As an on the ground China observer over the last ten years I can’t help but comment. I’ll preface my remarks by saying I too shun investment in Chinese companies, but not necessarily for the same reasons cited in Saul’s note.
It’s a little hard to know where to begin, but I’ll start with this comment: Mr. Xi’s take on Communism — called “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” — has been unveiled with great fanfare across the country.
It may not be immediately obvious, but this is a reference to Deng XiaoPing; the guy who instituted economic reforms in China moving the country away from Mao’s socialist dreams toward an economic system based on the capitalistic principles of competition and free markets. Deng created Special Economic Zones (SEZz). Each SEZ was observed, modifications were incorporated based on lessons learned and the system progressed rapidly throughout China. Nevertheless, Deng referred to it as “Socialism with Chinese Characteristics.” The wording carefully chosen in order to make it sound as if he was following a plan consistent with Mao’s dream of a socialist China. To this day, Mao is still revered in China in much the same way George Washington is here in the US. Just pointing out that a literal translation does not always mean exactly what it sounds like it means.
Others who have commented on this thread have mentioned the rampant corruption in China. That was certainly true prior to Xi Jinping’s rule. But Xi made it known before his election to President that one of the primary goals of his administration would be to break the back of government corruption. He saw it as a direct threat to the one party rule as the Chinese people were becoming increasingly cynical of the government. Though no one thought Xi would succeed in this effort, he had (and continues to have) unfathomed success. The former Minister of Railroads (controlling an enormous budget) is in prison. Bo Xilai (former Mayor of ChongQing with jurisdiction over 30M people) and his wife are both in prison. Numerous party officials from all parts of China have been demoted or imprisoned. Exorbitant party functions at 5 star resorts and restaurants have ceased. Elaborate, modern architecture buildings with plush offices for government officials are no longer being built.
Xi’s enormous success at reversing and reducing government corruption had significant political fallout. First, he quickly won the hearts and minds of most of the Chinese people. He set out to do the impossible, something everyone thought would simply be lip service, but instead of just PR campaign he largely succeeded in doing what he said he was going to do (note, he never claimed he would end corruption in the non-government sectors of the economy, cutthroat business practices continue more or less unabated). The other political payoff was that by jailing and demoting so many powerful party members he pretty much eliminated most all his rivals, thereby clearing the way for the recent change in the Chinese constitution allowing him to serve more than two terms as president (as an aside, the institution of a process for orderly succession of leadership and two 5-year terms of service were political reforms instituted by Deng XiaoPing).
President Xi has announced a plan to eliminate abject poverty in China by 2040. Will he succeed with this big goal? Most observers are sceptical, but it is certain that he won’t succeed if he destroys the businesses that are moving the economic needle in China. On the other hand, he also announced plans to shut down coal mining in China over an unspecified time period and shuttering hundreds of SOEs (State Owned Enterprises) over the next two years. His plans for closing SOEs includes economic aid for displaced workers and government funded retraining programs. Unlike the shrinking middle class in the US, President Xi is taking positive steps for expanding the middle class.
And China will continue to expand its aggressive infrastructure development including new and modernized seaports and airports. There’s a new airport under construction in Guilin, my wife’s home town as I write. Last year we were able to take high speed rail from Guilin to Guangzhou making total travel time less than air and far more convenient in that the rail stations are inside both cities as opposed to the airports which are far outside of the city. New highways criss-cross much of the Chinese countryside. I’ve been on some of these roads and they are impeccably dead flat highways with zero potholes. The electrical grid is also under rapid development with increasing amounts of renewable energy sources. China erects a new wind turbine at the average pace of one a day. China has a goal to become the world leader in clean energy. Rather than reversing regulations that protect the air and water, China is doing just the opposite under President Xi’s leadership.
What this all indicates to me is that despite the fact that the Communist Party permeates many aspects of Chinese life, I think it extremely unlikely that the Chinese government would whimsically nationalize any of their internationally important businesses. And the internationally important businesses are the ones that trade ADRs on US exchanges. As I mentioned earlier, the Chinese government is far more focused on closing SOEs than creating new ones.
However, I will concede Saul’s point that the government most certainly has the power to take over just about any business should it find a reason to do so. As recently as last February the Chinese government seized control of Anbang Insurance Group, owner of New York’s famed Waldorf Astoria hotel and one of the largest insurance companies in China if not the world. A few of the officers have been prosecuted and imprisoned. The government has asserted that they will maintain control of the business for a year during which it will be restructured and deleveraged. After these revisions, the stated intent is to return it to private control. No policyholders or business associates are to be adversely impacted by the takeover although some business relationships will surely be terminated. The reasons for this take over are manifold. The primary reasons given by the Chinese insurance commission were the extent of highly leveraged acquisitions, corrupt practices (this probably means money laundering and facilitation of capital flight), and high levels of risk for one of China’s too-big-to-fail businesses.
But, in my opinion wanton nationalization of Chinese companies is not a significant risk. Given that I don’t think the risks of government takeover is great, why am I reluctant to invest in Chinese companies?
My reasons are based on what I perceive as accounting risks and insider attitudes about the investment community. In a word, financial reports from Chinese companies are not trustworthy. Even companies that employ American accounting firms and file all the SEC required documents are not to be trusted. I’m not saying that all financial reports are falsified, not by a long shot. But, if a company gets into trouble, there’s little to stop them from bending the truth when it comes to reporting. The reports my have the appearance of GAAP compliance and they may have been produced by PWC or whoever, but the operational numbers that feed the reports are subject all kinds of manipulation. The other big risk of investing in a Chinese company is that virtually all Chinese companies are managed by an inside circle. Typically, the members of the inside circle hold investors in disdain. Jack Ma, for example, even said so a number of years before AliBaba went public. Mr. Ma is famous for lists. On a list he produced several years ago of the ten things that makes a business successful, he put investors dead last. He’s learned to tone down his rhetoric, but I’m confident his attitude has not changed. So long as the interests of the inner circle align with the investors, meiyou wenti (no problem). But, the investors are rarely considered when Chinese executives make decisions. Should the interests of the inner circle run contrary to the shareholders, the shareholders will inevitably be the losers.
In my opinion there are simply too many opportunities for profitable investments in Western companies with officers with a shared culture, boards with outside directors, closer scrutiny by accounting firm audit teams and more direct oversight by regulatory agencies to accept the additional and substantial risks of investing in Chinese companies.
You might argue that the risks I’ve cited are also present in Western companies. And that is true. But I maintain that these risks are not common and expected in Western companies. For Chinese companies I think just the opposite is true.