After some 15 years of travelling in and out of Kuala Lumpur, I finally had a chance to visit nearby Bukit Batu and its famous caves. My Malaysian colleagues had little interest in joining me: “Why would you want to climb all those steps?” A visitor does indeed navigate 272 of them to reach the principal cave; fortunately, they are divided into groups
of 17.

“Bukit Batu” means “Stone Hill” in Malay. This limestone outcrop is best known for a labyrinthine complex of some 18 caves. Of the few open to the public, the best known is the enormous Temple Cave. The complex was discovered by Europeans in 1878 and was heavily quarried until the 1970s, when the government began to protect it for tourism.

The half-day trip to the Batu Caves offered some reminders of our own global investment strategy. Metaphorically, we see themes in geology, archaeology, and ecology. These may be worth exploring as we look deeper into 2009 and a probable economic recovery in 2010.

Geology: Constantly Changing

The Batu Caves are made of limestone and are therefore constantly changing in shape and size. Calcium carbonate (limestone) dissolves easily in the acid that forms when carbon dioxide combines with ordinary rainwater. Likewise, investment markets constantly change in scope and dimension.

The concept of ever-shifting markets may seem embarrassingly obvious. Yet the way investors’ minds work, once we are scalded by investment activities, we can fail to regroup. In meetings with me in the first half of 2009, both individual and institutional investors pondered whether it really makes sense to ever return to the discipline of asset allocation. I reminded them, politely and deferentially, that it may have been the lack of such application that found them in a performance predicament.

There of course may be a very tangible issue here related to the practice of Shari’ah-sensitive asset allocation. The discipline is relatively young and has yet to be tested across multiple market cycles. Only limited research has been published in this area, suggesting that more work needs to be done for financial advisors to fully satisfy the needs of Islamic wealth management clients.

To be fair, just about any strategy would have had difficultly in avoiding the asset-value collapse we have seen worldwide. Yet home-market biases and affinity investing may have landed investors in more trouble than they might have otherwise experienced.

Certainly the extent of the fiscal and monetary stimulus we have seen globally will likely bring about at least a degree of inflation, providing companies with relative pricing power and revenue buoyancy. In our view, the rally we have seen in global equities has likely not been forward-looking enough to discount this fundamental opportunity. Rather, recent stock-price gains reflect technical considerations in relatively thin markets. We are prepared for the rally to subside near term.

Archaeology: Measuring the Footprint

The Batu Caves have never yielded any major archaeological find, despite their prominence. One theory is that any prehistoric human evidence was dissolved by extensive bat guano. Likewise, we ran the risk in the early-to-mid stages of the credit crisis that the sheer collapse in confidence could have destroyed the global economy, including advances we have seen in the Islamic financial sector. Riyadh was rife with hubris last year, as Islamic banker after Islamic banker proclaimed their organisations immune to conventional-sector foibles. The worldwide recession has since suggested otherwise.

It is sobering to think about our own heritage on Wall Street, dubbed by some the “neighborhood that destroyed the world.” But we can appreciate—from our proximity to the cause—that the industry is unlikely to succumb again anytime soon to such gross risk misjudgments. Statistical anomalies can occur, correlations do break down, and mean reversion is largely academic. Most importantly, financiers now understand how frail their judgments can be, a notion inherent
to the philosophical underpinning of the Islamic banking business.

In contrast to the utter lack of human evidence in the Batu Caves, we suspect the credit crisis will leave a durable “archaeological footprint” on the global financial services industry. Renewed calls for so-called sustainable banking harken to ideas long held sacred to Islamic banking. The Financial Times supplement on this subject, published in early June, was instructive in timing and content. Our own efforts on the multilateral playing field now seem less marginal than they once were considered.

Ecology: Integrated Versus Isolated

The ecosystem of the Batu Caves is surprisingly variegated. This complexity is fed by bats, which transport sunlight into the caves by processing it in their metabolisms and “depositing” nutrition for other species. Yet, because the ecosystem is a relatively closed one, scientists argue that it is highly sensitive to change. Likewise, the financial sector has historically been detached from the rest of the global economy, which may be among the reasons it convulsed.

