I was stumped. Not because I haven’t thought about it, but because it had been so long since I’d heard the question. These discussions were more common in the pre-credit crisis era, when the liquidity cycle was peaking. They have all but evaporated in the current environment.

Held Back by Space and Time

By any reasonable measure, Islamic wealth management—comprehensive advisory relationships with well-to-do investors—has not shared the growth trajectory of Islamic banking and finance. I conclude there are two reasons:

• Space. This enterprise model lies somewhere in the middle of the spectrum of retail and wholesale banking functions. Ultra high net worth families demand a unique mix of corporate banking products, cash equivalents, and personal investment services. In universal banks, such a function can get lost on the organizational roadmap. Too small to matter, too big to ignore.
• Time. Islamic wealth management is quite unlike the retail business, where there is a clear reward for attracting large volumes of individual assets. Nor is it like the wholesale business, where transactions can quickly generate high profits. Islamic wealth management takes time to develop into an effective, efficient commercial model. It is a deep-mining proposition that provides long-term rewards, but it may lack a certain bling.

I should not be entirely pessimistic. There have been important strides taken by financial leaders in some corners of the Islamic world. Realistically, however, it is hard to identify a cadre of firms that are either first-movers or fast-followers.

Prospects for Future Development

Still, the credit crisis could be the best thing that has ever happened to the Islamic wealth management business. I see two macro trends potentially leading to a higher profile for this industry segment:

• Diversification Requirements. Islamic investors seem prepared to move beyond local investments, many of which have disappointed. A shuttered real estate project in Bahrain is perhaps unlikely to offer more attractive returns than a China-related investment idea over the near-term. Certainly neither the Gulf nor Southeast Asia lacks meaningful investments for the Islamic investor, but these may not be readily at hand in a slow-growth global environment in which liquidity is constrained. By way of example, I just finished a preliminary roadshow across the Gulf for a Shariah-compliant Australian equity fund that my firm is helping launch for qualified institutional investors. Two or three years ago, I would have expected objections about (1) better returns locally and (2) Australia being too far afield. I heard very little, if any, of these once-routine pronouncements.
• Compressed Investment Returns. It is hard to take a disciplined approach to investment portfolio construction, legacy planning, and cash flow management, when a venture down the street is aspiring to offer annual returns above 40%. Ideas about economic cycles and investment waves tend to be ignored during asset bubbles. But outsized returns are likely to be a distant memory in the post-crisis era. Some Islamic investors have dealt with this new reality by ceasing to make new investments altogether. While I appreciate the human nature behind such behavior, it seems to be an artless tactic, given that there are always portfolio opportunities somewhere in the world. Coming back to personal example, the 25% average annual total return generated over the past decade by our client’s Shariah-compliant Australian equity strategy commanded some attention. It may be consistent with selected global opportunities in offering an antidote for fear-induced paralysis.

In Search of an Irrational Mind

If the Islamic wealth management business cannot attract the involvement of major firms, even when macro themes support its viability, there may be a strategic opportunity an “irrational mind” to back such an enterprise model. I use the term irrational because the investment proposition may be such: “Invest a lot of money up front and wait a long time before you see sizeable returns.”

Because I once led a firm backed by venture capital, I am all-too-familiar with the expectation for high returns in a short period of time. This legacy dates to the heyday of the technology cycle. It no longer fits with reality.

Irrationality may be at home in the Islamic banking business. Five years ago, when I transitioned my company into Islamic asset management, I was told by a Wall Street pundit that I was marginalizing myself. Today, such efforts are commonplace.
Fifteen years ago, when I asked the CEO of a US-based financial monolith about prospects for the firm entering the Islamic finance business, he said, “Never.” Today, the successor firm aspires to be a player.

Thirty years ago, Islamic banking and finance was merely a concept promoted by a few visionaries across the developing world. Today, its advance is likely to be one of the most important industry themes this century.

Call to Action

I wrote a chapter for a book on Islamic wealth management two years ago, but in hindsight, its direction was likely misplaced. That chapter ended with a call to action intended for firms with nascent Shariah-compliant private banking businesses. I should actually have addressed that call to venture-capitalists and entrepreneurs, who have the appetite for the stable returns of the Islamic wealth management business, not to mention the stamina to wait for them.
I reiterate that call to action. In general, we need more strategic and less emotional approaches to building the enterprise model. I see three areas for prompt consideration:

• Assemble a broad and innovative product array to support advisory work.
• Fund research budgets to provide grounding for advisory work and convey a proprietary “voice” in company communications.
• In building organizational structures, focus on substance instead of veneer.

Each of these points interacts with the others; none has to be controversial. Proper implementation should help the Islamic wealth management business take a truly competitive stance, as the industry re-thinks its development in the post-crisis era.
All the better with the unequivocal support of an “irrational mind,” whether individual or corporate.

Notice to Readers

This article was originally published in So Far: The Journal of Strategic Thinking in Islamic Finance, Volume I Issue 2, follow this link to visit the publisher’s website.

Codexa Capital is a specialized investment banking firm concentrating on Islamic finance, serving institutions outside the United States. Codexa is not registered as a securities broker-dealer or an investment advisor either with the SEC or with any state securities regulatory agencies. The information, opinions, or recommendations in this article are submitted solely for informational purposes.

