One thing I like to do on this blog is engage in some “live” analytical exercises. So here is one in the vein of my reasoning from first principles post. I will play a round of Socratic Solitaire to examine Russia’s belligerence on the geopolitical stage. This is not a trivial exercise to me. I have real dollars on the line (see disclosure at bottom).
In general I think people do a poor job of analyzing geopolitical risk. There are many reasons for this. Availability bias is probably the most significant issue, especially in emerging markets. Also people do not put themselves in the shoes of the person on the other side of the table. Investment analysts especially tend to be quantitatively oriented people. They struggle to price the “squishy” stuff. So what I am really challenging myself to do here is think like Vladimir Putin.
What Motivates Me?
This is tough. But anyone who enters the political arena does it for some combination of the following three things:
- Power
- Money
- To make the work a better place
Given Russia’s behavior on the geopolitical stage I would say we can safely rule out “making the world a better place.” That leaves me with money and power.
If I am Vladimir Putin, and I am motivated primarily by money, the smart thing for me to do is straightforward: play nice with the other Great Powers (US, China, EU) and simply focus my energy on looting the Russian economy. Without some overriding desire for political power, things like backing Bashar Al Assad and invading Crimea make no sense. They introduce catastrophic risks into the equation. Namely: a large scale military conflict I might lose.
Thus, on a weighted average basis I think it is safe to say that power is the most significant driver for my behavior. The relevant question from the perspective of an investor in Russian securities is: to what extent am I willing to put constraints on my drive for power?
Why Would I Constrain My Desire For Geopolitical Power?
All else equal I would simply work to swallow up the world. What would stop me?
As mentioned above, catastrophic downside risk might give me pause. That happens in a couple of different ways:
1) lose a war,
2) villagers with pitchforks revolt, and
3) a coup.
How Do I Protect Myself From Catastrophic Downside Risks?
In the short term, Risk #3 can be addressed in straightforward fashion with political repression and violence. Indeed, this appears to be the current game plan. The Financial Times recently published an interview with the Russian oligarch Vladimir Potanin. Potanin is notable for being one of the only old guard oligarchs who is still alive and wealthy.
“Why did we survive, [Mikhail] Fridman and myself? Maybe because we never tried to dictate to the government, to the Kremlin,” he says. He recalls a meeting where he and Fridman told Khodorkovsky, “Mikhail, the problem is you are trying to play political games. The perception is you are trying to buy power. It is unacceptable, not just for you but for all of us — we will all look dangerous.”
In Russia, it is perfectly okay to loot. It is not okay to play politics. A meta-reading of the interview suggests Potanin is addressing Putin and Russian state security directly. “I am not a threat,” he is saying. “I am not interested in political power. No need to bump me off or confiscate my wealth.”
Risk #2 is trickier to manage as it requires balancing economic and social considerations. The CIA World Factbook gives excellent high level macroeconomic data for Russia. We can slice and dice Russian GDP in several different ways but there are a couple of data points that stand out. Agriculture, energy and heavy industry play significant roles in the Russian economy. Russia also runs a trade surplus. Its top trade partners are China (22% of imports; 10% of exports); Germany (11% of imports; 7.8% of exports); and the United States (8% of imports). Heavy industry and energy are both intensely cyclical industries. The Russian economy is thus extremely sensitive to trends in global commodity prices, and subject to dramatic boom-bust cycles.
Unsurprisingly then, Vladimir Putin is acutely aware of “villagers with pitchforks risk.” In October 2017, The Financial Times reported on a 2009 incident where the Russian president publicly shamed oligarch Oleg Deripaska over unpaid workers:
In June 2009, in the depth of Russia’s previous sharp recession, Putin gave aluminium magnate Oleg Deripaska a public dressing-down after workers in the northern town of Pikalyovo, where his company is the main employer, took to the streets over production stoppages and unpaid wages.
“I must say that you’ve made thousands of residents of Pikalyovo hostages of your ambition, your unprofessionalism and maybe your greed,” the president told Deripaska in front of rolling cameras. As the tycoon hung his head, Putin asked why he had “neglected” his factory. Before the president had left town, Deripaska had ordered that all outstanding wages be paid.
“The effect of that show lingers until today,” says Zemlyansky. “After what happened in Pikalyovo, in all Deripaska towns, they keep on a certain number of employees even in companies that should be shut down, just because of the fear of Putin.”
And the Kremlin is keeping a close eye on things. The National Guard, the police force in charge of riot control, monitors social stability in some monotowns. The federal government has also set up a system to collect more comprehensive data on their social and economic state. The statistics are kept secret, making it impossible even for local governments to assess the situation properly.
Aside from economic policy measures, one highly effective way of managing “villagers with pitchfork risk” is through scapegoating. In fact, this tactic can be used to kill two birds with one stone. In China, for example, the Chinese premier (now dictator for life) has used an anti-corruption campaign as cover for greasing squeaky wheels. In the US, there is nothing Donald Trump loves more than making an individual or organization a scapegoat for some real or imagined threat.
The solution to Risk #1, meanwhile, is simple but not necessarily easy: do not lose a war with a Great Power.
