s and now spent his time doing deals in the Balkans and Uzbekistan. Whatever he was doing, it was clear he had not accumulated his fortune by diligently investing 10% of his monthly salary into an S&P 500 Index Fund.
“My friend, do you trust me?”
Fast forward to last night in London, where a Goldman Sachs analyst and I chatted with Harvard President Drew Faust about the challenges of teaching business ethics to future derivatives traders at the Harvard Business School. I was struck, yet again, by the U.S.-style idealism of trying to shoehorn a lifetime’s worth of ethical behavior into a semester-long business course. I can almost imagine the derisive roar of laughter I’d hear from the table of East European Don Corleones as I’d relate Harvard’s idealistic aspirations to them.
In the United States, we like to think that if you play by the rules, you get rewarded for your efforts. So I decided to investigate whether investing in countries that broadly adhere to U.S.-style ethics offer a better return to investors than their less “ethically correct” counterparts. My conclusions may surprise — and perhaps even disturb — you.
Trust: The Invisible Lubricant
Francis Fukuyama first wrote about the importance of ethical behavior in his book “Trust: The Social Virtues and The Creation of Prosperity,” in which he defined “trust” broadly as honest, and cooperative behaviour, based on commonly shared norms among members of a community. “Trust” is the invisible lubricant that greases all business interactions.
Fukuyama divides societies in the world into two groups on the basis of “trust.” Fukuyama argues that China, France, Korea and Italy are “low-trust” societies, whereas Japan, Germany and the United States are “high trust.” Only “high-trust” societies permit the development of modern capitalist structures, like multinationals and global stock exchanges. Low-trust cultures rely more on the extended family to build commercial, social and political networks. As a result, companies in a low-trust society are either small, family-run ventures or very large, state-operated and, therefore, generally corrupt.
You can argue with the accuracy of Fukuyama’s sweeping generalizations. But if you’ve travelled outside the United States, you know what a pain life can be in “low-trust” societies. For all of the flack it has taken recently, the United States is a “high-trust” society. Yes, we have corrupt mortgage brokers and Bernie Madoff. But in most social daily interactions — paying for a cab, picking up a tab at a restaurant or buying gas for your car — you can be pretty sure that you’re not going to get ripped off. But try doing those three things in the Ukraine, and you’ll quickly find that things don’t quite work out that way.
Investing in “High-Trust” Markets
Intuitively, you’d think that the “high-trust” societies would make for the best investments. As a surrogate, I looked at the 2010 Corruption Perceptions Index of Transparency International. The top 10 ranking countries this year were Denmark, New Zealand, Singapore, Finland, Sweden, Canada, Netherlands, Austria, Switzerland and Norway.
The list has substantial overlap with the World Economic Forum’s report on the world’s most competitive economies. The top 10 countries in the competitiveness report consist of Switzerland, Sweden, Singapore, the United States, Germany, Japan, Finland, Netherlands, Denmark and Canada.
For good measure, I threw in the UN Human Development Index, and the list again is familiar: The top 10 consists of Norway, Australia, New Zealand, United States, Ireland, Liechtenstein, Netherlands, Canada, Sweden and Germany.
It seems that if you restrict your investments to those approximating “high-trust” markets, you’d limit yourself to Northern Europe, the German-speaking countries, the United States, Australia and New Zealand, with Japan and Singapore thrown in.
You’d also completely leave out the countries that had the top-performing stock markets of the past decade…
“Low-Trust” Markets Rule
Three of the top-performing markets in the world in 2010 — Thailand, Indonesia and Colombia — are also among the most corrupt, according to Transparency International. The highest ranking BRIC country is Brazil — at an unimpressive number, 69. China ranked 78, India finished 87 and Russia fell near the bottom at 154.
Fukuyama does not predict lasting success for China, as a “low-trust” society. And, indeed, trust is a huge issue with investing in China. U.S.-listed Chinese small-cap stocks trade at a deep discount to their Western peers, as more of them continue to be rocked by accounting scandals. Even if investors in Internet portal Baidu (BIDU) are making a mint in the stock this year, the company itself faces a huge obstacle to become a global brand. Why? People don’t trust it because of its collusion with the Chinese government.
At the same time, the consensus is that the size of China’s stock market will overtake that of the United States within the next two decades… Go figure…
As Americans, we’d like to think that countries and companies are rewarded for “high-trust” behavior. But stock-market returns over the past decade in “high-trust” economies do not bear that out. This leads to a highly counterintuitive, and perhaps even disturbing conclusion: Keep your money in “high-trust,” developed markets and you are heading for the poorhouse.
None of this would have struck any of my Don Corleone-like friends at the back of that Central European bar as odd. It’s just the way of the world…
It seems that in the global investment game, nice guys do finish last…