How to approach China’s variable interest entity structures

‘As with anything, you really should be focusing on companies where the value that you’re getting exceeds the price that you’re going to pay’: Anil Jugmohan of Nedgroup Investments.

SIMON BROWN: I’m chatting now with Anil Jugmohan, a senior investment analyst at Nedgroup Investments. Anil, I appreciate the early morning time. Talking China – I want to maybe get to the end of the story first and work our way backwards, which is the VIEs, those variable interest entities, [with] a lot of companies such as Tencent, Alibaba; if we are buying them, we are actually buying them via these VIEs. It’s a weird structure used in China. Is it something that shareholders should be massively worried about – the short answer? Is it a dangerous structure for us?

ANIL JUGMOHAN: Good morning, Simon. Thanks very much for having me here. I’m very pleased to be here. That’s very good question you bring up on the VIEs. I think for a long time they have [had] a lot of risk inherent to them. As you know, probably more recently investors have become a lot more aware of inherent risks, and that’s what’s leading to a lot of share price falls.

I think if you look at just in South Africa, Naspers, as you said, we are buying Tencent through this VIE structure and it’s probably worth mentioning at this point that not all VIEs have the same level of strength in terms of actual access and ownership to the underlying cashflow. So investors do need to do their work. It’s not a case where you can just take a blanket approach and say, look, they are all good or they are all bad.

But there is definitely risk in the end and, as with any investments, you have to be comfortable and confident that you are being suitably paid to take certain risks, and, if there’s a mismatch between those risks, you probably should rather stay away.

SIMON BROWN: I hear what you say. Then the question, I suppose is: Is the Tencent VIE one that is a better structured and perhaps a lower risk, or is it perhaps one of the more scary ones?

ANIL JUGMOHAN: It’s quite hard to say whether it’s completely good or completely bad; probably at this point it’s not as good or as bad as people are making it out to be. But nevertheless, I do think that, as I mentioned, there’s now investor trust. If you are wary of where they believe true intrinsic value is, relative to the price that they are required to pay…. And probably right now, the share price has come back a bit relative to early in the year, investors are getting paid a bit more to take those risks, and they have to make that kind of analysis for themselves.

SIMON BROWN: I like your point there – in essence it’s that risk balance.
Let’s move to ‘common prosperity’, a phrase that Communist Party leaders have been throwing around a lot in China. In essence, they are sort of worried about the exceedingly rich and even some of the sectors such as education; private education basically got closed down overnight. This has scared investors a lot over this year, late last year. Is it something which is as scary as it sounds? Common prosperity as a sort of broad idea – I look at it and I think that can’t be the worst thing in the world.

ANIL JUGMOHAN: Yeah. Simon, I agree with you. I actually don’t think it’s the worst thing in the world. I think with China we often see the headlines [of] some of these super wealthy billionaires often making news going off and buying fancy planes and so on. But we don’t actually hear about kind of half of the population who are in dire need of poverty relief. One day we’ll probably look back at this whole thing and say, look, when China was an excellent case-study for kind of the three ESG (environmental, social, governance) pillars – because what they try to do now is focus in kind of each of those areas and really try and uplift the country from various sectors. You mentioned education as well. A lot of those private-education companies are literally just after profits at the expense of really costing people huge amounts of money, which it’s difficult for them to pay for their children, and to buy houses, and just do the basic things which many of us take for granted in South Africa.

So we will probably look back and say the Chinese government is doing the right thing. The Chinese typically have their own way of doing things which may shock Western investors, as you’ve seen with the share-price moves as well.

I think in the long term they probably are doing the right thing and there will certainly be an adjustment period.

But what you’ll probably find is that, as income levels of the broader population do increase, the typical corporates that where we’ve seen share prices getting hit now, they will ultimately benefit from that as well. So there will be a longer-term benefit, I believe.

SIMON BROWN: Then the question which a lot of people have been asking is: Should China even be considered an investment destination at this point? My sense from chatting with you these few minutes is that the answer is ‘yes, but’ – and the ‘but’ is, like with any investment, there are risks. I suppose make sure you know what you’re doing and make sure you are aware and comfortable with the associated risk.

ANIL JUGMOHAN: Simon, I think you are exactly spot-on. Unfortunately from a human behavioural bias perspective, human beings don’t tend to do very well when it comes to investing. As you know, after a market crash everyone’s reaction is to pull out, and after the market has done really well, they want to invest and that’s usually exactly the wrong time when people should be actually making those moves. You can’t expect to kind of buy high and sell low, expecting huge amounts of money in investing.

But just when you question whether China is investible, I think, as with anything, you really should be focusing on companies where the value that you’re getting actually exceeds the price that you’re going to pay.

Coming back to your VIE question, there are actually many local-listed companies that are operating in line with government policy and which are doing fantastic things, and are offering excellent value.

So it’s not like you can consider a blanket thing that would just discard anything that is China-related, and it’s the same with any other region that you could consider investing with, whether its an EM [emerging market], or DM [developed market]. You really have to be careful.

SIMON BROWN: Yeah. Know what you’re doing, know your risks, be comfortable with those risks. We’ll leave it there. Anil Jugmohan, a senior investment analyst at Nedgroup Investments, I appreciate the early morning this morning.

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