If I Am Vladimir Putin, How Far Will I Push The Other Great Powers?
Answer: As far as they will let me.
There are military and economic dimensions to this and we could spend years gaming it all out. The bottom line is that the optimal strategy is a carefully choreographed dance, similar to the Cold War.
The underlying dynamics are similar to those of the Prisoner’s Dilemma in game theory. The Prisoner’s Dilemma, or, rather, the Iterated Prisoner’s Dilemma, is therefore an interesting model to consider. From Wikipedia:
Interest in the iterated prisoner’s dilemma (IPD) was kindled by Robert Axelrod in his book The Evolution of Cooperation (1984). In it he reports on a tournament he organized of the N step prisoner’s dilemma (with N fixed) in which participants have to choose their mutual strategy again and again, and have memory of their previous encounters. Axelrod invited academic colleagues all over the world to devise computer strategies to compete in an IPD tournament. The programs that were entered varied widely in algorithmic complexity, initial hostility, capacity for forgiveness, and so forth.
Axelrod discovered that when these encounters were repeated over a long period of time with many players, each with different strategies, greedy strategies tended to do very poorly in the long run while more altruistic strategies did better, as judged purely by self-interest. He used this to show a possible mechanism for the evolution of altruistic behaviour from mechanisms that are initially purely selfish, by natural selection.
The winning deterministic strategy was tit for tat, which Anatol Rapoport developed and entered into the tournament. It was the simplest of any program entered, containing only four lines of BASIC, and won the contest. The strategy is simply to cooperate on the first iteration of the game; after that, the player does what his or her opponent did on the previous move. Depending on the situation, a slightly better strategy can be “tit for tat with forgiveness”. When the opponent defects, on the next move, the player sometimes cooperates anyway, with a small probability (around 1–5%). This allows for occasional recovery from getting trapped in a cycle of defections. The exact probability depends on the line-up of opponents.
By analysing the top-scoring strategies, Axelrod stated several conditions necessary for a strategy to be successful.
Nice
The most important condition is that the strategy must be “nice”, that is, it will not defect before its opponent does (this is sometimes referred to as an “optimistic” algorithm). Almost all of the top-scoring strategies were nice; therefore, a purely selfish strategy will not “cheat” on its opponent, for purely self-interested reasons first.
Retaliating
However, Axelrod contended, the successful strategy must not be a blind optimist. It must sometimes retaliate. An example of a non-retaliating strategy is Always Cooperate. This is a very bad choice, as “nasty” strategies will ruthlessly exploit such players.
Forgiving
Successful strategies must also be forgiving. Though players will retaliate, they will once again fall back to cooperating if the opponent does not continue to defect. This stops long runs of revenge and counter-revenge, maximizing points.
Non-envious
The last quality is being non-envious, that is not striving to score more than the opponent.
If one views Russia’s behavior (or any belligerent nation state’s behavior) through this lens there are elements of the Iterated Prisoner’s Dilemma in play. In particular, some belligerence must be used as a deterrent. Likewise, some forgiveness and cooperation must be utilized to stop “long runs of revenge and counter-revenge” (read: World War III). In this context, seemingly “crazy” actions such as backing Bashar Al Assad are in fact totally rational.
Why Would I Start World War III?
As Charlie Munger says, “always invert.” So, let’s examine the issue of Russian belligerence through another angle. Why would I, as Vladimir Putin, intentionally ignite a global conflagration that could result in my total loss of power and personal demise?
- I believe there is a high probability of winning
- I am a pure ideologue / religious fanatic (not a rational actor)
- Nothing left to lose
At this juncture none of these appear to dominate decision making on the Russian side. There is some level of ideology in play here in terms of a desire to ensure Russia remains a Great Power and a geopolitical player. However, it’s not the type of fanaticism that renders someone an irrational actor, such as Islamic Fundamentalism.
Key Learnings
Russian aggression is not irrational. There is a method to it. The method stems from the fact that Vladimir Putin is motivated to expand Russia’s power and influence (and by extension, his own power and influence). This requires a certain level of calculated belligerence so as not to be steamrolled by other Great Powers.
Domestically, the #1 rule for business leaders is to keep out of politics. The #2 rule is to allow the state some latitude for looting. Most investors look at #2 and say “forget it, I am out” (availability bias). I look at SBRCY on forward PE of 5.67 with a 20% ROE, having just announced a doubling of its dividend, and say, “gee, maybe the looting is more than priced into the stock.”
The most controversial asset expropriation in the history of modern Russia is Yukos, which was owned largely by the oligarch Mikhail Khodorkovsky. Russia did not expropriate Yukos for arbitrary reasons. Khodorkovsky had political ambitions. Worse yet (from the Russian government’s point of view), his vision for Russia ran counter to that of Vladimir Putin. Therefore, if you are invested in Russia, an easy qualitative screen to run is whether company management and ownership is aligned with the Putin regime. This is a critical to assessing expropriation risk and ensuring you are taking calculated risks versus stupid risks.
Full Disclosure: Long OGZPY, SBRCY and RSXJ. Short RSX (as a partial hedge)