Chapter Twelve

Pri·va·ti·za·tion

The Trend That Can Bring Huge Opportunities

So how did privatization help transform markets such as Russia? It sounds like the driest of bureaucratic abstractions. Just say it—privatization—and those Latinate syllables literally drag on your tongue. But privatization is much more than an abstraction. It’s a revolutionary trend that has been sweeping the world for a number of good reasons, not the least of which is that it is the only way for long-dormant value to be pried out of moribund state industries, which have been black holes for capital instead of generators of it.

This has proven true not only in former Communist and socialist countries, and not only in emerging markets, but in developed markets as well. Great Britain and France made fortunes by privatizing their national phone companies, while achieving better service into the bargain.

Privatization has been the engine driving the lion’s share of the world’s emerging markets. For example, during the first half of 1997, Latin American stock funds produced some of the world’s highest annualized returns. The reason? Stock markets in Brazil, Argentina, Mexico, Venezuela, Colombia, Chile, and Peru were all fired up by a wave of privatizations.

In Brazil, the wholesale shifting from the public to the private sector of several key companies, including Telebras (the national phone company), Eletrobras (the national electrical utility), and Petrobras (the state petroleum company), was big news.

Priming the Pump

Getting in early on newly privatized companies is one of the best ways to benefit from the resulting unlocking of value. Of course, gauging these situations can often be tricky, because some countries (and some central governments) rig the process to benefit insiders, while others simply bungle it in less venal ways that can result in horrendous rip-offs of shareholder value.

To the institutional investor, visiting companies in the early stages of privatization—generally before the shares become listed on international exchanges—is the next best thing to knowing the future. A comparable step for a small investor is buying the shares locally if there is a local listing early on in the privatization process. If the valuations are attractive, an investment via the initial public offering (IPO) can be a good opportunity.

Privatization allows governments saddled with unprofitable state industries to obtain the level of investment necessary to turn these crippled colossi around. Though the fairy tale of the sleeping frog being kissed by the princess and turning into a prince might be a somewhat romantic analogy, privatization can be almost miraculous in its ability to pry long-lost treasures out of rusty industrial chests to which the state had long ago misplaced the key—the key being incentive, of course. More than money, incentives are the royal road to riches.

Profitable investing in emerging markets demands a close study of the privatization process, because the difference between a good and a bad investment can be simply a matter of timing—buying at the right moment in the privatization process. Getting in early on the privatization curve is the key to riding the wave of the future.

Here’s How It Works

Under the classic privatization model, state-owned companies seeking to go private are often told by their governments—which still own them—to go hunting for a strong strategic partner, typically a leading company in the same industry as the company undergoing privatization.

The rationale is to provide the resulting joint venture with the technical and managerial benefits provided by the strategic partner, so that these more often than not antiquated, clunky dinosaurs can be turned into lean, mean high-tech machines.

The oft-heard phrase strategic investor was no sweeter music to my ears than the dread term underwriters—the latter are the investment bankers who manage the issuing of new shares on behalf of new companies, and they like to set higher prices than I like to pay.

In general terms, my experience with strategic investors has not been terribly positive. Why? Because while a portfolio investor like us is looking to make money, a strategic investor is looking to gain control.

In most national privatization programs, the national telecommunications companies have been among the first firms to be taken private. That’s because the revenue to be raised by selling off the telecom operation can be quite hefty, while the investment required to upgrade the system to international standards is typically so great that only a well-heeled, deep-pocketed strategic partner is going to be up to the task of jump-starting these creaky jalopies and kicking them into high gear.

In the 1990s, in Estonia, for example, the Ministry of Posts and Communications hoped for a partner willing to help upgrade the entire domestic phone system, not just the urban network. This was a potential fly in the ointment, because although it was clearly more profitable to serve the more densely populated urban areas, for political reasons the government could hardly ignore the sizable slice of citizenry who lived out in the countryside, many of whom had been on waiting lists for decades hoping one day to be granted the privilege of having their own phone.

Now let’s look a little more closely at this decision, because it’s critical to any foreign investor, large or small. Why is the company often placed under a legal obligation to find a strategic partner? Because, just as the management of any private company looking to sell it would want to buff it up to fetch the highest price, the government’s goals tend to be:

• To maximize the proceeds from privatization.
• To curry political favor by improving services.

What usually happens is that the new company gets saddled with the political imperatives of the old company. So the government says to the strategic investor: Let’s make a deal. We’re going to give you an opportunity to make one heck of a lot of money. But in exchange for this opportunity (which we’re going to guarantee for a period of time by extending the monopoly enjoyed by the present company’s state-owned predecessor) we’ve put down two nonnegotiable demands:

If all goes well, a well-handled privatization can be a win-win situation for everyone involved, from the government to managers to customers to underwriters (investment bankers) to you and me—foreign investors in general.

Why They’re Good Investments

The reason that privatizations (provided you get in on them early enough) tend to make good investments is that a combination of higher investment—from the people who buy the shares and from the strategic partner, if there is one—with improved management almost invariably leads to higher productivity. I said almost invariably—not always.

Whenever you buy stock in a company, you’re placing a bet on that company’s long-term prospects. The price of that stock is really just the average of a range of potential buyers’ and sellers’ opinions of what the shares are going to be worth in the future.

Common characteristics of public-sector telecom companies in emerging or, more so, the frontier markets include low penetration rate, excessive prices for the average citizen, and poor phone service. As mentioned earlier in the book, in the developed countries, we tend to take mobile phone service—or more than 90% market penetration—practically for granted. But in Nigeria, for example, it was 55%, while in Bangladesh it’s even lower at 46%!

Privatization offers cash-strapped emerging nations:

• A way to get cash out of their antiquated phone networks, which would take millions to bring up to speed.
• A way to close the telecom gap as quickly and efficiently as possible, at next to no cost to the taxpayer.

Low telecom penetration rates represent high potential growth. (Investors like telecom companies that start out near the bottom, because that only enhances their upside potential.)

After telecoms, public utilities usually comprise the next wave of state-owned companies to be privatized. They tend to be vast and unproductive, and need serious money to be upgraded into profitability. But on the upside, once they’ve got their infrastructure in place, their costs can be pushed lower with good management and their profitability can be pushed up with fair rates.

Utilities may not be sexy, but they can be sleepers. The three big questions to ask with any utility:

Thus, investing in a newly privatized company can lead to substantial profits since you’re getting into the company in its early stages of development. As the company becomes more efficient and productive, profitability and subsequently share prices should increase. So it’s always wise to keep a lookout for such companies—especially in frontier markets.