The information provided here has been obtained or compiled from sources we believe to be reliable; we cannot and do not guarantee the accuracy, validity, timeliness or completeness of any data made available. Opinions and estimates reflect current judgment as of the date appearing on the article; they are neither all-inclusive nor can they be guaranteed to be complete or accurate. Past performance does not indicate future returns.

This material is for general information only. Every effort has been made to ensure that it is accurate; however, it is not intended to be a complete description of the matters described. This document has been prepared without taking into account any personal objective, financial situation or needs. It does not contain and is not to be taken as containing any securities advice or securities recommendation. Furthermore, it is not intended that it be relied on by recipients for the purpose of making investment decisions and is not a replacement of the requirement for individual research or professional tax advice.

It is noteworthy, then, that Pirsomani’s sense of the ordinary extended to a man in oriental costume holding the tether of a Bactrian camel. Tartar Cameleer evokes the Silk Road, suggesting that the commonplace extended to caravans passing through Tiflis (now Tbilisi). In view of the painting’s 1914 date, the cameleer image may have been nostalgic, but it is a vivid, if rustic, indication of Georgia’s longstanding role as trade junction between Central Asia and Europe.

From the perspective of global investment strategy, Pirosmani’s portrait of the camel driver conveys the cosmopolitan nature of the Georgian economy. His worldview prevails into the present day as Georgia looks both East and West to affirm its progressive identity.

Georgian Economy in International Context

The Republic of Georgia is the western anchor to the land bridge that connects the Black Sea with the Caspian Sea (see map below). Armenia and Azerbaijan are neighbors to the southeast. Farther afield, the country has active diplomatic and economic agendas with the nations east of the Caspian Sea, including Kazakhstan, Uzbekistan, and Turkmenistan. In the other direction, Georgia has a dynamic relationship with Turkey. The Caucasus Mountains to the north not only separate Georgia from Russia, but also serve as a bulwark against the situation in Chechnya and Dagestan.

Key Statistical Comparison

Note: We compare Georgia with Singapore because of its favorable comparison in the World Bank’s Doing Business survey and similar population size.

Source: See www.doingbusiness.org and www.transparency.org. Other data obtained from most recently available CIA World Factbook, typically based on 2008 estimates. PPP (purchasing power parities) are currency conversion rates that also equalize purchasing power. Gini Index measures income distribution among citizens, ranging from 0 (perfect equality) to 100.

As a former Soviet republic, Georgia is often lumped together analytically with Eastern Europe. Actually, the similarity may end with its Orthodox-Christian heritage. In practice, Georgia’s position at the corner of the Black Sea has hosted a confluence of many traditions. The architecture of Tbilisi exemplifies the blend of Western and Eastern cultures. The 1851 Tbilisi Opera House, for instance, is a somewhat fantastical blend of Moorish embellishment and classic Western design.

Georgia thrust itself onto the world stage in 1991 as the first Soviet satellite to assert its sovereignty. As the nation weaned from central economic planning, it saw a sharp collapse in output, consistent with the experience in Eastern Europe. Multilateral organizations helped stabilize the economy during the 1990s. Unfortunately, under the stewardship of Eduard Shevardnadze, the country’s second president, Georgia was better known for cronyism than capitalism. A seismic shift occurred with the so-called Rose Revolution in November 2003, which up-ended the country’s power structure.

In 2004, the economy took a turn toward rapid growth as Mikheil Saakashvili became president. His administration—currently in its second term—is pinning the economy’s long-term potential on a deregulation and anti-corruption platform. Posters at the country’s two international airports remind visitors that official bribery is a criminal offense. The free-market policies of the Saakashvili administration appear to have succeeded: Georgia is now ranked 11th in the Ease of Doing Business Survey by the World Bank, sandwiched between Norway and Thailand. Russia, by comparison, is ranked 120th. See www.doingbusiness.org for further background.

Georgia Forecasts Economic Turnaround (Real GDP Growth)

Source: World Bank, National Bank of Georgia for 2009-10 estimates.

With the global credit crisis, Georgian economic activity declined dramatically in 2008-09 from the double-digit growth seen in 2007. The IMF has identified five causes of this collapse: contraction of export markets, lower remittances from citizens working abroad, the freeze in international credit-markets, falling commodity prices, and capital repatriation back to major economies. Importantly, these factors largely fell outside domestic developments. The Russian invasion of August 2008 may simply have been a caustic addition to an already volatile mix of international macro-events.

Despite the near-term set-back, the outlook for the Georgian economy remains attractive. The economy is heavily oriented toward agriculture (accounting for more than 50% of employment), with generous water resources to sustain above-average growth in the sector. Global macro themes such as hunger alleviation and food security bode well for Georgia. Meanwhile, its role as a trans-shipment corridor for nations to the east—especially in the hydrocarbon and mining sectors—will help national growth percolate upward as the global economy improves. Low labor costs make Georgia attractive for foreign direct investment. For perspective, real annual GDP growth averaged an impressive 6.6% in the 10 years prior to the credit crisis (1998-2007).

Access to the Hinterland

While Xian and Istanbul are known as the eastern and western terminals of the Silk Road, intermediate stops such as Tbilisi may be less commonly appreciated. This city lies on the Eurasian Steppe route that ran around the northern end of the Caspian Sea. The trade route helped forge a society deeply influenced by its diffusion of craftspeople, scholars, and emissaries over the centuries.

