Following is an excerpt from the second chapter of the September 2010 FT Press volume The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, a book I co-authored with my colleagues Yiannis Mostrous and Elliott Gue.

The emergence of sovereign wealth funds (SWF) and other similarly structured state-sponsored and state-owned entities is more evidence of emerging economies exercising increasing influence in the global economy. SWFs have been key institutional players in the aftermath of the Great Recession, even after many suffered serious losses in their efforts to prop up damaged Western financials. What they do and how they do it were once the object of intense scrutiny, then the source of stabilizing capital. Now they’re fixed in the 21st century international financial machine. The Rise of the State provides a starting point for understanding how they came to be known in the US, the nature of their investment activities and what might come of their increasing influence.

The most remarkable aspect of sovereign wealth funds (SWF) and related vehicles is what their emergence says about the present and future of the global economy.

Special-purpose investment funds or businesses created and owned by the general government for macroeconomic purposes have existed for decades. The term “sovereign wealth fund” was coined by Andrew Rozanov in a May 2005 article in Central Banking Journal to describe, generally, government investment activities. The definition most useful for our purposes, which is to understand the rising role of the state and how this impacts decisions for individual investors, comes from Bryan J. Balin’s paper Sovereign Wealth Funds: A Critical Analysis:

Sovereign wealth funds are defined by the US Treasury Dept as “government vehicles funded from foreign exchange earnings but managed separately from foreign reserves.” Along with financing, sovereign wealth funds also differ from other government vehicles in their objectives, terms, and holdings: while foreign reserves have historically invested in sovereign fixed income notes for the purpose of intervention on the foreign exchange market, SWFs typically take a longer-term approach, where international equities, commodities, and private fixed income securities are used to achieve the long-run strategic and financial goals of a sovereign.

It should be strongly noted that sovereign wealth funds are not the only vector through which sovereign entities make foreign private investments. Another way through which countries invest in foreign entities is through purchases by state-owned enterprises.

The history of such activities has been traced to 1953, when the Kuwait Investment Board was created to manage the excess oil revenue for what was then still an “independent sheikhdom under British protectorate.” But rapid growth in their number and a shift in investing behavior brought SWFs and state-operated enterprises (SOE) to the attention of politicians and the public shortly before an otherwise normal downturn became the Great Recession with the near-collapse of the Western financial system. SWFs, several of which came to the aid of weakened US and European banks, have proven resilient in the aftermath of the 2007-09 turmoil. Once happy to quietly work the wings, SWFs have fixed themselves prominently on an otherwise evolving global financial and economic stage. The composition of the leadership will change, with less agile markets receding in importance. The influence of these types of vehicles, however, will only grow. They are important instruments that will help sponsoring countries diversify their economies, provide for future generations, stabilize government revenue in times of economic crisis, and also access particular knowledge that will help development in the present.    

Controversy stoked for domestic political purposes in the US obscures the more nuanced case that on the whole state-sponsored entities present no inherent threat to public markets, and that their long-term focus, objectives and behavior as investors in fact add to financial and economic stability. Whether convenient for the US and the West or not, SWFs are here to stay. Current estimates–because so few report portfolio information in the manner of Western institutional investors, these are ballpark figures–place their total assets under management somewhere between USD1.5 trillion and USD3 trillion.

During the proliferation phase of 2005-08 some market observers projected SWFs aggregate assets under management would reach USD12 trillion, USD15 trillion, even USD20 trillion by 2020. One study has identified more than 2,500 investments worth an aggregate USD3 trillion in the listed equity of private firms by state-owned investment companies, stabilization funds, commercial and development banks, pension funds, and state-owned enterprises. Including state purchases of government and corporate bonds, SWF holdings and foreign exchange reserves, the total value of state-owned financial assets may already exceed USD15 trillion.

It wasn’t until an SOE tried to buy strategic US assets that the new prominence of state actors in the global economy came to wide political and public attention in the US. Shortly thereafter the US financial system began to buckle under the weight of subprime-mortgage backed securities, among other synthetic financial instruments; sovereign wealth funds were able to at least paper over balance-sheet holes in the short term via the infusion of more than USD31 billion into three US-based financial institutions.

Indeed, the economic crisis forced a reevaluation of deeply held convictions about the role of the state and state-sponsored entities in the economy. Among the many issues still under consideration by global policymakers are the roles of regulation and regulators in financial markets. In addition, governments and extra-governmental organizations have had to reconsider how foreign trade and capital flows impact at the local as well as the international level. Specifically regarding the West, the crisis has also forced a reassessment of economic orthodoxy that touts the self-regulating nature of free market economies and suffers lightly intrusions by the state into private economies. The top criticism of SWFs is that they lack transparency; however the depth and breadth of the global recession can be blamed on a financial crisis arguably caused by opacity in the over-the-counter derivatives market, in the composition of synthetic mortgage-backed securities and with regard to banks and special investment vehicles. 

Understanding the reasons for and the consequences of the increasing prominence of state actors in the global economy will help open-minded investors profit in the coming decade.

