Lesson 11

Copyright 2005 by Milton Garber

Companies do not exist in a vacuum. They exist in countries and in the world; consequently, there are both national and international factors that shape the investment environment. In general terms a favorable investment climate is one marked by peace, prosperity and predictability.

General conditions of economic prosperity favor all companies and hence all stocks. As they say, a rising tide lifts all boats. War, on the other hand, benefits companies that sell to the military; however, most companies do not and most companies prosper more in peace time than in war time. Not only war but also civil violence such as that stemming from insurrections, revolutions and organized crime are disruptive to economic prosperity.

Predictability is also essential to business success and hence to the success of investments in business. A company must be able to plan with some degree of assurance regarding the continued availability of capital, raw materials, supplies, labor sources, and markets. A lack of some minimal degree of predictability, or “visibility,” with respect to a company’s business prospects is a heavy strike against that company in the minds of most investors.


There are some fundamental preconditions necessary for a favorable investment environment, and while these preconditions can be taken as given in most developed countries, e.g., the United States, Canada, Western Europe and Japan, they should be considered carefully when deciding whether or not to invest in the stocks of companies in the emerging countries. The preconditions are of three kinds—political, economic and technological.

The political preconditions are: (1) The existence of a widespread belief that government is legitimate. This is usually achieved through popular control of the policy-makers by means of elections and freedoms of speech and press. (2) The rule of law, meaning laws are knowable in advance, impartially applied and effectively enforced. And (3) a government that exercises pro-growth economic leadership.

The economic preconditions are private ownership of property, free markets and the legal recognition of some sort of limited-liability business entities such as corporations or limited liability companies. Limited liability means that a business as an entity is liable for its debts and other obligations, but individual shareholders are not liable for the obligations of the company. If everyone who bought a share of stock in General Motors were personally liable for the debts and liabilities of GM there would be few people willing to buy GM shares and the whole process of equity-funding of business enterprises would dry up. Some economic historians believe the invention of the limited liability company was the single most important invention in making modern economies possible.

The technological preconditions for a favorable investment environment are the economic use of integrated circuits (semiconductor chips), modern computers and communications.

These preconditions can all be taken for granted in the developed countries today; however, before investing in a stock of in one of the emerging market countries one should run down the checklist and if that country is too far behind in meeting the preconditions forget it. The investment environment may not be sufficiently safe. Two good sources for getting information on particular countries are the CIA’s web site, www.cia.gov/cia/publications/factbook/, and www.heritage.org/research/features/index/countries.cfm which is the Index of Economic Freedom web site produced by the Heritage Foundation and The Wall Street Journal.

Just because stocks of foreign companies trade on the New York Stock Exchange as American Drawing Rights (ADRs) does not mean that you should forget to analyze the country in which those companies exist and operate. When you buy the ADRs of, say, a Chinese company, traded on the NYSE you are not actually buying shares of the company, rather you are buying rights to those shares. That is why they are called ADRs. For all practical purposes, however, you can consider that you are buying the shares. Hence you must be concerned about the investment environment of the country in which that company operates.


Let’s suppose now that we are dealing with American companies, and we know all the preconditions for a favorable investment environment are met. Is that it? Not really. We should look more closely at the actual current condition of the American investment environment, and this means evaluating the economic environment, the interest rate environment, and the foreign affairs environment.

When economic conditions, interest rates and foreign affairs are good stock market investing will be good; when they go sour so will stock market investing. That means one should be more aggressive when conditions are good and more conservative when conditions are bad.

One way to be more conservative in picking stocks is to pick those that not only satisfy all the conditions of The Almighty Formula (good business, good finances, and good price) but that also pay a nice dividend. The regular payment of a dividend will tend to insulate a stock from a precipitous decline in price. Assume a stock is priced at $20 and pays a $1 dividend (5%) each year. If the stock dropped to $10 and the company continued paying that $1 dividend the dividend yield would now be 10% which would probably attract more buyers of the stock and the stock price would go back up. That is why dividends are good buffers against precipitous price declines.

So how is one to evaluate the economic, interest rate and foreign affairs conditions? The answer is simply to read a lot, reading such things as The Wall Street Journal, Business Week, The Economist, and Foreign Affairs, and then make your best judgments. Or you can read The ARRVIN Report (available at www.arrvin.com) where it is done for you. Each issue has a brief evaluation of the current investment environment. Here, for example, are the ratings from the 9/1/05 issue of The ARRVIN Report:

Each condition is rated on a five point scale ranging from 1 = Great to 5 = Horrible.



U.S. Economy. Average. Katrina was a big deal. One analyst, speaking of the gasoline market, put it well when he said, “You take a market that’s already running on the edge of ragged and you wallop it—it’s not a pretty sight and it will affect consumer spending.” Consumer spending accounts for about two-thirds of the economy. Even before Katrina, orders for durable goods fell 4.9% in July, the biggest decline in more than a year. Taking the city of New Orleans with its $50 billion GDP offline for a quarter or two will also have a negative effect on national GDP which had been expected to grow smartly in the third and fourth quarters. That’s less likely now; consequently, the outlook for the economy goes down from good to average. Score = 3.

Foreign Affairs. Below Average. The quagmire in Iraq continues to deepen with the Sunni rejection of the proposed constitution. The constitution goes to a vote on October 15 where a defeat in three provinces will kill it. The Sunnis are a majority in four provinces; however, there will be a great temptation to do some vote-rigging on the part of the existing government. Either defeat of the constitution or its passage in a flawed election will not make it easy for the Bush Administration to embark on troop withdrawals given its commitment to staying the course until we have brought democracy to Iraq. Such a course will probably take decades if it can be accomplished at all. Meanwhile the war remains a huge drain on our finances, troops, and international standing. On a more positive note, with China’s aid the negotiations with North Korea are inching forward. Things could be worse. Score = 4.

Interest Rates. Good. The Katrina may have stopped the Fed in its tracks. The markets are discounting the likelihood of any raises to 4.25%, 4%, or possibly even to 3.75%. The last raise in August was to 3.5%. This level, or even 3.75%, remain favorable, and long-term rates, which remain around 4%, are also looking good. The interest rate environment remains good. Score = 2.

In sum, you should pay attention to the investment environment for it can have a significant impact on how businesses do, and how businesses do goes a long way toward determining how stocks do. When the investment environment is good you want to be most aggressive with your investments since that may be when you make most of your money. When the investment environment goes bad that is the time to become more conservative in your stock-selection, focusing largely on stocks that pay good dividends.

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This column on stock market investing is educational and is not meant to provide specific investment recommendations even though particular stocks will be discussed as examples from time to time. The basic idea is that good stocks all have three qualities--good businesses, good finances, and good price. The relationship of a good stock to these three qualities is The Almighty Formula, and The Almighty Formula has been implemented in a computer program called ARRVIN. For recent stock picks by ARRVIN and for more information on The Almighty Formula and ARRVIN go to www.arrvin.com.