Source: Yahoo! Maps.

The Black Sea Coast of Georgia, stretching some 325 kilometers between the Turkish and Russian borders, has long been a preferred transit point to larger markets. This route steers clear of Iran and Turkey, which can be desirable for geopolitical as well as logistical reasons, depending on the state of regional and international diplomacy.

We focus on the potential for five markets that export and import through Georgia:

• Azerbaijan, though not an OPEC member, is a major oil exporter at an expected rate of about 1.2 million barrels per day in 2010, roughly half of what we will likely see from Norway. A decade ago the number was perhaps one-fifth the size. This growth results from of billions of dollars in investment from a range of international names, helping to diversify Azerbaijan away from Russia in both economics and geopolitics. For context, as long as China’s oil import requirement remains about the current 4.5-to-5.0 million barrels per day, Azerbaijan alone could satisfy one-quarter of Chinese demand. Yet Azerbaijan faces a de facto ceiling on oil exports imposed by the capacity of existing pipelines and non-captive transit routes. The country has long been flush with oil, especially in its Caspian Sea wells. When the first Baku oil gusher was struck in 1873, it took four months to cap because of its strength.
• Armenia is slightly smaller than Georgia geographically and about one-quarter the size of Azerbaijan in GDP terms. The country is in self-declared transition from a resource-driven to a knowledge-based economy. Its success will likely derive from its ability to attract foreign investment, in which it benefits from a large overseas population of Armenian descent. At maybe 10 million, the diaspora is about three times the population of the country itself. Meanwhile, mining and related industries will continue to play a key part in economic activity, with the government working aggressively to attract overseas firms that will raise standards to international levels of competitiveness. The Armenian Ministry of the Economy now heralds external investment in the mining sector from an array of North American and European companies.
• Kazakhstan, Uzbekistan, and Turkmenistan are the largest of the Central Asian Republics, with a combined GDP of some $280 billion. As a group, these nations comprise roughly the 40th largest economy in the world, slightly smaller than Hong Kong and roughly 13 times the size of the Georgia. Vibrant hydrocarbon industries define all three, but Uzbekistan and Turkmenistan also have important cotton export businesses. The Kazakh economy—despite credit-crisis-induced challenges faced by the banking system—is the most evolved because of its well-diversified resource base and relative political stability. Meanwhile, Uzbekistan and Turkmenistan have been working hard in recent years to integrate better into the regional economy. These two smaller economies face material governance hurdles, as indicated by their poor rankings in Transparency International’s Corruption Perceptions Index.

The South Caucasus states of Azerbaijan and Armenia, along with the larger Central Asian Republics, have in common a renewed orientation toward Georgia for improving access to international markets. These economies have traditionally relied mainly on trade with Russia—a relationship that periodically goes askew. There are countless examples of such turbulence, ranging from the recent pipeline spat between Turkmenistan and Russia to longstanding differences over Caspian Sea rights, whether resource ownership or naval protocol. Certainly the Georgian role in linking these hinterland economies with international markets helps to keep multi-lateral relations within the region as constructive as possible.

GDP per Capita

Note: Based on PPP (purchasing power parities) estimates, typically 2008 data for comparison purposes. Source: CIA World Factbook.

Understanding Development Issues

Like many developing countries, Georgia faces challenges both under and outside its control. The most critical issue may well be the outlook for global economic momentum. Within the context of local and regional affairs, however, we identify three issues with which Georgia will likely continue to wrestle:

• Relationship with Major Powers. Georgia has increasing aligned itself with the West under the leadership of President Saakashvili. While clearly benefiting the government in technical and developmental assistance, this alignment has heightened animosity with neighboring Russia, perhaps reaching a high watermark with the August 2008 invasion. Georgia is caught somewhat awkwardly between its Cold War heritage and its modern-day vision.
• Foreign Aid and Fiscal Exit Strategies. The double-barreled impact of credit crisis and Russian invasion led to significant foreign financing in the form of grants and concessionary loans. The Georgian government has shifted spending dramatically from defense toward social expenditure, with some 35% of the 2009 budget going to health, education, and the like. In the future, Georgia will have to rely more on the private-sector to sustain its desired growth trajectory.
• Hydrocarbon Management. The ongoing success of Georgia as an oil and gas transit corridor depends on the government’s ability to negotiate favorable agreements. Both the Baku-Tbilisi-Ceyhan oil pipeline and Baku-Tbilisi-Erzurum gas pipeline, for example, fit into this framework, but the arrangements need to be nursed carefully. Ongoing improvements in the road and rail infrastructure will further support transit channels. In general, Georgia needs to demonstrate strong engagement in the hydrocarbon transit businesses, reinforcing the confidence of international players.

We find Georgia to be a resilient and progressive country. Its deep track record of pro-growth reforms and aggressive external alignment with major liberal economies should give investors confidence in the business backdrop, especially as a center for regional activity.

Black Sea Coastal Trade

While exotic in its particulars, Tartar Cameleer typifies Pirosmani’s subject matter of people at work and play. Another work relevant to our topic, entitled Batumi, is one of the relatively few landscapes he executed. The painting shows a steam train chugging up the coast from the port, perhaps toward the village of Supsa on its way to the Samtredi junction, where it would turn toward Tbilisi and other points in the Southern Caucasus.

