China rules
Photo by Nick Fewings on Unsplash
This past week saw the long-awaited IPO of Chinese ride-hailing super app, DiDi Chuxing, only for the Chinese authorities to just days later torpedo the brand-new investment in many investor portfolios. Since we wrote the first draft of this blogpost earlier this week, everyone it seems has provided an opinion so here is our take in the context of some longer term thinking we have been doing in this regard. For background, please read our piece we wrote some time back entitled “The Weaponisation of Stock Markets” which touched on some of the points before this all blew up again this week. The headline issue for Didi this week is the government crying foul on data security – something which clearly for the Chinese is an issue of national security.
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This is becoming an all-too familiar story for investors in Chinese names as many wake up to the fact that China (unbelievably) plays by its own rules. It reminds me of a book I read a couple of years back called Mr China by Tim Clissold. Clissold, an Englishman in China learning mandarin finds a job at a Wall Street firm investing in Chinese factories just as the country began to open up in the 90s. The firm raised hundreds of millions of dollars as the “biggest investment opportunity in history” theme began to catch on in the US. The plan was for them to build a private equity vehicle and invest the money into numerous factories which had been handpicked by the team on the ground. It was a great story. The only problem was that in reality, China worked a little differently to things in the US. The story tells of how the suits on Wall Street couldn’t understand why when things got tough workers couldn’t just be fired. It tells the tale of Mr Shi, the best factory manager in the portfolio who after 2 years of raking in profits, decided to build a new competing factory across the road. Then there was another factory manager who went on a trip to the US and simply vanished, along with all the cash in the bank. This was of course a different time and China has evolved dramatically since then in terms of business practices (nevermind global stature) but one cannot help but feel that the way it deals with foreign investors remains, in principle, the same as it has for longer than you think. Like many civilisation states, they take what they need from foreigners but no more.
In the book an example is given all the way back from 1793 when King George III sent his emissary to visit the Qian Long Emperor to try to build a business relationship. The mission involved seven hundred people – doctors, musicians, painters and soldiers who arrived complete with telescopes, porcelain, fabrics, chronometers, model gunships and even a planetarium as gifts for the Emperor. The emissary was only allowed to see the emperor once they had agreed how he was to address him. The Emperor expected him to kow-tow by knocking his forehead on the ground 9 times before addressing him. Britain at the time was a mercantile power and on the cusp of industrialisation. They also had the most powerful navy on earth. Hence, logically, King George III considered himself an equal when dealing with the Emperor. But that wasn’t quite how the Chinese saw it. They viewed King George merely as custodian of a faraway vassal state and as such it was appropriate for him to pay tribute and prostrate himself before the Emperor. Eventually, they agreed that the emissary would go down on one knee when addressing the Emperor (as a representative of the King). And so he did, only to be presented with a written edict prepared weeks before.
“Although your country, O King, lies in the far oceans, yet, inclining your heart towards civilisation you have specially sent an envoy respectfully to present a message. We have perused the text of your message and the wording expresses your earnestness. From it your sincere humility and obedience can clearly be seen. It is admirable and we fully approve.”
The edict then went on to dismiss the emissary and his entire entourage with a firm message that their business is neither needed nor welcome.
“We have never valued ingenious articles, nor do we have the slightest need of your country’s manufactures.”
As the book continues and as we know, the British eventually responded by blowing up Nanjing. And the Chinese haven’t forgotten.
Many China specialists have written about this clampdown on DiDi in the context of national security saying that Didi allowed the US access to all the personal information of the DiDi drivers and, when framed like that, one can understand somewhat what the problem was. One can also be very sure that Didi are not completely innocent either. Stories of them being warned about data security in the lead up to the IPO are abundant. Apparently they were told not to IPO until this had been sorted out. Truth is we will never know. And we are not experts on Didi – as a new IPO there is only so much available in the public domain. The point here is that today still China is a completely different place with a different set of rules as the Bitcoin crowd most recently discovered.
For better or for worse, the Chinese authorities have a history of regulating strategically important industries. They tend to let the industries grow and evolve and then regulate later rather than stifling growth and innovation through early regulation. For those who may have forgotten, the internet is also a strategically important industry – the Variable Interest Entity (VIE) structure under which many internet companies from Tencent (yes, even in Hong Kong, which is “offshore”) to Alibaba to DiDi operate is a workaround towards which the Chinese authorities have, until now, chosen to overlook.
The same applies for other culturally sensitive businesses like New Oriental (education) and technologically sensitive operations like NiO (electric vehicles). For anyone who has taken for granted that the VIE is “substantially equivalent” to owning the stock of the underlying operating companies, here’s a reminder: owning the VIE shares entitles a stockholder to a claim on a Cayman shelf company that has a couple of contracts for economic benefits made with the local operating company. Voting rights? Don’t even expect that as a shareholder of a VIE, you would have any say over how the operations of the company are undertaken.
