Investing in a Country where the “Rules Don’t Always Apply”
Category: Investment Research
This past January, I spent 10 days in mainland China with the intention of gaining further insights into the factors souring investor sentiment towards Chinese assets in 2018. With the Chinese A-Share equity market down 20% last year, I knew pessimism was at a high when no DiDi Chuxing (Chinese Uber) taxi drivers offered up any stock tips. 
As I traveled the country, I was struck at how the marvels of an advancing society contrasted against the unintended consequences of “progress.” This was best exemplified during the 1,200km train ride from Shanghai to Beijing (an equivalent distance as New York to Chicago). Taking only four hours – a feat unimaginable to any frequent passenger of the Amtrak Northeast Corridor – the smog outside ceased to disperse as I passed billowing factories, half-built high-rises, and multiple “ghost cities” with nonexistent traffic and disproportionately low electricity consumption. Many observations like these helped add depth to my understanding of China’s (still) tremendous growth potential, but also highlighted the future challenges the country faces as it transitions away from the debt-driven, fixed-asset economic model that drove growth in the past.
Over the course of the trip, I met with long-only, private equity, and venture capital fund managers, market strategists, business owners, US ex-pats, and China-based US government officials. The variety of these backgrounds provided differentiated viewpoints across a range of topics, but a commonality was the recurring theme of the Chinese government’s influence within the private sector. Over the course of the trip, I met with Irrespective of the topic, the conversation almost always shifted towards the difficulty of operating a private business in a centrally-controlled regime, and how the lack of a democratic process leads to the perpetual threat of sudden regulatory disruption. Although the absolute power of the Communist Party of China (CPC) is well documented in the West, I was struck by its looming presence over companies both large and small, public and private.
While the government will adopt a seemingly laissez faire attitude as nascent industries develop, they exhibit complete command when this growth begins to conflict with national interests. On a national scale, recent examples of this influence can be seen within the peer-to-peer (P2P) lending, video game, and education industries.  On a more local level, I heard comments from members of Beijing’s food & beverage industry that the government unexpectedly closes restaurants and bars even when they are registered, licensed, and up to code. In recent years there have been numerous instances of “bricking” in Beijing’s historic hutongs (alleyways), where commercial locations are forced to shut down operations immediately. In the US, this process might occur with a government official showing up with a ‘cease and desist’ letter. In Beijing, the local government ‘closes shop’ by laying physical bricks in the entranceway during off-hours.  Upon hearing of this method, I immediately hypothesized that Edgar Allen Poe’s The Cask of Amontillado had been translated to mandarin; but to many I spoke with, they viewed “bricking” as nothing out of the ordinary.  This micro observation helped lay the foundation for a pivotal conclusion from my trip to the mainland; that regardless of what business you are running, and no matter the scale, “the rules don’t always apply” when it comes to running a private enterprise in China.
Naturally, this “rules don’t always apply” concept increases the difficulty of investing in China. This view was reinforced by Chinese investors who highlighted that the most common mistake foreign investors make is analyzing Chinese companies through the lens of Western business model frameworks. One investor specifically used Michael Porter’s Five Forces model to illustrate how traditional investment philosophy underappreciates the Chinese government’s influence. Within Porter’s framework, the role of government is suggested to be a “factor not a force” and “neither inherently good nor bad for industry profitability.”  Though this model has exhibited success of assessing profitability in free-market economies, it needs to be adjusted when applied to China businesses. Dismissing the government’s involvement as simply a “factor” leads to an inadequate assessment of the competitive environment. Compared to democratic societies, the CPC’s intervention can be swifter, harsher, and more unexpected. Operating in a centrally-planned state that lacks defined governance and private protections means a businesses’ competitive positioning can drastically alter from one day to the next. Investment opportunities can diminish or emerge at the same rate investment risks emerge or diminish.
So how do you invest in a country where “the rules don’t always apply”? For some Western investors, the obvious answer is to not invest at all. This cohort will never get comfortable with the Chinese government’s absolute power and omnipresence within the private sector. They support their argument by citing historic examples of nationalization (e.g., Cuba, Russia, Venezuela, etc.) and reference Dagny Taggart’s struggle in Atlas Shrugged. I personally find these arguments to be too extreme—a topic I’ll save for another blog—but more importantly, I believe portfolios underweight Chinese assets are at a greater risk than those that own them. China continues to represent some of the best growth opportunities over the coming decades, as the middle class is expected to expand to 700 million people by 2020, and Chinese equities could represent 40% of the MSCI Emerging Market Index. 
Of course, this bullishness is balanced against the uncertainty that comes with investing in a communist country. Thus, from my time abroad, I have an increased preference for Chinese companies that: (1) are aligned with serving national state interests in a win-win framework, and (2) have the flexibility to navigate the rapidly changing regulatory environment. While Michael Porter and I might argue about the semantics of “factor” versus “force;” in China, assessing these characteristics is just as important a task as analyzing the competitive environment. This process is imperative given the perpetual threat of having to play by a new and arbitrary set of rules at any point in time; as well as the possibility that the front door of your workplace could be replaced by a wall of bricks.