The painting also shows some eight ships moored in the harbor. They may be taking on goods for markets elsewhere, given the wind direction away from shore and the oarsman apparently maneuvering his pram to upload cargo to one of the waiting freighters. The density of traffic suggests a high volume of coastal trade.

In this landscape, there are no camels, only then-modern conveyances. Such features emphasize Georgia’s potential as a regional entrepot. That vision is now fast becoming a reality as Georgia asserts itself as an East-West trade bridge.

Acknowledgment

We acknowledge the contribution, to our observations, of the book Pirosmani: A Legend in Naïve Art, published in conjunction with an art exhibition by the Pera Museum of Istanbul in 2007.

Notice to Readers

This research commentary was prepared under the sponsorship of Black Sea Product Ltd. of Tbilisi, Georgia. Codexa Capital received compensation for the preparation of this article, in relation to its role as investment banker for the Seaport of Supsa development project.

Codexa Capital is a specialized investment banking firm concentrating on Islamic finance, serving institutions outside the United States. Codexa is not registered as a securities broker-dealer or an investment advisor either with the SEC or with any state securities regulatory agencies. The information, opinions, or recommendations in this article are submitted solely for informational purposes.

The information provided here has been obtained or compiled from sources we believe to be reliable; we cannot and do not guarantee the accuracy, validity, timeliness or completeness of any data made available. Opinions and estimates reflect current judgment as of the date appearing on the article; they are neither all-inclusive nor can they be guaranteed to be complete or accurate. Past performance does not indicate future returns.

This material is for general information only. Every effort has been made to ensure that it is accurate; however, it is not intended to be a complete description of the matters described. This document has been prepared without taking into account any personal objective, financial situation or needs. It does not contain and is not to be taken as containing any securities advice or securities recommendation. Furthermore, it is not intended that it be relied on by recipients for the purpose of making investment decisions and is not a replacement of the requirement for individual research or professional tax advice.

There are few unified stories across the world today; Australia stands among them. Certainly the dimensions of its investment substance may surprise those distant to the story. Consider these points of uncommon knowledge:

• The four largest Australian banks are all rated AA (stable) by S&P, placing them within the top 3% of banks globally on a credit-quality basis.
• Australia’s largest trading partner is China, with the rest of Asia, including India, Korea, and Japan, amounting to some 50% of exports.
• Australians have the largest pool of investment fund assets in Asia, more than 45% greater than Japan.

From an investor’s standpoint, we identify themes that suggest the relevance of Australia to a prudent, risk-adjusted portfolio strategy.

Negligible Impact from the Credit Crisis

During the first months of 2009 when other major economies saw economic downturn, Australia actually grew, albeit slowly. Real GDP growth was up some 0.4% in the quarter ending March, compared to declines of 3.6% in Germany and 1.5% in the United States. Credit can go to policy makers, whose stimulus efforts did not have to fill a “black hole” created by overextended banks.

Non-Performing Loan Rate in 2007
(percentage of total bank loans)

Source: International Monetary Fund, Global Financial Stability Report, April 2008.

Australian lending practices have historically been more conservative than among the nation’s Anglo-Celtic peers, thanks to a banking culture of intermediation rather than securitization. As a result, loan activity has been tied to the real economy, as banks had to balance risk and reward directly.

No Australian bank had to be rescued in the thick of the credit crisis, suggesting that the casual analyst may misread relatively weak bank stock price trends. The run-down in share prices during the credit crisis was largely a result of global sentiment working against financials, as well as general concern about economic buoyancy in the Australian economy.

Emerging Economic Recovery

Relatively buoyant economic activity and a strong banking sector have meant that Australian business and consumer confidence was not pummeled as dramatically as elsewhere. This has lead to a better-than-expected economic growth trajectory, with the Reserve Bank raising interest rates at three consecutive meetings in 2009.

Australian Cash Rate (monthly)

Source: Reserve Bank of Australia. Real cash rate calculated using quarterly weighted-median inflation rate.

Indicative of underlying economic strength, housing prices appreciated by some 10% in 2009. Widespread economic gains mean that the margins and sales volumes of domestic companies are relatively resilient, supporting profitability. We contrast the ongoing restructuring seen elsewhere in the developed world.

Ties to Asian Growth Story

Australia has an impressive trade profile with Asia, where there is strong recurring demand for its exports, especially in the minerals and fuels area. Over the past 25 years, Australia has been aggressive in building its “power of proximity.” About half of its exports are now sent to China, India, Japan, and Korea, with China being its most important trading partner.

Macroeconomic fundamentals have also favored export momentum to Asia. Competitive exchange-rate policies have been complemented by fiscal stimulus in key export markets. The combination has turbo-charged this element of economic activity, offering both a “push” and a “pull” to export growth across both extractive and services industries. As a result, Australia was the only major economy not to see a drop when global trade volume declined by about one-fifth in the year following the Lehman bankruptcy.

Market Size and Depth

The Australian Stock Exchange has a market capitalization of about US$1.2 trillion, ranking eighth in the world. Its weighting in developed-markets world indices is roughly in line with the Netherlands. The mature nature of the country’s pension scheme provides underlying support to the market. In 2008, when the credit crisis started, Australia was ranked fifth in the world in share capital raised by private companies, ahead of both India and China.

