Vast amounts of capital are flowing into Chinese technology giants like Baidu, Tencent and Alibaba – but Stewart Investors portfolio manager Nick Edgerton says he is sitting on the sidelines.
Part of the rationale, Mr Edgerton said, is Stewart Investors’ Hippocratic Oath which pledges: “We will not forget in our search for returns that the primary risk faced by our clients is losing their capital.”
While Chinese tech companies are currently flavour of the month, there has always been a risk of losing significant capital due to government or regulatory action.
Mr Edgerton pointed to the example of Shell, which was the largest foreign operator of petrol stations in Shanghai throughout the 1950s and ended up having its assets seized.
“Shell employed several thousand Chinese staff, but they still had all of their depots and service stations seized by the government. That reminds you of the importance of having rigorous property rights,” he said.
Furthermore, Chinese tech giants like Baidu, Tencent and Alibaba are structured as variable interest enterprises (VIEs) – a structure that was infamously used by Enron to hide its losses, Mr Edgerton said.
“A VIE only give you a share in a listed company with no actual ownership of the most valuable assets of the business.”
“You’re effectively getting a promissory note or an entitlement of cashflows that are often routed through cash havens with very little disclosure – such as the Cayman Islands – and they bear huge risk to offshore investors,” Mr Edgerton said.
JD.com, one of China’s largest internet companies, clearly states in its prospectus that its risks include the government confiscating its income or forcing it to relinquish interests if regulations are changed.
Alipay founder Jack Ma has been involved in a dispute with minority shareholders Yahoo and Softbank after he transferred ownership of the business without informing other shareholders.
“So there is a risk that minority shareholders are treated poorly while other large owners enrich themselves. Or, in the worst-case-scenario, you may get action by a government,” Mr Edgerton said.
“Ultimately there is little protection of property rights, and because of valuation there are significant risks of loss of capital and even permanent loss of capital.
“So it’s incumbent on us as a long term investor to be more sober in analysis of these companies,” he said.
