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What to do about the Chinese situation?


Lately, Chinese language firms have turn into problematic funding propositions for international buyers. This case is exacerbated in South Africa, the place Naspers and its sister creation straight out of Dr Frankenstein’s lab Prosus, have a big shareholding in a Chinese language firm.

Naspers, as I’m positive you understand, made one of many single finest funding choices in historical past when it purchased 32.8% of a Chinese language enterprise known as Tencent for $20 million in 2001. At the moment, that funding is value $200 billion, i.e. a ten 000 bagger. In funding parlance, a ten bagger is an funding that goes up by a a number of of ten occasions, and is a uncommon achievement – making a ten 000 bagger further particular.

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Merely put, a ten 000 bagger turns a thousand {dollars} into 10 million.

Discuss unicorns!

It ought to come as no shock that Naspers/Prosus is a well-liked funding in South Africa, and because of the implausible efficiency of Tencent, they occupy very giant positions in indices to which buyers examine their efforts. A fast perusal of the most important funds in South Africa exhibits that they’ve allocations of between 10% and 20% to those investments; some funds have extra.

As such, South African buyers have enormous publicity to the ‘Chinese language state of affairs’, even of their home investments.

However what precisely is that this ‘Chinese language state of affairs’ and why is it problematic? Most educated buyers will level out that Tencent has developed into among the best companies on this planet. So what’s the issue? To grasp why, it’s value a cursory look beneath the hood.

Understanding Tencent

Tencent is a Chinese language holding firm that’s the world chief in gaming and runs the most important messaging, social networking, and cellular funds platform in China. It additionally invests within the subsequent technology of firms in China and across the globe. Tencent combines the diversification of an old style conglomerate with the expansion and decentralisation of an internet-native enterprise.

In China, Tencent is like Fb, Nintendo, Shopify, Netflix, Spotify, Slack and PayPal rolled into one.

Its flagship product, WeChat, has 1.2 billion customers and people customers spend extra time within the app daily than Individuals spend on all social media apps mixed.

Companies in China run on WeChat. They will talk with prospects, get distribution, construct total functioning merchandise, and settle for funds by WeChat Pay.

WeChat is Tencent’s unfair benefit in China. It’s the highest of Tencent’s acquisition funnel. Three of Tencent’s 4 largest holdings – Meituan Dianping, JD.com and Pinduoduo – are Chinese language e-commerce companies that run on high of WeChat.

So not solely does Tencent have an enviable core enterprise, however this enterprise places it ready to accumulate investments in different companies on beneficial phrases.

It’s clear that Tencent is in a very advantaged aggressive state of affairs and will carry a valuation premium to mirror its historic excessive charges of development in addition to the excessive development anticipated to materialise because of its dominance in a big market.

What’s to not like?

As they are saying, the satan is all the time within the element.

Sadly, by governmental decree non-Chinese language shareholders usually are not allowed to personal shares in firms in sure sectors in China. Tencent is a kind of firms.

China has been turning a blind eye …

The Chinese language authorities does need to encourage capital inflows, in order that they flip a blind eye to the construction that enables international buyers (resembling Naspers) to realize entry to investments in Chinese language companies.

This construction is known as a VIE (variable curiosity entity). VIEs don’t symbolize precise possession however are contracts that permit entry to the companies’ money flows. On this construction, the onshore Chinese language firm is capitalised by a international shell firm – usually a Cayman-listed entity. This, in flip, owns a contractual settlement with the nominee shareholders of the China-based enterprise (the VIE) which confers some rights: considerably all of the financial advantages and all of the anticipated losses of the China-based enterprise – in brief, a contractual curiosity however not an possession curiosity.

It’s essential to notice that VIEs are unlawful devices which have been traditionally tolerated by the Chinese language authorities.

China’s door is mostly closed to inbound visitors – web content material and different types of media in addition to channels of cultural affect.

For capital, the inbound door stays vast open, however the way in which out is more and more shut.