Importantly, the market is relatively deep with over 2000 listed companies on the Australian Stock Exchange. Included are some major international names, with the top 10 stocks by market capitalization representing about half of the total market. The largest stock is BHP Billiton Limited.

Diverse Sector Composition

Despite common wisdom, the market is more than just resources. Basic materials may represent some 25% of the stock market by capitalization, but this is balanced by a diversified assortment of groupings including health care, consumer goods, and telecom.

Australian Stock Market Capitalization by Industry Sector

Data as of 30 June 2009. Source: Bloomberg. S&P/ASX 200 Index; Austrade.

Shariah-compliant investors, of course, would exclude from their opportunity set the financial stocks representing just over one-third of stock-market capitalization.

Australia Islamica

Australia is not an equity market driven by Shariah-sensitive investors. Less than 2% of the total population of 22 million claims Islam as their religion, with large proportions of these Muslims having ties to Lebanon or Turkey.

Conventional wisdom notwithstanding, Muslims were likely among the first settlers in the country, whether fishermen arriving from what is now Indonesia or navigators from the coasts of North Africa. The religion was formally established in the late 1800s in relation to the import of camels from Muslim lands to help explore the Australian interior. One of the oldest mosques in the country, in Adelaide, dates to the 1890s.

In Australia today, Islam involves a diverse community of believers, especially given the influx of Muslim students from Southeast Asia. In addition to the dominant Lebanese and Turkish Muslims, the country is home to a contingent of Bosnian and Albanian Muslims, tracing their local heritage to the “White Australian” era in the first half of the 1900s. Australia, as an immigrant country, has more recently welcomed groups from Iraq, Afghanistan, and Somalia.

Real Economy at Work

At a time when “de-risking” has become industry jargon, Australia may provide one of the few opportunities globally where financial and economic trends complement a mature and well-diversified investment market. Certainly in 2009, it was a major market that offered emerging-market scale returns.

2009 MSCI Index Price Returns (US dollars)

Source: MSCI Barra.

Other points of opportunity in a global portfolio have their downside. Canada’s banking sector may be as well-founded as Australia’s, but its economy is too heavily tied to a potentially weak US recovery. China’s equity market is increasingly robust, but its lack of institutional support suggests ongoing volatility. European markets offer diversification potential, but the strong currency dampens earnings upside.

We likely are on the verge of investment focus away from bubble-induced stories and their dark underbelly, in favor of long-term sustainability. We believe there is strength to underlying Australian economic and financial-market trends—especially given the health of the banking system—not found elsewhere. The ties to Asia are a key factor in support of real economic activity.

Amid the worldwide opportunity set, the Islamic investor may find an unexpected harmony between Australian values and a Shariah-biased view of the world.

Notice to Readers

This research commentary was prepared under the sponsorship of Hyperion Asset Management Ltd. of Brisbane, Australia. Codexa Capital received compensation for the preparation of this article, in relation to its role as structuring agent for the Shariah-compliant Hyperion Australian Equity Fund.

Codexa Capital is a specialized investment banking firm concentrating on Islamic finance, serving institutions outside the United States. Codexa is not registered as a securities broker-dealer or an investment advisor either with the SEC or with any state securities regulatory agencies. The information, opinions, or recommendations in this article are submitted soley for informational purposes.

The information provided here has been obtained or compiled from sources we believe to be reliable; we cannot and do not guarantee the accuracy, validity, timeliness or completeness of any data made available. Opinions and estimates reflect current judgment as of the date appearing on the article; they are neither all-inclusive nor can they be guaranteed to be complete or accurate. Past performance does not indicate future returns.

The Calcutta Madrassah is a proud building, sensibly designed. It opened in 1824 off Haji Mahammad Mohsin Square, some 50 years after the founding of the original Islamic college. On approach through the compact urban turmoil surrounding it, the building looks like some sort of Alexandrine temple complex. Overpowering Doric columns flanking the main entrance direct you inward, where two floors of classrooms surround a courtyard. At the far end of this attempt at a grassy space, there is a lone water hand-pump. Despite its somewhat topsy-turvy condition, the Calcutta Madrassah is a haven of peace in the tightly-knit urban landscape.

This is a favourite of mine among the city’s countless historical buildings. Unlike some heritage sites, locked away in a pneumatic tube, this site has a bio-structure composed of squatters in the building’s perimeter, children playing in the courtyard, a caretaker living in a closet-sized room nesting between two classrooms on the ground floor, amid students routinely streaming through and the souk-like market scene on the streets outside.