Of course, most investors will happily say, “I don’t need to vote on anything anyway. Just send me the massive earnings that are coming.” Except that contract runs the risk of being voided at any time, as duly disclosed in any SEC disclosure. It literally says, in twitter lingo, “Risk of rug pull by Chinese authorities.” The “VIE issue” might seem to have been “settled” all those years ago. In reality it’s like Damocles’ sword, just that it’s stopped swinging for the moment.
A rug pull of the VIE structure would be the biggest rug pull in the history of capitalism. Its not the base case, but its always there hovering in the background. We wrote about this in our “Weaponisation of Stock Markets” piece.
From banking to the telcos to the internet companies there is a very consistent pattern of behaviour. Anything strategically important has to be regulated and controlled by the government, with an onshore entity that is within reach of the relevant authority. It is simply too risky to allow entrepreneurs to direct such important entities once they cross a certain threshold. Most recently, Jack Ma, being “brought to heel” was a strong message. The party cannot allow anyone who is even remotely popular or admired to develop anything close to enough influence to mount even a small challenge to authority. After Jack Ma, the resignations of entrepreneurs accelerated with Zhang Yiming (Bytedance founder) moving to another role in the company at age 39 and Colin Huang (Pinduoduo founder) resigning to “pursue new, long-term opportunities” at 40. Didi’s founder and CEO, Cheng Wei, is 38.
While all this may be innocuous and similar to Jeff Bezos stepping down, it is unlikely. What is also possible is that the cult of personality that we have seen in Silicon Valley around tech founders and CEO’s has scared the sh*t out of the Chinese government. Elon Musk has nearly 58 million smitten followers on Twitter, nearly five times as much as US president, Joe Biden, who clocks in with just under 13 million. Bezos and Musk are fighting it out to go to Space (with Richard Branson hot on their heels), while Facebook Founder, Mark Zuckerberg, wished everyone a happy 4th of July with a power move – a video of him waving the American flag on his electric hover surfboard across Lake Tahoe. Cringeworthy or not, it does the job.
Celebrating the 100 years since the founding of the party last week, Xi Jinping, didn’t mince words - China doesn’t need anyone’s help and is doing just fine by itself. Remember George III? The party didn’t last 100 years by even taking the slightest of risks. That is not going to change. And just as the Party, and its version of Socialism with Chinese characteristics, is the reason for China’s success in achieving a xiaokang (moderately prosperous) society, the success of the past 100 years is all the more reason for the next 100 years to be greater.
But that greatness is the greatness of the country, of the party and of the people. Just think for a moment about what is arguably the biggest telco in the world, China Mobile, with 942m subscribers, of which 165m are on 5G already while the rest of the world struggles to put 5G in place. Now here’s the pop quiz question: without looking on Google, what is their CEO's name? Or think about China’s mega banks – ICBC has the largest balance sheet in the world, with north of US$4tn of assets. In fact, China’s top banks (ICBC, CCB, ABC and BOC) all have larger balance sheets than JP Morgan (c. US$3tn on its balance sheet). But while everyone knows Jamie Dimon, the challenge is naming any one of the leadership team of any of China’s state-owned banks. Same story with the energy giants CNOOC, Petrochina and Sinopec. The insiders and analysts covering the companies will know – it’s their job to. But are the leaders of these national champions recognised for who they are or for the companies they work for (“the CEO of ICBC”)?
That’s the difference between the greatness of the country and the greatness of entrepreneurs. The people may fade to obscurity, but the country, the party and its institutions must be seen to rise to greatness. That is the way.
Whatever the reasons for it, the Didi debacle is an insult to investors, authorities and regulators in the US. One can only wonder what would have happened had Jack Ma NOT made that fateful speech before Ant Financial’s IPO. Ant most likely would have had a spectacularly successful IPO, but at what point would the authorities have begun their inevitable regulatory clampdown on the company?
We have written before about Alibaba in particular, and how it reminds us of the trajectory of Russian stocks which had been darlings of the market before political developments required everyone to realise that the rules of the game in Russia are different (they still are). The point is that not everything is sunshine and roses, and more than a little bit of scepticism is needed when putting money to work in places where the rules are not the same. It takes years and dedication to understand how these places operate and it is not for the faint-hearted. Even then it is difficult to navigate.
Of course, low valuations make all these stocks attractive to investors and the internet sector in theory is a fantastic and ongoing structural investment opportunity but as we have learned before, just because something is cheap doesn’t make it a good investment. These stocks will all have their time in the sun from time to time, sometimes spectacularly so, but in our base case, the structural investment opportunity is over. And if you can find names that are fundamentally oppressed, it opens up a whole new world of opportunity on the short side.
And once again, a reminder that the company and its stock price are not necessarily one and the same thing.