Insurance policies round preliminary public providing (IPO) approvals, VIEs, web management, anti-monopoly regulation, and funding coverage are centered on capturing and holding onto exhausting forex inflows. China wants this influx as its present account surplus shrinks and (unlawful) capital outflows from non-public people intensify.

Regardless of their questionable authorized place, VIE listings have usually offered good returns to underwriters and buyers. VIEs labored as a result of potential earnings trumped worry of regulatory scrutiny. Worrying in regards to the particulars of possession constructions can come later.

China adjustments its tune

Sadly, Chinese language regulators have turn into more and more interventionist, curbing the financial and social energy of China’s once-loosely regulated web giants.

The primary warning photographs have been fired in 2018, when curbs on the web gaming business have been launched.

Final yr, the IPO of ANT Monetary (the monetary companies arm of Alibaba) was pulled. Jack Ma, the founding father of Alibaba and proprietor of ANT, stays unaccounted for.

Final month, the CAC – ‘Our on-line world Administration of China’ (!) – introduced it had launched an investigation into Didi World on suspicion the corporate had violated nationwide safety legal guidelines. This occurred two days after it listed within the USA and precipitated a 50% decline in its share value.

At roughly the identical time, the Chinese language antitrust regulator ordered Tencent Music group to surrender exclusivity on it labels, inflicting a 60% decline in its share value. And much more not too long ago, China’s ban on non-public schooling precipitated declines of over 50% in a slew of listed schooling firms.

It’s clear that the time to fret in regards to the particulars has now arrived.

Current crackdowns present that Chinese language authorities are extra involved about coverage than market costs and Chinese language authorities should determine they don’t have any additional want for VIE constructions.

The danger in context

If this have been to occur, the worth of Tencent to international buyers – together with Naspers/Prosus – could possibly be zero.

Zero.

You’ve understood this appropriately – the Naspers/Prosus funding in Tencent faces existential dangers.

That is very completely different from regular market volatility, the place the costs of excellent high quality companies like Tencent can decline sharply, however then get better once more over time. When governments applicable your property for coverage functions, you usually get nothing in return.

So we now have a sort of Schrödinger’s cat state of affairs right here – in a single state, Tencent is a priceless enterprise, in one other it’s nugatory (to western buyers, a minimum of).

The query thus turns into: how do you handle this threat?

One of many methods to handle threat in a portfolio context is to make use of place sizing. A great way to take care of the Chinese language state of affairs could be to keep away from it being the one largest place. That’s, if you’re investing as a principal.

It’s comprehensible if brokers (who handle cash on behalf of different individuals) are compelled into giant positions if the benchmark calls for it.

A small place – if it have been low-cost sufficient to personal – appears eminently wise in a portfolio context. Right here the chance of Tencent going to zero could be very completely different to different dangers embedded within the portfolio, offering diversification advantages. And, if it does occur, the small place protects the general portfolio from struggling a big loss. If the Chinese language authorities continues to disregard VIEs, then the portfolio may even profit.

Within the numerous Counterpoint Asset Administration worth fund methods we now have by no means held Tencent (or its proxies Naspers/Prosus) as we believed the valuation premium the market positioned on Tencent was too excessive. Now, with the good thing about hindsight, it’s clear that we constantly underestimated the intrinsic worth of the enterprise. Even worse, early on we didn’t even perceive the funding proposition.

Our funds haven’t participated in any of the ten 000 luggage that Naspers shareholders traditionally loved. This error of omission has value our buyers dearly.

However that’s now water beneath the bridge.

Given the current sharp decline within the share costs of firms related to VIEs (which, by the way, haven’t damage our funds) there may be a case on valuation grounds for proudly owning shares within the Tencent/Naspers/Prosus nexus. Nevertheless, the existential threat has additionally elevated considerably.

There’s a accountable approach of coping with this specific Chinese language state of affairs: ignore index weightings and slightly dimension the positions primarily based on one’s personal threat urge for food, which requires thought on how this threat interacts with different dangers embedded in a single’s portfolio.

Piet Viljoen is portfolio supervisor at Counterpoint Asset Administration Worth Technique.



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