In a post-crisis world, the Calcutta Madrassah and a global investment portfolio may have a lot in common. Even though the former is fairly concrete, while the latter is quite abstract, we see parallels that are worth exploring:

• Understand–and respect–the context. The school was originally set up for the “benefit of mankind or embellishment of the city.” It may barely be hitting these marks today, largely because of funding issues. Likewise, many institutional investors, at least until recently, may not appreciate the sober reality of their investment choices. Witness the credit crisis and its attendant fallout. Certainly Islamic banking has a new-found mandate in promoting sustainable banking.Further, I saw a small article in the local newspaper Indian Express about the US consulate sending an official to the school to determine whether students were being trained as terrorists. Chances are this was a deliberate piece of misinformation. Nevertheless, we wonder if Shariah-compliant portfolio management continues to be dogged by similar public-relations problems with Western audiences. Certainly a conference call I had this week with a US-based client touched on persistent concerns along those lines.
• Evaluate the discipline. Just as the school board presumably meets regularly to evaluate standards of education in the community, so must investment committees review and assess portfolio positions before their remit spirals out-of-control. It is a form of risk management. Far too many oversight committees, especially in the Islamic banking and finance community, merely rubber stamp decisions made by others.Kolkata Municipal Corporation recently declared the status of local Muslims as “pathetic.” There are many causes here, just as there are in mismanaged portfolio situations. It is perhaps best to anticipate potential portfolio problems through active and ongoing criticism.
• Sort out conflicting priorities. The Headmaster’s Office at the Calcutta Madrassah oversees a range of programs at the primary and secondary level, including a touch point with students from Aliah University, which uses rented classroom space here. How to allocate limited school funds across multiple audience demands?These challenges are characteristic of asset allocation decision-making. How to allocate across a range of opportunities? For the Islamic investor, we think global portfolios currently should have a bias toward private equity and Asia-related stocks, taking advantage of both distressed and growth situations. The conventional investor should likely continue to look toward US corporate bonds, at least over the near-term, given the potential for widening credit spreads.
• Invest available cash reserves. There seems to be a lot of unused space at the Calcutta Madrassah, including classrooms under seemingly long-term renovation. Likewise, we sense that institutional cash reserves would benefit from more proactive use, while maintaining, of course, sufficient liquidity to address opportunistic situations. Cash positions may be overly defensive at present, given that they were raised to extraordinary levels during the credit crisis.Especially in Middle East markets, institutions tend to do a poor job of exploring the full range of asset-class opportunities. A worldwide context almost always yields investment ideas worth exploring. We are now working, for instance, on an Islamic fund structure for Australian equities, a market relatively unscathed by the credit crisis and an interesting angle on the Asian growth story. Likewise, perhaps because of oil exposure, Gulf-based investors seldom consider other commodity groups.
• Adhere to an investment framework. The library at the Calcutta Madrassah sits next to the biology, chemistry, and physics labs. While these facilities are at the opposite end of the spectrum from those at secondary schools in Mayfair, London or the Upper East Side of Manhattan, the attempt at classification and segmentation indicates a certain respect for the sciences.My early-career mentor drilled into me an investment strategy framework based on (1) liquidity trends, (2) valuation readings, and (3) earnings momentum. Comparing fundamentals across markets and asset classes through strict application of these lenses consistently helps identify the better investment opportunity. Sometimes one may just get it wrong, but over time the form and structure afforded by this and similar approaches should provide rewarding outcomes.

One of my favorite images at the Calcutta Madrassah is a wooden school desk in Classroom 4 with “Shabbir” etched into the top. This piece of youthful expression does not strike me as vandalism in its context. It could have been carved last year or 50 years ago. It is a poignant reminder that the action-of-the-moment may have effects that can persist for decades.

Portfolio management falls into a similar construct. An educated framework helps to give one conviction to take action amid a chaotic and fragile world. And confident investors presumably are all-too-happy to brand their efforts.

Over the past year, the government has served as white knight to the auto industry, tried to stimulate the housing industry with tax credits, and pumped untold additional billions into the financial system. Congressional legislation meanwhile has been chock-full of spending programs in an attempt to amplify the wave of hand-outs. When combined with the Federal Reserve’s asset-purchase program, the total stimulus package has amounted to almost 20% of GDP. The figure is staggering by developed-world standards.

This profligacy now seems justified by nascent economic improvement. Yet caution needs to be exercised in interpreting a handful of better-than-they-have-been statistics. The US economy is driven by the mighty consumer, and consumer spending remains feeble in the context of bloated debt levels. Moreover, unemployment nationwide is 9.7%, and substantially higher in states like Michigan and Nevada. The true level of joblessness, including discouraged and unwillingly self-employed workers, is likely even more sobering. Meanwhile, business investment remains lacklustre, despite an effective zero-interest-rate policy.

The economy is flush with Demerol. Yet what happens when the drug runs out? No one quite knows, but I suggest that the outlook is not so promising. Demerol is considered sufficiently addictive that New York State health authorities allow hospitals to administer it to a patient for only two consecutive weeks. There may be an analytical parallel here.

Demerol works quickly, setting off a “rush” at its onset and thereby creating a vicious cycle of dependence. Our economic perception has been distorted by recurring injections of the opiate. That suggests the likelihood of a nasty withdrawal period as the economy moves into fiscal detox. Officials need to figure out how to downgrade to a lesser painkiller… the economic equivalent of codeine.

Warnings of Demerol dependency may be found in the US Treasury market, with yields notching down during August. As a lifelong equity strategist, I rarely am willing to make such a capitulation, but the rapid “V”-shaped recovery suggested by the sharp gain in the S&P 500 since March is not realistic. The technicians support this view by arguing that the equity rally has been unusually thin in volume, a sign that institutional investors continue to hide—or run—in fear.

