You may have noted that the vast majority of popular global equity funds hold a few crowded China trades such as Tencent and Alibaba. We do not, and this is deliberate. Why is it useful for those tasked with portfolio construction to know this? Namely, for both risk management and fund blending aspects.
Investing in nations with political attributes such as China requires a holistic understanding of the political regime, its regulatory framework and how this has evolved over time.
We spend considerable effort in understanding the history of China particularly during the Mao Zedong era (1949-1976). There are strong parallels emerging in ideology between Xi Jinping and Mao Zedong. This is fundamental to understanding any investment case for holding a Chinese company.
Many investors wrongly assumed that political freedom would follow new economic freedoms in China. That its economic growth would be contingent upon the same foundations as in the West. China instead devised a hybrid economy and has adopted a distinct development model. It has been highly successful so far. One needs to understand how the Chinese Communist Party rules, and how the state works. Its cultural foundations and history generally, and specifically its history with the West requires understanding. Decisions it makes today and into the future within its businesses, and with those companies and nations outside its borders, are shaped accordingly by this.
Tencent – a no-brainer, or was it?
Tencent exemplifies many of the challenges facing investment in China. Yes, it is a wonderful company. It has a strong competitive advantage. It’s highly profitable and possesses a long runway of growth with more than one Megatrend propelling it. Worldwide, there is no parallel comparison to Tencent Holdings.
Tencent’s ecosystem spans gaming, ecommerce, music, cloud and artificial intelligence. The US$500 billion tech giant is a collective answer to Facebook, WhatsApp, Spotify, Apple Pay and others.
It met all our financial and management criteria
Management have been outstanding and when listening to the numerous conference calls and analysing the numbers, it was clear that Tencent was being managed in line with some of the other wonderful investments we have in our portfolio. Valuations also looked attractive, thus Tencent ticked all the boxes.
Overall, our research had us very enthused and the China country specific risk factors were also within acceptable parameters. So, we invested in Tencent in 2018. However, we sold the stock 9 months later in 2019. This is highly unusual for us as we typically have a turnover ratio of around only 20%. Our average holding period is 5 years.
What caused this change in view, and one we have maintained ever since, was that the negative risk factors of Chinese investment accelerated sharply soon after without forewarning. They rose well above the positives. This has not changed today except for it to become significantly worse. Investors, however, are often good at self-deception and are adept at blocking out negative developments if they have a developed a positive view (it is called confirmation bias). This is something we, at Insync, are highly vigilant of in our decisions.
Joining the dots is key
Investing is not only about numbers and stories. To get a complete picture of the potential opportunity and risks involved, investors require a deeper understanding of how the world operates. This requires understanding a broad range of subjects to help join the dots. These subjects range from psychology to history to anthropology, politics, and economics. Insync devotes a large amount of effort to all this.
Dot one … a bit of history. One of the key ideologies of the Mao Zedong era (1949-1976) was that a revolution against capitalists should be won by violence and mass support. As chief of the Chinese Communist Party, he ushered in extreme state control of the economy.
Recognising the colossal damage his policies inflicted on the people, the leaders that followed over the next 35 years progressively pushed through market reforms. They emphasised economic development based on capitalistic principles. They promoted opening up the country for foreign investment and trade and establishing a thriving market-based economy.
This encouraged an explosion in long-held Chinese entrepreneurship (that was initially suffocated by communism). These entrepreneurs were remarkable visionaries driving innovation and building businesses at a gargantuan scale. This resulted in some of the most advantaged companies globally. They includes the likes of Alibaba and Tencent, both in under just 25 years! Again, acceleration of progress came to the fore.
Western capital eager for growth and noting this acceleration rushed in. Huge excitement within the investment community ensued, rarely with anything but a positive lens applied. As a result, many funds now hold sizeable investment positions in both China overall and specifically in these two companies alone. The bigger the manager the more widespread this feature of their portfolio is by in large.
Then came a new leader with old ideas
Xi Jinping is the 5th man to rule the People’s Republic of China. The first that was born after the revolution, in 1949. In researching him, even though his style was technocratic, it was progressively becoming clearer to Insync that he was rejecting decades of market economy reforms.
He was starting to reassert the power of the Communist Party and narrow controls within the economy as well as society. One crucial aspect was the redirecting of Chinese business focus inward.
Insync’s considerable time spent researching the Mao era and strong parallels in ideology alerted us to Xi Jinping’s likely style of similar increasing control.
Xi’s influence on the big tech companies became clearer when it was announced in November 2018 that Jack Ma, co-founder of China’s most valuable company, was officially confirmed as a member of the communist party. The lines between business and politics were starting to become increasingly hazy. A concerning trend of disappearing billionaire CEOs from public life began. As President, Xi Jinping led a campaign to ensure the Communist Party plays a leading role across all aspects of society.
Insync is a pragmatic investor. Our political views do not come into the decision-making process. The investment rationale for a buy or sell decision include how companies in China are likely to be regulated and controlled compared to other parts of the world.
The country is steeped in rich tradition, has the world’s largest population and is a nation of incredibly hardworking people. However, these are not pre-requisites for a successful enduring investment environment alone. The significant downside risks were clear as events accelerated. Our discipline led us to exiting our position in Tencent over 3 years ago. We have held no Chinese stocks since then.
China is not an investable proposition today
China’s latest five-year blueprint called for greater regulation of vast parts of the economy. It provided a sweeping framework for the broader crackdown on key industries such as technology, cybersecurity, food, medicine, education, and financial services.
The examples of its impact are many
The acceleration of political controls and the significant investor losses of increasing control can be clearly observed. The scuppering of the Ant Financial IPO at the last minute, and the investigation into data security at Didi Chuxing, China’s biggest ride-hailing company listed on the NYSE. This was only a month after its listing in June 21. A further example was banning for-profit tutoring in core school subjects. This led to a 70%+ fall in the share price of the leading player, TAL Education. No sector is safe and little warning is given.
As disciplined pragmatic investors we ask ourselves a simple question. Compared to other places to invest our client’s capital, are these accelerating risks worth it? Can other good opportunities without these severe risks be found elsewhere?
When Amazon loses a $10b government contract, they can sue the government. Legal process is applied. But companies and investors can do little against the Chinese government. “What are we supposed to do? We can’t fight the Communist party” — says one Ed-tech executive (Financial Times). Being a great company with sound tailwinds is not enough. The environment for their investors must also be supportive.
The bottom line for our investors is that after the most recent actions by the Chinese government, China will be off limits to us for at least the next three to five years until it becomes clear how China will interact with foreign investors positively.
There are plenty of ‘outstanding’ investment opportunities outside of China without incurring these large risks. It means sometimes diverging from the popular view and from the herd. This is nothing new to us at Insync.
In terms of blending arguments, Insync is one of the few managers with this position on China. Insync’s differentiated approach make us an ideal blending partner with the larger more popular funds in client portfolios. Additionally, this approach to China is another example of the focus that we place on risk management.
Full July 2021 fund commentary (pdf): July 2021 Monthly Update
Learn more about Insync’s investment philosophy