There is plenty of evidence to suggest that we forgot just how perilously closed and isolated the banking system was. For starters, regulators were sent scrambling as value-at-risk and other statistical methodologies failed. A colleague of mine (who ran a small community bank in California) reminded me that the long-held assumption that any system risk would arise from small banks was completely turned on its head when the large institutions started failing.

Other than size issues, the concept of detached and integrated systems is where Islamic finance and conventional finance have stood in stark contrast to each other. The asset-backed and risk-sharing nature that underlies most elements of Shari’ah-compliant banking embraces the notion of mutually engaged economic and monetary systems. We can argue that disengagement is at the crux of the conventional system’s failure. After all, economic and monetary connectivity yields informed decision-making that brings greater resilience to financial networks.

Going forward, we will no doubt see more in common between conventional and Islamic banking, given that the former is being forced to adopt interdisciplinary approaches to regulation and oversight. This evolution should help to avoid a repeat of the credit crisis. All would agree that the type of systemic financial panic that started in 2007 must be relegated permanently to the economic history books.

Unexpected Reminder

During my half-day at the Batu Caves, I was struck by their Hindu orientation. At one point I was caught up in a Tamil wedding ceremony at the Ganesha Temple, which sits the foot of the giant staircase to the main cavern. The festivities helped to refocus my attention on India, currently one of our preferred emerging-market choices.

There are many reasons to buy India, other than the fact that it is a major index component. Our case rests on two factors. First, we see widespread corporate restructuring, which will engender more globally competitive manufacturing and services companies throughout the country. Secondly, it is does not have the same direct exposure to diminished international trade and a volatile oil price as China and Russia, respectively. Indian banks also have been able to ride through the credit crisis somewhat unscathed. We are particularly enthused about the untapped opportunities in the small- and medium-sized enterprise segment.

Malaysia of course is predominantly a Muslim country, but many observers fail to appreciate that it has a sizeable Hindu population, estimated at maybe 8% of the nation’s total of about 22 million. This dates back to late 19^th century migration by Indian workers, primarily Tamil, in search of work.

Message of the Caves

Circling back to behavioral finance, we wonder if investors may be too shell-shocked after a cycle of asset inflation to act effectively in a new found framework. It may take years to slough off the misguided investment tactics of the past. Yet, we have long argued that in a world of opportunity, there is always something attractive to consider:

• Opportunistic ideas. Most of the funds that have been announced in the trade press this year center on distorted valuations. Investors should distinguish between distressed assets and distressed sellers. We look to target real estate and selected private-equity investments, areas that tend to be Shari’ah-sensitive in construct.
• Thematic concepts. These plays are transcendent, as they move beyond stock-picking entertainment; they are durable because they resist the wear-and-tear of market cycles. We think of infrastructure-related stories, especially those tied to demographic shifts to urban centers. The fact that the Islamic banking sector has been birthed by the developing world suggests vast potential to advance such themes.
• Rent equivalents. We are looking for products that generate consistent cash flow to provide ballast for an investment portfolio. Admittedly, buyers may pay a premium for the assurance of income delivery. Consider high-dividend-paying stocks, especially in the emerging markets. Similarly, asset-backed investments with recurring income streams are well known to the Islamic investment community.

We are looking in each category for those investments that exhibit an unusual degree of transparency and disclosure. In particular, we favour structures with well-articulated, if not proven, investment processes.

Fewer Obstacles in 2009

As I left Bukit Batu, with the Ganesha Temple behind me, I was reminded that in the Hindu tradition, Ganesha is deified as the “remover of obstacles.” Such polytheism of course is unknown in the Abrahamic faiths. Yet, the setting was at least a symbolic reminder that there may be fewer obstacles in 2009 to constructing a successful global investment strategy, than some would now suggest.

For help with my metaphor, I am indebted to Shaharin Yussof’s booklet “The Natural and Other Histories of Batu Caves,” published by the Malaysian Nature Society (1997). It is available at the small kiosk inside the Temple Cave entrance, after you climb those 272 stairs.