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

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.