The Dangers of Chinese Stocks: A Warning
Cultural anthropologists refer to ethnocentrism as the propensity for individuals to view the world through the lens of their own culture and customs. For Americans who want to see their own inclinations towards this behavior, read the classic paper on Body Ritual Among the Nacirema by Horace Miner. Then have your kids read it to you and chuckle when they can’t figure out the punchline. For investors, this has implications that go beyond domestic bias – the favoritism investors show companies in their own country.
Spending time in emerging markets puts the risks and rewards into perspective very quickly. Risk-management products don’t sell well in a culture where risk-taking is admired and encouraged. That’s what risk-management software provider MSCI found when they tried to make inroads into the land of the panda. As the leading global index provider, MSCI is more than familiar with how China operates a bit different than the rest.
Lurking in the Shadows
Nearly one-fifth of people on this planet are Chinese. Around 800 million Chinese people have been lifted out of poverty since the 1970s. Six out of ten female billionaires are Chinese. While America’s youth talk about how you should be as lazy as possible in your place of employment – “quiet quitting” – China’s youth have a work ethic reminiscent of Americans in the 50s and 60s. What they call 996 – from 9AM to 9PM six days a week – isn’t necessarily the evil employer, it’s often ambitious young Chinese workers hustling above and beyond what’s required. The country has a great deal going for it, but what’s lurking in the shadows is an environment full of risk takers and rule breakers.
Chinese love taking risks, and plenty of that can be found in the $13 trillion shadow banking market where companies can take off-balance-sheet loans to fund their operations when state-owned banks don’t come through. If you know the right people, you might be able to get shadow funding which is provided by big state-run banks to fund certain job-creating development projects. The below diagram shows just how easy this system is to understand:
And if you believe the above diagram accurately describes this convoluted mess of a financial system, we have some swampland in Guilin to sell you. But before we start talking turkey, it’s time to go drink baijiu.
Chinese Business Culture
Remember what we said about ethnocentrism? The success of a Chinese businessman is often measured by the number of mistresses he keeps. As a foreigner doing business in China, you better be able to handle your alcohol. Don’t worry, if you have mild alcoholic tendencies you’ll be just fine. The Chinese don’t drink nearly as much as the Russians or Poles. After you drink them under the table, prepare to politely decline the prostitutes on offer, or dabble. They’ll likely poke fun at you either way in a good-natured way. If you still have some “energy” left when you get back to the hotel, visit the “sauna.” You’ll never look at a red rope the same way again.
“Entertainment” is a normal part of doing business in China with Chinese firms spending twice as much as their Korean counterparts on entertainment and travel costs (ETC). That’s according to an academic study that looked at such expenditures for 15,000 Chinese firms that found “strong evidence that ETC consists of a mix that includes expenditures on government officials both as grease money and protection money, implicit CEO pay, and managerial excesses.” Chinese businesses are so reliant on the government that it’s estimated up to 30% of businesses’ profits come from the Chinese Communist Party (CCP) which is said to be the sole gatekeeper that determines which businesses succeed and which fail. That brings to mind a popular 2009 survey that showed prostitutes in China are actually more trustworthy than government officials. (Ladies of the night were in third place after farmers and religious workers. Soldiers were in fourth place.) Trust is something you may want to keep a check on when you invest in Chinese companies.
Due Diligence for Chinese Stocks
Doing business in China is probably easier than investing in China because you never know what’s under the hood unless you physically go look. The short report on EHang by Wolfpack Research is notable, not because of the conclusion they reached, but because it shows just how hands-on you need to be when conducting due diligence. Knocking on doors, walking through warehouses unannounced, visiting building locations, these are all ways of confirming that what’s being advertised on the tin matches what’s actually happening on the ground. Sophisticated institutional investors hire experts – usually trusted locals – who can find out what the true story is. Even then, you still can’t be certain a firm isn’t cooking their books. Accounting companies in China are as prone to corruption as any other entity and stories like Luckin Coffee abound.
Even if you manage to convince yourself that a business is legitimate and worth your investment dollars at a given point in time, you’ll still need to look past what we see as an absolute showstopper – the VIE structure.
Tell Me Lies, Tell Me Sweet Little VIEs
Okay, we stole that subtitle from an article by the Financial Times of the same name which talks about the dangers of variable interest entity (VIE) structures which seem to escape many eager retail investors. Simply put, the Chinese government has strict rules regarding foreign direct investment and VIEs are a way to bypass these rules using complex structures that usually involve shell companies in the Cayman Islands.
Yes, it’s as shady as it sounds, and here’s the clincher. If you choose to invest in the 543 Chinese mainland companies (mostly tech firms) that utilize VIE structures to list their companies on major U.S. exchanges, you have no legal right to the shares you think you’re holding. It’s a fact that’s almost too incredible for some to believe, and it’s why we sold our largest holding – Ali Baba (BABA), the Amazon of China – several years ago at an average price of $270 a share which happened to be the right time to exit. It’s something we cover in our piece on A Big Bear Thesis for Ali Baba Stock, and the situation only seems to be getting worse because of deteriorating U.S./China relations.
Some media outlets have been suggesting that progress is being made towards clarifying the VIE structure with Beijing providing commentary – even approval – of this listing method.
Dig into the details and you’ll find that little has changed. Or better yet, let someone with extensive subject matter experience interpret what’s happening. Cambridge Law School Teacher Fa Chen has studied the topic extensively and provides the following succinct statements which capture the legal risks associated with the ongoing uncertainty around VIE structures.
The strategic ambiguity of the VIE legality can help Chinese authorities maintain regulatory flexibility to leverage economic development but with legal risks to foreign investors. Chinese VIE structures present “multifaceted legal risks to foreign investors.” In the event of invalidation of VIE structures, involved foreign investors could find themselves lacking effective remedies at both local and international levels.Credit: Fa Chen
The VIE structure is still as risky as it has always been because foreign investors have no legal right to shares of the companies they believe they’re investing in. Some investors find this too difficult to believe, and they’ll point to institutional ownership as evidence that the concerns aren’t warranted. As we covered in our recent piece on What Institutional Ownership Really Means, passive investors could care less if these structures implode into oblivion. They’re just tracking indices. One study proposed that VIE structures trade at a discount of 30% relative to the intrinsic value of the underlying companies because of these legal risks. When we consider investing in Chinese stocks, this is a showstopper we can’t look past.
If the VIE structure issue were to be sorted, and we could look past the risks around how Chinese firms conduct themselves, China might make for a worthy investment. Perhaps the best way to invest in China right now is by purchasing shares of large Chinese firms on the Hong Kong market where they trade as “H shares,” some of which can be seen below.
That’s a good reminder that we need to take another look at what the largest electric vehicle producer in the world, BYD, has been up to. Stay tuned.
We couldn’t be more excited about China’s potential, but as risk-averse investors, we don’t believe most foreign investors understand just how risky it is to invest in Chinese firms that operate under a different set of rules. The CCP alone represents a large systemic risk for any business that operates in China – foreign or domestic – and that regulatory risk represents a system that’s corrupt and unpredictable. Now that the U.S. and China relationship is worse off than it has ever been, now is a good time to consider whether it’s worth holding those exciting Chinese tech stocks that may be one decision away from disaster. Investors in Chinese stocks should proceed with extreme caution, at least until some of the legal ambiguities have been clarified.
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