China Internet: For growth; But first and foremost, for the Country.
Photo by Zhimai Zhang on Unsplash
To be absolutely clear, the note that you’re about to read is NOT a political piece. We are sure everyone has a view on China’s political system (as do we) but this is an investment piece in which we are telling it as we see it. The usual rules apply (ask your paid advisors if you want advice, this isn’t it), and VERY importantly, we mean no offence to anyone. It is what it is, and it is in failing to understand this that lots of discontent (and losses) comes about.
Investing in China’s Internet ecosystem has been at the core of many great investment theses. The underlying story goes something like this: Here is one of the biggest populations in the world which, at least over the last 3-4 decades, has gone from a communist state to a thriving economic superpower. Its people have gone within a generation from abject poverty to being the host of the greatest absolute number of millionaires (and probably billionaires) in the world, many of which no one knows (or ever will know) about.
Along with that structural wealth generation, unequal as it may seem, comes the rise of the middle class, and following the textbook of how economies develop, a thriving middle class leads to huge economic growth. Add to that the age of the internet, where winner-takes-all structures that thrive on scale economies lead to structural monopolies for the top players, and you have the perfect set up: national champions in the internet space, dominating in their specific realms, mopping up all of those scale benefits and feeding it to their shareholders.
We’ve seen this pan out in the western markets, China is just following close behind, and yes, it’s been a long road of building and investing, but it will all soon pay off. The huge returns will come, the free cash flow is coming, the profits are coming, and all of these companies are trading so cheap because everyone’s afraid and missing out on the opportunity. What’s the point of “national champions” if they’re not going to win? Buy the winners!
To borrow a Twitter term – “it’s all just FUD”. How can you not invest in the biggest single market in the world? It’s just a matter of time before the payoffs come. If you can’t see it, you’re being short-term and myopic in thinking.
At least, that’s what we’re often told as the top reason in favour of owning the Chinese internet champions. And at this stage we are told VALUE – wow they are so cheap!
The only problem is it isn’t really panning out this way. It’s not a matter of the fundamentals being poor – these businesses are enjoying tremendous success. Rather, it’s a much more philosophical matter.
And it might not be a matter of just “having patience”.
Another Gazprom moment
For anyone who missed it, another “Gazprom moment” occurred in China last week, this time with food delivery champion Meituan Dianping.
First, the policy move: last week, the NDRC published this piece of policy guidance (read: “instructions”) aimed at helping businesses adversely affected by the resurgence of COVID in the country. The entire document is in mandarin, and unfortunately isn’t on the NDRC’s English website, so a (very) rough translation of the paragraph in question at the bottom of page 3 (point 12) is all we can provide:
“To direct takeaway delivery online platforms to further lower service charges to food and beverage businesses, in order to bring down operating costs for these businesses; To direct online platform companies to offer temporary/ad hoc discounts/rebates to F&B businesses located in mid-high COVID risk regions.”
Now, the optimist will point to the word “temporary” as the cue to write this off as a short-term development that should reverse, and that has been the consensus view from most analysts. After all, why say “temporary” if it’s meant to be permanent?
Regardless, Meituan Dianping traded -15% on the day of the announcement. Fundamentally, this isn’t a great development, but surely as the national champion in food delivery this isn’t an insurmountable challenge?
That may well be the case, given the impact is only in Covid-affected areas (mid-high risk), and they also have a much broader range of businesses than food delivery, including travel and other consumption related sectors. In all likelihood, things will get better eventually, Covid will be under control, and we’ll have a year with huge earnings revisions up as the company laps the one-year impact of this policy measure.
Long term, people! Look at the long term!
Except, in our view, however, the issue is much more profound than simply whether earnings will eventually come through and whether the right multiple is being paid for these companies.
The issue, rather, has to do with the fundamental purpose of a company, of private enterprise, within the Chinese economic machine.
One team, one dream, one country
There is no doubt at all that the philosophy around the role of private enterprise is a very different one in China than it is everywhere else. The difference lies between those who hope that this will eventually change and become “western” and “capitalist”, and those who recognise the permanence of a culture that has lasted more than 5,000 years – WAY longer than any western civilisation still in existence.
And culture is CRITICAL in constructing a framework within which decisions at the individual, organisational and governmental level are interpreted. Without the right understanding, one risks interpreting observations in a manner that is biased towards a specific train of thought. For many of us, and many the debutant China observer, what we see is perceived through the lens of our largely liberal “western” paradigm.
Contrary to the laissez-faire principles of the version of “capitalism” about which we are taught in economics classes, what few understand is that while China has turned to free markets over the past 3-4 decades, in its current form, the end goal is not the same.
Rather than nurturing capitalism in a way that allows unfettered wealth to accrue to successful entrepreneurs, creating wealth beyond compare in a free democracy where anyone is free to do (and get as rich) as they wish, China’s use of capitalism is that of an instrument rather than an end in itself. Put differently, free markets are only free when they serve the goals of the state, and the goal of the state (and by consequence the party) is that of a harmonious, moderately prosperous country with no extremes, neither extreme affluence nor extreme poverty.
So when “national champions” are named, one may assume that these champions are going to be “winners”, like celebrity winners in a race – to be lauded and showered with praise and reward. On the contrary, one could consider the “champions” the “anointed ones”, those tasked with blazing the path forward for a specific purpose: e-commerce, food delivery, semiconductors, AI etc. The deal is pretty straightforward: do this for the country, and if you succeed you will get your due reward, and if you don’t…
None of it goes to say that these businesses won’t be successful – in fact, in all likelihood, they will be. However, the cause of that success will be made abundantly clear: through the permission and blessing of the state, success comes; and so, when the state calls for help, the champions must step up and help.
Private enterprise in China, in our view, is actually a very intelligently implemented means of using Adam Smith’s invisible hand to get things done which centralised government planning would never be able to achieve. The means of doing so (the “how”) may be provided by the free market, but the agenda (the “what” and the “why”) is determined by a greater political agenda. Once the means are exhausted, they become what they always were meant to be: a public utility, to be provided at a reasonable cost under the auspices of government policy, rather than a means of extracting supernormal profits for an enterprising founding team. And no – it doesn’t matter at all that the government doesn’t have an explicit equity stake/board seats in a company, those are but mere formalities. It is the unspoken rules that carry the greater weight.
Furthermore, no one can say that there was NO benefit to anyone: the people have benefited from huge conveniences, the state of technology has advanced greatly, and the founders of these businesses (think the likes of Alibaba’s Jack Ma, Tencent’s Pony Ma, Meituan’s Wang Xing etc) have been made billionaires as a result. As for the shareholders who bought into the shares of these companies, they are welcome to ride along for the success of the business as it grows, but there’s little reason to believe that they should be owed the top priority spot when it comes to the companies’ strategies.
Put differently, China’s internet champions – or any of their champions, for that matter – are run first and foremost for the benefit of the country. Profits are secondary – they’re not anti-profit, and investors are free to participate, but profits to shareholders are NOT top priority, and will be subordinated to other interests without hesitation.
Most importantly – this isn’t going to change. There is no intent to change it.
We first saw this with Alibaba; we’ve seen it with Tencent, with their WeChat payments monopoly built over more than a decade broken at a snap of a finger; we’ve now seen it with Meituan. Call it “National Service”, call it whatever you would – we’ll probably keep seeing more of these, and we won’t be surprised.
Those who hope for this change, unfortunately, hope in vain.
Hope isn’t really a strategy.