This trend emerged well before an ordinary recession became a global financial and economic crisis and has only strengthened with the extraordinary participation of Western governments in the rescue and support of their respective economies.

Treated with skepticism by Western elites in 2005-08, Middle East and East Asia-based SWFs and SOEs have become critical pillars of the global financial system in the aftermath of the Great Recession. Their rapid growth in the years preceding the crisis resulted from the accumulation of massive excess foreign reserves by sponsoring governments due to the rapid rise in the oil price and credit-fueled consumption in the West. Their contribution to mitigating the worst effects of the global economic downturn at home and abroad as well as the resumption of consumption trends that will help them grow mean the individual investor with a long-term view must understand their activities.

The Roundup

In an interesting move that allows it to grab a slice of cash flow after a movie’s theater life Canadian Edge Aggressive Holding Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF) launched a digital download service. The new feature at www.Cineplex.com launched Nov. 18. New releases for digital download will be available the same day they become available on DVD and Blu-ray.

A low payout ratio will allow Cineplex Galaxy to continue to add technology to its theaters–and earn back the premiums paid for 3D and IMAX tickets–while it keeps its dividend rate at the income-trust level following conversion. And it is the dominant player in Canadian movie theaters. Cineplex Galaxy Income Fund is a buy up to USD20.

Here are highlights from the Transports section of How They Rate.

Canadian National Railway (TSX: CNR, NYSE: CNI) has taken several major steps in its quest to become a supply-chain master for its customers, initiating scheduled grain service in Western Canada, agreeing to work with Canada’s major ports and establishing “level of service” contracts with terminal operators. Management also executed a new agreement to provide end-to-end, mine-to-port handling of Western Canadian coal for export.

Grain volumes have surged in 2010 to levels last seen during Canada’s 1996-97 bumper crop. Overseas intermodal traffic reached a record high with a 29 percent year-over-year increase. And domestic coal traffic was up 75 percent from the comparable nine-month period of 2009. All this added up to 21 percent increases for both net income (to CAD556 million) and operating income (to CAD834 million).

Diluted earnings per share (EPS) of CAD1.19 increased by 23 percent from a year ago, while adjusted EPS rose 27 percent. Revenue was up 15 percent to CAD2.1 billion on an 18 percent increase in railcar loadings. Revenue ton-miles rose 9 percent. The operating ratio–which xxx–improved two full points to 60.7 percent.

Free cash flow for the nine months ended Sept. 30 was CAD938 million, up from CAD657 million during the same period of 2009. “Greater freight volumes in almost all markets reflected the continued recovery in North American and global economies,” noted CEO Claude Mongeau in a statement. Canadian National Railway, which has raised its dividend each of the past five years, is a buy up to USD65.

If CN’s focus is on grabbing a greater share of its customers’ logistics budgets, Canadian Pacific Railway (TSX: CP, NYSE: CP) is looking to leverage its 15,300 mile network to establish a presence in North America’s burgeoning oil and gas market. Canada’s No. 2 railroad reported a third-quarter operating ratio of 73.7 percent (better by 270 basis points) and a 27 percent increase in adjusted earnings per share to CAD1.21. Total revenue increased 15 percent to CAD1.3 billion on 14 percent growth in traffic. The operating ratio is the best CP has registered in three and a half years.

A lot of what CP does is tied to the state of the US-Canada economy; cross-border traffic accounts for a quarter of business, while another 35 percent is domestic, or within Canada or the US. Of course business will improve as the North American regains its footing and auto shipments increase. But approximately 40 percent of traffic is tied to the global economy, and bulk transport is literally half of the business. CP is the sole rail transporter for Canpotex, the marketing agent for potash giants Potash Corp of Saskatchewan (TSX: POT, NYSE: POT), Agrium (TSX: AGU, NYSE: AGU) and The Mosaic Company (NYSE: MOS), and all its exports to Asia. A 10-year contract with Teck Resources (TSX: TCK/B, NYSE: TCK) isn’t typical, but it locks up a key customer with clear long-term needs based on rising coal demand from China and provides a lot of revenue certainty.

CP is already taking “a couple of hundred carloads” of shale crude oil from the Bakken play in North Dakota. Bringing “inbound products” for use in constructing and running rigs in the Marcellus natural gas play is likely to provide growth over the next decade; every well that gets drilled needs frac sand, drilling pipe and other components that are readily moved via rail, and CP also serves frac sand origination sites.

The company also occupies a unique place in the ethanol transport equation; whether the current levels of government support continue is open to question but there’s no way the corn byproduct will be eliminated altogether. Subsidiary Canadian Pacific Logistics Solutions’ lines run in some of the windiest corridors in North America. CP took advantage by becoming one of the biggest movers of wind-turbine equipment.