We are unlikely to see much of upward economic trajectory when the anecdotal evidence remains dreary. The State of California is even resorting to a jumble sale
of incidental government assets to help plug its budget deficit. Granted, the state has some unique taxation challenges, but California is the world’s eighth largest economy and chock full of information-age industries like entertainment and technology. Riddled by stumbling state economies, including other pivotal ones like Illinois, Florida, and Ohio, overall US activity will likely take longer to improve than suggested by Business Week’s recent prosperity-peddling cover, “The Case for Optimism.”

In this environment, our preferred asset class remains US corporate bonds. Certainly credit is not as cheap as it once was, but we are likely to see further buying opportunities. We especially target lower grade issuers, given selectively wider credit spreads, if the economy disappoints over the near-term.

The bond recommendation is admittedly pointless for our Shariah-compliant relationships because of riba prohibition. For these investors, we suggest exposure to equities influenced by Chinese growth trends. One of the surprises over recent weeks has been the strength of Asian growth in the face of frail activity elsewhere. Mid-cycle characteristics of selected investment opportunities in China, South Korea, and Singapore will afford comfort for those investors displaced by the volatility of early-cycle investments. In the complex neuro-system of global finance, China and its related growth themes may be a node worth emphasizing.

Longer term, we are enamoured with private equity, given the sharp discount in asset values we see just about everywhere. Our contrarian story in this asset class falls to Eastern Europe, where the debt overhang is scaring away conservative investors. Other players may find an allocation to South Asia to be better suited to their tastes. India survived the brunt of the global downturn because of its relatively limited exposure to merchandise trade, as well as regulatory prudence in the financial sector. Growth may reach 8% next year, making it the flavor of 2010.

Signs of Demerol dependency include a need to increase the dose to maintain its effects. Yet abruptly stopping Demerol intake is not recommended, because of an associated set of withdrawal symptoms ranging from severe anxiety to insomnia
to muscle spasms. These effects start within hours and can last for many days.

The analogy to government-stimulus spending is instructive. The US economy will likely need ongoing medical attention for some time, yet the formula for easing off public painkillers has yet to emerge. While we have not succumbed to the full-blown dark-future theory, the global investor might best let the US addiction subside, while selectively exploiting market vulnerabilities.

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.

In an inaugural week, you would expect the international news weeklies to carry a cover story on the incoming US president. Time ran a feature on President Obama entitled, “Great Expectations.” The Economist did the same, but called it, “Renewing America.” Newsweek? Well, their editorial board decided to publish a special issue, labeled “Why China Works.”

Maybe that says two things: that the world does not revolve around Washington and that the global economy may be a bigger issue than who is in the White House. The subhead to the Newsweek cover story certainly had a sobering message for many US-focused economists: “Inside the command-capitalism model that will outrun all rivals.”

One reason why China works is that it has lots of cash. At maybe $2 trillion, its central-bank reserves—the world’s biggest—are staggering. This means that the US-China bilateral relationship may well prove to be the most important anywhere over the years ahead, as China recycles its cash into US Treasuries to prop up a deflated American economy.

The world’s biggest saver and most profligate spender are rather stuck with each other. While tradition would have President Obama head to Europe for his first overseas trip as the new face of America, it would say a lot more about concern for US economic wherewithal if he were to head to Beijing. Presumably his economic policy team should be in tow.

China is having its cyclical problems like everyone else. Real GDP growth for 2008 was recently announced at 9%, the lowest since 2001, but still above the generally accepted rate of 8% required to preserve some semblance of social stability. The slowdown was expected, given that exports may account for as much as one-third of China’s output. But, as a lagging indicator, the data are not surprising.

What may be more interesting is anecdotal corporate information. Just recently, Swatch Group (the watchmaker) announced intentions to open 15 stores across China. Alibaba (the online marketplace) said it intended to move beyond its China-centric model and pursue multilateral opportunities. Lurking in the details are the notions that China remains a buoyant market and that Chinese companies are likely to use their cash hoards to expand in ways that companies elsewhere simply cannot.

So why does China work? It may have much to do with its oft-derided government intervention in the economy. The great irony here is that economists have been arguing for decades that an open-market model is more advanced than a state-controlled model. In a bit of a turnabout, the opposite now seems to be true. Who would have imagined that the US would effectively nationalize its banking and auto industries?

To quote the Newsweek article, “Once seen as the bad habit of an immature economy, China’s state meddling is now seen as a bulwark of stability.” The piece goes on to conclude that the real key may simply be command capitalism’s ability to sustain confidence. And that is something sorely missing just about everywhere else in the world right now.

For the global investor, there is a certain strategic logic to exploring China-related ideas. China equals confidence, which in turn equals investment opportunities—all the more as the speculative money leaves Shanghai and Beijing. What is left is a playing field devoid of exuberance, on which one might actually have some true clarity on the investment prognosis.

Does that mean we should all run out a buy a Chinese equity fund? Maybe. But putting your money to work in such a product likely has an opportunity cost, until we see a whiff of global inflation and some sign of a worldwide recovery. In our view, better to invest in this bemired environment through a direct investment such as private equity.

Befuddled at where to head with our thinking, I contacted a banker-colleague who happens to work in the Gulf for an Asia-based financial institution. My question was simple: “How does a Shariah-compliant investor access the China story?” I intentionally asked someone closer to the origination side of the business, figuring that the perspectives of secondary-market players on where long-term opportunities exist were shaded by capital-market turmoil.

