Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 290

Risk is the permanent loss of capital

Our investment philosophy is that we will not forget in our search for returns that the primary risk faced by our clients is losing their capital. Our definition of risk is simple: the permanent loss of capital.

Lessons from history

One of the most shocking ways of losing capital is when ownership is taken without proper compensation, either by force or stealth. The majestic buildings on the Huangpu River in Shanghai serve as a good reminder of how quickly and terribly circumstances can change. Number 12, the Bund, was designed by British architects to be ‘the best bank in the world’ in the 1920s. This magnificent building was the headquarters of HSBC in Shanghai before it had to be handed over to the municipal communist government in 1956. Further along the road, the Keswick family lost control of number 27 on two occasions, first to the Japanese and then to the Chinese government in 1954[1].

At this time, Great Britain was one of the most significant investors in China, four times larger than the USA, and had the most to lose from nationalisation. The then British Chamber of Commerce (chaired by J. Keswick in Shanghai - possibly slightly biased!) estimated British investment amounted to £1 billion in Shanghai alone. Another large loser was Shell. According to The Story of Shell in China, the company was the largest foreign operator of filling stations in Shanghai and employed some 2,600 Chinese staff. However, we are told “over the years 1951-53 Shell relinquished most of its depots, residences and service stations in the Republic to the government, together with various quantities of oil and chemicals”. Not only were assets under threat of confiscation but income was reduced by insidious expense inflation after the government linked Chinese wages at British firms to the price of rice, which was in chronically short supply. It was a difficult time for foreign investors and what made matters worse was the absence of recourse in the law courts to claim compensation.

Turning eastwards, the ever-developing skyline of the Pudong is an impressive sight. On a recent trip, we could actually see the futuristic skyscrapers set against a clear blue sky, rather than noxious clouds which have obscured the buildings in previous years. It is easy to get carried away with the sheer scale of the vista. It is intended that way! This special economic zone was the brainchild of the indomitable politician Zhu Rongji who wanted to inspire confidence in domestic and foreign investors after much social disquiet. This worked; the skyline is now one of most photographed in the world and has come to symbolise a bold future with wealth creation aplenty, although not for everyone.

Less impressed by this view are the farmers and families who were encouraged, with scant compensation, to vacate their homes and livelihood to make way for construction. Author Zhaohui Hong calculated these farmers received only one-third of the value of the land with the remainder benefitting the public coffers[2]. A study by the World Bank estimated that local governments expropriated around US$320 billion worth of land from farmers between 1990 and 2010[3]. The common thread is a continued disrespect for ‘property rights’.

It is with this in mind that we are especially vigilant to study the substance rather than just the form of each possible investment in China.

Lessons that apply today

The extremely popular internet giants (Alibaba, Tencent and Baidu) and the legal structures on which they rely are a case in point. These structures are known as variable interest entities (VIE), an American creation, made famous by Enron in 2001. In the case of China they are used to circumvent restrictions on foreign investment in certain key industries, such as steel and media. It is a complicated arrangement as it permits two different parties (the Chinese regulators and foreign investors) to claim ownership of the same operating assets. Each VIE is different but the common feature is that investors can only buy shares in a listed company with no actual ownership of sometimes the most valuable assets, gaining only a promissory note of entitlement. Instead, investors are asked to rely on a legal agreement that entitles the ‘listco’ to a share of the profits from the separate company. Using the prospectus of JD.Com as an example, investors are clearly warned that the government could confiscate income or force interests to be relinquished if it is deemed that regulations, or the interpretation of existing regulations, is changed. It is worth pondering how companies incorporating such risks could be allowed to list in the US but the SEC (Securities and Exchange Commission) cannot ban offerings for being too risky or even potentially illegal, all they can do is require full disclosure of the risks. With such warnings in writing, it would be extremely difficult to protect investors' rights should anything untoward unfold.

These risks have arisen in China not just in the early decades of communist rule, but recently. In 2008, the Agria Corporation lost control of a Chinese subsidiary to a discontented executive. The asset was only retuned to the company when the executive received additional compensation. Another example is the disappearance of Alipay, much to the chagrin of minority investors, Yahoo and Softbank, to a company owned by the founder Jack Ma. More recently, shareholders of RenRen (a social media network) alleged in an open letter that the founders were attempting to “enrich themselves to the detriment of all other shareholders”. In this case governance was tested, animosity lingers and the share price has fallen 75% from its all-time high. One further governance concern is an iniquitous number of votes, attached to different classes of shares, which is common among these companies. In the case of JD.Com, foreign investors need to be completely confident of their alignment with the founder as he controls twenty times more voting power should any disagreement occur. While these arrangements have so far been honoured, they are ripe for abuse and give no guarantee that they will stand the test of time or any political change.

Politics can change quickly

We are particularly nervous about Emerging Market billionaires who become politically connected and advantaged. Political connections can provide tailwinds but we find it very difficult to predict, if and when, such winds may alter course. At present, media in China is mostly closed to foreign competition but should the increasingly powerful Chairman of everything, Xi Jinping, feel threatened, or simply be so inclined, circumstances could quickly change. We remember too well what happened to the share price of Russian company Yukos when its CEO fell out of political favour. He who giveth can taketh away! In addition to politicians, society provides a license to operate which, as in the case with Facebook, can be harmed if it is deemed to be overly intrusive or misused. Despite such apparent risks, Chinese internet companies have proven to be extremely popular. In 2017 they doubled in value and are collectively worth more than US$1 trillion in market capitalisation. Their substance is poor but their form is good with strong operating and share price momentum. For many investors this presents interesting behavioural challenges.

We follow a strict adherence to another tenet: "We will not succumb to irrational exuberance in good times, nor unjustified gloom in bad times."

 

Chris McGoldrick is a member of the Sustainable Funds Group investment team at Stewart Investors, a semi-autonomous business unit within Colonial First State Global Asset Management, a sponsor of Cuffelinks. This article is for general information and does not consider the circumstances of any individual.

For more articles and papers from CFSGAM, please click here.

[1] M. Keswick, The Thistle and the Jade.

[2] Zhaohui Hong, The Price of China’s Economic Development: Power, Capital and Poverty. p124

[3] China’s Economy – What Everyone Needs to Know. Arthur Kroeber. P36.

 

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.