Recently, Chinese companies have become problematic investment propositions for global investors. This situation is exacerbated in South Africa, where Naspers and its sister creation straight out of Dr Frankenstein’s lab Prosus, have a large shareholding in a Chinese company.
Naspers, as I’m sure you know, made one of the single best investment decisions in history when it bought 32.8% of a Chinese business called Tencent for $20 million in 2001. Today, that investment is worth $200 billion, i.e. a 10 000 bagger. In investment parlance, a ten bagger is an investment that goes up by a multiple of ten times, and is a rare achievement – making a 10 000 bagger extra special.
Simply put, a 10 000 bagger turns a thousand dollars into 10 million.
Talk about unicorns!
It should come as no surprise that Naspers/Prosus is a popular investment in South Africa, and as a result of the fantastic performance of Tencent, they occupy very large positions in indices to which investors compare their efforts. A quick perusal of the biggest funds in South Africa shows that they have allocations of between 10% and 20% to these investments; some funds have more.
As such, South African investors have huge exposure to the ‘Chinese situation’, even in their domestic investments.
But what exactly is this ‘Chinese situation’ and why is it problematic? Most knowledgeable investors will point out that Tencent has evolved into one of the best businesses in the world. So what’s the problem? To understand why, it’s worth a cursory look under the hood.
Tencent is a Chinese holding company that is the world leader in gaming and runs the largest messaging, social networking, and mobile payments platform in China. It also invests in the next generation of companies in China and around the globe. Tencent combines the diversification of an old school conglomerate with the growth and decentralisation of an internet-native business.
In China, Tencent is like Facebook, Nintendo, Shopify, Netflix, Spotify, Slack and PayPal rolled into one.
Its flagship product, WeChat, has 1.2 billion users and those users spend more time in the app every day than Americans spend on all social media apps combined.
Businesses in China run on WeChat. They can communicate with customers, get distribution, build entire functioning products, and accept payments through WeChat Pay.
WeChat is Tencent’s unfair advantage in China. It’s the top of Tencent’s acquisition funnel. Three of Tencent’s four largest holdings – Meituan Dianping, JD.com and Pinduoduo – are Chinese e-commerce businesses that run on top of WeChat.
So not only does Tencent have an enviable core business, but this business puts it in a position to acquire investments in other businesses on favourable terms.
It’s clear that Tencent is in a particularly advantaged competitive situation and should carry a valuation premium to reflect its historic high rates of growth as well as the high growth expected to materialise as a result of its dominance in a large market.
What’s not to like?
As they say, the devil is always in the detail.
Unfortunately, by governmental decree non-Chinese shareholders are not allowed to own shares in companies in certain sectors in China. Tencent is one of those companies.
China has been turning a blind eye …
The Chinese government does want to encourage capital inflows, so they turn a blind eye to the structure that allows foreign investors (such as Naspers) to gain access to investments in Chinese businesses.
This structure is called a VIE (variable interest entity). VIEs do not represent actual ownership but are contracts that allow access to the corporations’ cash flows. In this structure, the onshore Chinese company is capitalised by a foreign shell company – generally a Cayman-listed entity. This, in turn, owns a contractual agreement with the nominee shareholders of the China-based business (the VIE) which confers some rights: substantially all the economic benefits and all the expected losses of the China-based business – in short, a contractual interest but not an ownership interest.
It’s important to note that VIEs are illegal instruments that have been historically tolerated by the Chinese government.
China’s door is generally closed to inbound traffic – internet content and other forms of media as well as channels of cultural influence.
For capital, the inbound door remains wide open, but the way out is increasingly shut.
Policies around initial public offering (IPO) approvals, VIEs, internet control, anti-monopoly regulation, and investment policy are focused on capturing and holding onto hard currency inflows. China needs this inflow as its current account surplus shrinks and (illegal) capital outflows from private individuals intensify.
Despite their questionable legal position, VIE listings have generally provided good returns to underwriters and investors. VIEs worked because prospective profits trumped fear of regulatory scrutiny. Worrying about the details of ownership structures can come later.
China changes its tune
Unfortunately, Chinese regulators have become increasingly interventionist, curbing the economic and social power of China’s once-loosely regulated internet giants.
The first warning shots were fired in 2018, when curbs on the online gaming industry were introduced.
Last year, the IPO of ANT Financial (the financial services arm of Alibaba) was pulled. Jack Ma, the founder of Alibaba and owner of ANT, remains unaccounted for.
Last month, the CAC – ‘Cyberspace Administration of China’ (!) – announced it had launched an investigation into Didi Global on suspicion the company had violated national security laws. This happened two days after it listed in the USA and caused a 50% decline in its share price.
At roughly the same time, the Chinese antitrust regulator ordered Tencent Music group to give up exclusivity on it labels, causing a 60% decline in its share price. And even more recently, China’s ban on private education caused declines of over 50% in a slew of listed education companies.
It’s clear that the time to worry about the details has now arrived.
Recent crackdowns show that Chinese authorities are more concerned about policy than market prices and Chinese authorities may still decide they have no further need for VIE structures.
The risk in context
If this were to happen, the value of Tencent to foreign investors – including Naspers/Prosus – could be zero.
You’ve understood this correctly – the Naspers/Prosus investment in Tencent faces existential risks.
This is very different from normal market volatility, where the prices of good quality businesses like Tencent can decline sharply, but then recover again over time. When governments appropriate your assets for policy purposes, you generally get nothing in return.
So we have a type of Schrödinger’s cat situation here – in one state, Tencent is a valuable business, in another it is worthless (to western investors, at least).
The question thus becomes: how do you manage this risk?
One of the ways to manage risk in a portfolio context is to use position sizing. A good way to deal with the Chinese situation would be to avoid it being the single largest position. That is, if you are investing as a principal.
It’s understandable if agents (who manage money on behalf of other people) are forced into large positions if the benchmark demands it.
A small position – if it were cheap enough to own – seems eminently sensible in a portfolio context. Here the risk of Tencent going to zero is very different to other risks embedded in the portfolio, providing diversification benefits. And, if it does happen, the small position protects the overall portfolio from suffering a significant loss. If the Chinese government continues to ignore VIEs, then the portfolio will also benefit.
In the various Counterpoint Asset Management value fund strategies we have never held Tencent (or its proxies Naspers/Prosus) as we believed the valuation premium the market placed on Tencent was too high. Now, with the benefit of hindsight, it’s clear that we consistently underestimated the intrinsic value of the business. Even worse, early on we didn’t even understand the investment proposition.
Our funds have not participated in any of the 10 000 bags that Naspers shareholders historically enjoyed. This mistake of omission has cost our investors dearly.
But that is now water under the bridge.
Given the recent sharp decline in the share prices of companies associated with VIEs (which, incidentally, have not hurt our funds) there might be a case on valuation grounds for owning shares in the Tencent/Naspers/Prosus nexus. However, the existential risk has also increased substantially.
There’s a responsible way of dealing with this particular Chinese situation: ignore index weightings and rather size the positions based on one’s own risk appetite, which requires thought on how this risk interacts with other risks embedded in one’s portfolio.
Piet Viljoen is portfolio manager at Counterpoint Asset Management Value Strategy.