Perhaps the most promising growth area for CP is the Canadian oil sands. Bitumen production from the Canadian oil sands is forecast to double over the next five to seven years. And adding upgrading capability in Alberta has the potential to add a couple hundred thousand carloads to CP’s total. As it is, CP added 25,000 carloads by transporting diluents for the semi-upgrade for transport of bitumen for further upgrading and refining. The second part of solid North American transport play, Canadian Pacific Railway is a buy up to USD65.

Jazz Air Income Fund’s (TSX: JAZ-U, OTC: JAZZF) third-quarter revenue was off slightly, by 0.2 percent to CAD379.1 million because of exchange rate issues, lower billable block hours and the impact of reshuffled rates.

Departures, however, were up, and the company generated distributable cash of CAD30.6 million while maintaining a conservative, 60.1 percent payout ratio. Management also eliminated medium-term labor risk by negotiating agreements with all of its major unions. Total operating expenses rose 2.1 percent, pushed up the costs of converting and for starting up charter services for Thomas Cook Canada to the Caribbean, Mexico and Central America from Canada during the winter. Net income was CAD19.1 million, down from CAD25.3 million in 2009.

The unit price has suffered in the wake of the earnings announcement because the market doesn’t believe Chorus Aviation–what Jazz Air will become on Jan. 1, 2011–will be able to meet the dividend management says it will as a corporation. During a conference call to discuss the third quarter management said, in fact, that the payout ratio could shoot up to 100 percent and beyond in 2011. The primary variable is the planned purchase of turboprops from Bombardier (TSX: BBD/B, OTC: BDRBF) and whether they’ll be leased. It’s important to note that new equipment will allow Jazz/Chorus to compete as it continues its effort to expand beyond its contract with Air Canada (TSX: AC/B, OTC: AIDIF). The deal with Thomas Cook, which is expected to add CAD100 million a year to revenue, is indicative of this strategy, as is the purchase earlier this year of 25 percent of Uruguay’s flagship airline Pluna Lineas Aereas for CAD15 million.

Management’s projected decline in distributable income is cause for investigation, not panic. The third-quarter payout ratio is within the “Very Safe” classification for CE Safety Rating System purposes. And the effort to build the business is a good thing that’s shown positive results amid difficult economic circumstances. There are risks here, but a current yield of more than 11 percent reflects a lot of fear. Management’s mettle will be tested as it struggles to meet its commitment to keep the corporate dividend at par with the income fund payout. But Jazz Air Income Fund, soon to convert into Chorus Aviation, is a buy for aggressive investors up to USD5.

New Flyer Industries’ (TSX: NFI-U, OTC: NFYIF) third-quarter results and management’s guidance demonstrate that the effects of the Great Recession will be felt well into the future. Unemployment in the US is still hovering near double-digits, and according to the American Public Transit Association 60 percent of the people who ride buses do so to get to and from work. When joblessness increases, ridership decreases. At the same time, strapped governments mean future financing is uncertain, while federal legislation that would provide funding for state and local authorities is a year late.

In addition to reporting a 15.9 percent decline in revenue on lower truck-equivalent units (TEU) delivered (a whole bus equals two units), management, during a conference call to discuss the quarter, said that demand would likely decline another 10 percent over the next two years. New Flyer reported a year-over-year uptick in the payout ratio to 69.8 percent from 64.9 percent in the third quarter of 2009–still in a really good range–and the company’s backlog rose to 9,011 TEUs from 8,492. New Flyer is still making sales, however, and, critically, earning more than enough cash flow to cover its distribution. The revenue shortfall last quarter was basically because they sold lower-priced buses but masked a number of more positive developments, such as an increase in the company’s share of the aftermarket in the US, even as that market on the whole was contracting. Order backlog was actually up almost 7 percent sequentially in the summer quarter in both dollar value and units.

New Flyer improved its bottom line for the quarter, posting a CAD3.1 million loss versus a CAD9.2 million loss for the same period last year. Year to date the bus maker has produced total profits of CAD19.8 million, against a CAD19.1 million loss through the first nine months of 2009. New Flyer Industries is a buy up to USD11.

WestJet Airlines (TSX: WJA, OTC: WJAFF) notched its 22nd straight quarter of profitability, announced a new quarterly dividend and said it will buy back up to 5 percent of its outstanding shares. That’s all made possible by a 72 percent increase in per-share net income in the third quarter from year-ago totals.

The low-cost carrier, now Canada’s second-largest airline, will pay a CAD0.05 per share on Jan. 21 to shareholders of record on Dec. 15. The CAD0.20 annualized rate is good for a yield of 1.5 percent.

WestJet reported a third-quarter profit of CAD54 million (CAD0.37 per share), up 72 percent from CAD31.4 million (CAD0.24 per share) a year ago. Revenue was up 14 percent to CAD684.6 million.

WestJet reported an October load factor (percentage of available seats filled) of 77.4 percent, while traffic was up 13.4 percent. Capacity increased 13.3 percent from a year ago, a growth rate management expects will be repeated in the fourth quarter. WestJet Airlines–now paying an annualized dividend of CAD0.20 per share–is a buy up to USD13.