“The common prosperity we desire is not egalitarianism. We will first make the pie bigger then divide it properly through reasonable institutional arrangements”, said Chinese President Xi Jinping during a speech to the World Economic Forum in Davos in 2022.
About 12 years ago, I wrote the following after a meeting with the chief financial officer of a huge Chinese company which, at the time, was listed in Hong Kong and was popular with investors because it was supposedly run as a private sector company: “He described a Wild West where rules went out of the window long ago and almost anything could happen to stakeholders.”
My conclusion at the time was that China risked following the path taken by most other societies which had transitioned away from Communism: one of robber capitalism and ultimately kleptocracy. The shift, in our opinion, had not been beneficial for the mass of people in these countries, nor for foreign minority owners of listed shares.
With the almost useless lens of hindsight, Xi Jinping’s famous ‘tigers and flies’ speech certainly signalled a change. The downfall of senior party members (and competitors to Xi’s throne) is well documented, as is the tightening and concentration of political control in the hands of the few or even the one.
Given the appalling outcome for those in most former Soviet Republics, it is worth asking whether Xi Jinping was right to try and stop the spiral into lawlessness. The answer seems to be ‘yes’.
Far from pushing China towards a Russian-style kleptocracy, the actions of China’s leader have on balance brought it back from the brink of it. This may have been painful for investors who were often unwittingly backing the kleptocrats who were brought down, but thankfully history is mostly judged by historians and not fund managers.
Transparency International’s corruption index for China has risen from a low of 36 in 2014 to a more middling score of 42 now. This score is still too low for comfort and suggests there is more to do but it also does suggest the anti-corruption purges had some effect. Russia languishes at a score of 26 alongside other failing states like Nigeria at 25.
The fact that the slide into the chaos we feared hasn’t happened doesn’t mean there are lots of companies that are investible (a fact which holds true for us across all emerging markets). Our list across the whole universe of thousands of global emerging market companies struggles to get above 120. Having looked at Chinese companies for the best part of a quarter of a century, some useful pointers, in our opinion, have emerged.
Firstly, most large companies appear to have been fictions of private enterprise moulded by the communist party propaganda machine to serve broader objectives than mere shareholder returns. There’s little wrong with this if you don’t fall for it, even as these companies become globally very popular, which has happened several times.
Secondly, the Hong Kong Oligarch era appears to be over and it is therefore hard to back these families to prosper in the new China. This perhaps was inevitable once the handover from British colonial ownership happened in July 1997 but has taken surprisingly long to be widely understood because Chinese authorities acted cautiously here for quite some time.
But China is a massive economy with broad stock markets and there will likely emerge a small number of good quality companies that might offer excellent long-term returns to owners precisely because a degree of order has been re-established.
What features might these good quality companies possess?
- Long records of profitability in areas far away from the government’s five-year plans, which are more likely driven by the competence of owners and managers than backroom favours.
- No instances of minority shareholder abuse or evading the law through dubious corporate structures.
- Margins that are not overly high against similar businesses elsewhere (as that can be a sign of favouritism), no faulty accounting or poor governance with related parties to inflate profit.
- Ability to attract credible stakeholders such as top management teams and in limited cases, the very few credible quality-focused emerging market investors out there. The second of course might well end up a circular argument.
- The presence of a governance check, such as credible long-term private owners beyond simply the management and founders.
- Conservative balance sheets across economic booms and busts. Never too carried away by the hype when it happened.
- A willingness to pay dividends to minority shareholders and/or reinvest profitably in growth.
- A plan to address broader stakeholder issues around topics such as gender and environmental externalities.
There’s no such thing as a perfect company but applying these simple criteria quickly rules out for us the majority, including the largest. We have found about half a dozen Chinese companies that possess some or all of these characteristics (about as many as we have found in another large emerging economy, Brazil).
As part of a diversified portfolio of approximately 30 companies, bearing little resemblance to the typical emerging market benchmark indices, we aim to own some or all of these Chinese companies for clients when they are sufficiently unpopular so that they might provide decent returns for the significant risks we still take in backing them.
We are happy to leave the big index companies to those with shorter time horizons and even shorter memories.
Jonathan Asante is portfolio manager of the Global Emerging Markets fund at Chikara Investments. The views expressed above should not be taken as investment advice.