If you wake up some days feeling that your job puts you between a rock and a hard place, just see what Lou Jiwei, Chairman of the China Investment Corporation - CIC has to face up to every day. Whereas his favorite book used to be Tom Peter´s blockbuster “In Search of Excellence”, he is now looking forward to the follow-up “In Search of a Good Night´s Sleep” by the same author.

Last year China set up the CIC Sovereign investment fund to manage China's investment in equities along the lines of Singapore's Temasek Holdings. US$ 207.91 billion worth of special 12 year 4.5% p.a. yuan treasury bonds was issued to fund CIC. The idea of Sovereign funds is to set aside some money “for a rainy day”. (With climate change, how about “for a droughty day”?). 

According to Lou, the bond interest and operational costs are US$ 40 million per day so the CIC will need to earn at least US$ 14.6 billion per year (including about 2.8% in overheads) — or at least 7.3% on its total capital of US$ 200 billion. He has to service a flow of fixed contractual obligations (the bond interest) from an uncertain stream of variable revenues (share appreciation). This requires great portfolio management skill in timing, selection, allocation and divestment. About US$ 130 billion has already been invested in Chinese state banks, so we are only talking about US$ 70 billion of available capital, less the US$ 8 billion in already squandered on Blackstone and Morgan Stanley. It is noted that they are being advised by oxymoron “winning Wall Street names” such as Goldman Sachs and MS. 

We will now step up to the plate with some free advice. Our methodology will involve a diversified Marcowitz Efficient Frontier optimized portfolio with an average expected return of 15% and a standard deviation of 16%. Using the Exponentially Weighted Moving Average (EWMA) case of the Generalized Autoregressive Conditional Heteroskesdastic (GARCH) model or the stochastic Brownian Geometric Motion (also known as the random walk of a drunken sailor) leading to a full Monte Carlo simulation, we will estimate Value at Risk with a 95% confidence level. 

1. Vale Mining Company

Some party officials have suggested that China should invest in natural resources to increase its strategic reserves. Vale blue-chip mining company is a major iron-ore supplier to China but there has been some recent friction over ad-hoc prices increases by Vale. By buying 15% of the company (costing about US$ 15 billion), CIC could get a seat on the main board and with cunning might get control over the export pricing department. thereby taking the sting out of the annual price renegotiations. The currently undervalued share price with a price earnings ratio of only 9, could give a handsome profit to CIC with an intrinsic currency hedge. It would also be an act of “noblesse oblige” towards a fellow BRIC.

2. Alitalia

Other party officials say that China would like to get a foreign airline and certainly Alitalia would like to get its hands on some money so it could stop cancelling flights for lack of fuel credit. This one would be really cheap (there is no price earnings ratio since it loses money) because no bidding would be required. A genuine homemade Chop Suey instead of off-color pasta on its flights would have gourmet passengers flocking to Alitalia but the handling of staff lay-offs would need all the world renowned Chinese negotiation skill and diplomacy. The investment makes sense only if it serves as a platform for buying up other airlines which are also extremely cheap. The Alitalia investment would also be an act of “noblesse oblige”, this time towards a member of the PIGS group (a recently coined Financial Times acronym for the recession prone countries of Portugal, Italy, Greece and Spain. We are not saying we actually agree with this four letter acronym which, using factorial notation of 4! that is, 1x2x3x4, provides for 24 different permutations. Why the FT chose the most derogatory option is a mystery.) 

3. Buy call options on stocks

US$ 70 billion does not make much of an international splash on the stock market but it could really spice up the options market. An investment of US$ 20 billion in 180 day European call options at 10% over the initial share price could create an underlying share portfolio of US$ 570 billion without risking more than the US$ 20 billion because it acts as a sort of a stop-loss. If they buy the actual shares, they could lose many times more. All CIC has to do is to get it right 60% of the time and under no circumstances double up on a losing position. Note that a 50% drop in price then requires a 100% increase in the new price to get back to the old price. CIC also should avoid becoming involved in exotic one-touch barrier options (the roulette wheels in Las Vegas are less risky than these) which recently caused huge losses to some supposedly competent major Brazilian exporters, whose now jobless treasurers still swear that they were not speculating. The cheapness of the stock market makes call options a good strategy because “Cash is King” right now. It may be difficult to explain away any losses to the home crowd, but it has that problem anyway with the two bank investments it has already made.

4. Buy a major stake in Zimbabwe

The Goldman Sachs Financial Engineers can achieve anything they want to so turning Zimbabwe into a corporation would facilitate the Chinese love affair with natural resources in Africa.  as well as rescue the population of Zimbabwe (which has gold, nickel, copper, iron ore, vanadium, lithium, tin and platinum) from its current Chairman of the Board. It would also be an incredibly profitable investment at a knock-down price. For skeptics who think this cannot be done, India was virtually run by the British East India Company until 1858 and Zimbabwe is a previous British colony called Southern Rhodesia. The support of current members of the government for a referendum could be obtained by granting them stock options on the company and the population would jump at the chance to get some corporate governance.

5. Technology 

Yet other party officials would rather see the country acquire shares in high-tech companies to help China more rapidly close the gap with leading industrialized nations. The current liquidity crisis has separated the Men from the boys and even the mighty financial derivatives driven General Electric has included its own shares on the list of 900 financial shares which for now cannot be sold short by hedge funds and other derivative speculators because they are too vulnerable. It is as if Michael Phelps had asked for a breather in the middle of an Olympic length. If GE is too big to take on, CIC could have a look at Hewlett Packard which is a terrific real rather than a virtual high-tech player despite straying off into an insane merger with Compaq computers some years ago. The price earnings ratio is only 15 (very cheap). Its market cap is a mere US$ 118 billion, which means that with US$ 10 to US$ 15 billion CIC can buy a nice 10% chunk and it is much “safer than a bank” (a newly arrived oxymoron).

Conclusion

Our portfolio has diversification, timing (all the sectors are cheap right now), and a way for a US$ 70 billion investment to i) provide a good return on US$ 200 billion by leveraging on options; ii) please all the various party officials; iii) in the process do something concrete for Africa thereby earning Kudos in the international community; and iv) actually be able to pay off the bonds with interest.