He affirmed that the China-related work of the internationally oriented Islamic banks has not been “sufficiently comprehensive,” yet there are meaningful ideas to explore:

• Middle-Class Growth. Despite the cyclical setback, major opportunities remain in traditional consumer businesses such as fast-food, retail shopping, and white goods.
• Agribusiness Development. Investors often think of China as the world’s manufacturer, but the nation’s western regions suggest a range of agricultural plays, including livestock production, farm equipment, and food distribution.
• Water Infrastructure. China is relying on the private sector to develop its water supply and sewage treatment facilities. Suffice it to say that maybe three-quarters of the country’s natural water supply is polluted.

During recent prime growth years, few Islamic financial institutions used their excesses to diversify into China. Gulf banks with bulging cash balances evidently decided that at-hand opportunities in nearby markets like Turkey and Pakistan seemed more user-friendly. Somewhat mind-boggling, on the other hand, is that the Kuala Lumpur-based institutions were slow at the draw.

Presumably, demand from Islamic investors for China-related transactions was diverted by the many seductive “bubble projects” afoot across the Muslim world. Under current economic circumstances, however, we suggest a major wave of Shariah-sensitive capital will make a pronounced shift toward China. Global investors may want to move ahead of the curve.

As a newly declared finance major in college, I recall my Money & Banking professor proclaiming on the first day of class, “Don’t ever forget that our banking system is most fundamentally based on confidence.”

It struck me as an odd statement at the time. Given decades of institution-building and multiple regulatory overlays in the United States, her notion seemed almost antique. Or was it?

The professor’s precept popped back into my mind 25 years later as the subprime crisis made it newly relevant. Certainly a foundation of confidence is a tenet that the Islamic and conventional banking systems have in common, in part because confidence in the economy (or lack thereof) is impartial and all-encompassing.

Islamic banks in general will likely weather the current storm better than most conventional banks, but they are not immune to the spillover effects of the subprime crisis. Indeed, to the extent that Islamic banks depend heavily on transaction volume for their profitability, they will be ensnarled with their conventional peers in the worldwide downturn. Suffice it to say that a receding tide—like a rising tide—takes most things with it.

To be clear, Islamic institutions do not have exposure to subprime-linked assets because of the prohibition of engagement with riba. This feature kept them outside of last year’s unfolding financial-sector drama. In addition, the underdeveloped interbank market for Shariah-compliant banks means that they generally have high cash balances to ensure proper operational liquidity. The “cash crunch” that eroded confidence in most conventional institutions never befell the Islamic banking sector.

Yet I find it misleading to argue that Islamic banks are unscathed by global developments. Especially in the Gulf, such institutions may have relied too heavily on real-estate backed products and structures to support their profitability. And of course the demand for such business and the value of underlying assets has eroded or even collapsed. Niche situations aside, there appears to be no market globally where real estate is a growth opportunity nowadays.

Islamic banks will likely not see a meaningful recovery in profit generation for some time. For perspective, conventional banks traditionally can build revenue both in an early cycle economic-growth stage (because of the potential for higher spreads as market rates begin to rise) and during the mid-to-late cycle because of greater transaction volume. Islamic banks, on the other hand, have an earnings structure that primarily builds mid-to-late cycle, when business volume is most pronounced. Given that the global economy may not recover until late 2009, in conjunction with a presumed US economic rebound, it could be 18-to-24 months before Islamic banks again approach the sort of earnings levels seen earlier this decade.

As a point of industry structure, Islamic banks may be further affected by diseconomies of scale in the wake of failed economic growth prospects. Marginal players will no doubt find it hard to survive in this environment. Consequently, governments may be prompted to step in to offer assistance under the cloak of administrative guidance. Certainly the rapid growth of the Islamic banking industry begs some consolidation in a low-to-no-growth environment. In addition to some non-starters, we may see a chain of Islamic banking mergers over the year ahead, albeit provoked by the desire for cost reduction rather than the need to repair balance-sheet holes.

We see only pockets of growth in the Islamic retail banking segment at this time. There may, however, be strong opportunities in the traditional investment-banking roles of advising and structuring, especially in the near term as slow growth raises balance-sheet and business-model concerns among corporate clients. Also promising is the potential for a new range of Islamic investment products focusing on cash-flow for investors, as well as those tapping into distressed asset situations.

Long-term prospects for the Islamic banking industry remain bright. A side-effect of the post 9/11 era has been a powerful sense of cultural demonstration across the Islamic world, albeit not without its dark side. As Shariah-sensitive companies and consumers continue to identify with their Muslim heritage, the industry will no doubt prosper. Certainly with regulatory and fiscal support from governments as geographically diverse as Saudi Arabia and Malaysia, the industry is positioned to build impressively on its early-stage foundations.

In this sort of environment, Islamic banks could be particularly effective in helping to rebuild confidence in the global economy. That calls for moving beyond the standard retail model to adopting a more pronounced role in issuer/investor transactions, in risk-shared financing facilities, and in economic development initiatives. Such focus is an unexpected way for the Islamic banking sector to take a pronounced role in global economic leadership. Indeed, the overall Islamic banking industry may be surprised at how receptive conventional markets are to its style and substance.