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Welcome back. I got a lot of thoughtful mail on the question of competition and profits, so I will probably hit that topic again tomorrow. Meanwhile, it’s back to China. Email me robert.armstrong
What is the right price to pay for a company you’ll never own?
A week or so ago the Cyberspace Administration of China announced an investigation of Didi Chuxing, the newly US-listed Chinese ride-hailing group, and had the company remove its application from the Chinese market. The problem was violation of laws governing personal data collection. Didi shares have lost 27 per cent of their value since. Other US-listed Chinese technology groups have been hit too: search-engine company Baidu has fallen 9 per cent, ecommerce giant Alibaba by 6 per cent, gaming group NetEase by 4 per cent, and so on.
Let me say before we go any further that I know only a little about Chinese tech and Chinese politics. I’m a beginner here. What interests me about the story is a philosophical question: how much should you be willing to pay for something you don’t truly own?
You don’t really own the US-listed tech stocks in two senses. The first is quite explicit. There are restrictions on foreign ownership of Chinese assets. So Chinese companies’ route to the big, deep US capital market is through “variable interest entity” structures, which substitute contractual obligations for ownership. Here, for example, is how Lucy Colback and I described Alibaba’s VIE structure in the Financial Times six years ago, when that company was listing:
Owners of [Alibaba’s US stock] will have a stake in a Cayman-registered company that — via intermediaries — owns onshore Chinese companies. These operate much of Alibaba’s business. Because Chinese law restricts ownership of certain telecoms assets to its own nationals, however, the licences that make Alibaba’s business possible — and some of the group’s profits — are held in so-called variable interest entities owned by founder Jack Ma and his colleague Simon Xie. Ma, Xie and the VIEs have contractual relationships with the companies that shareholders own. Owning the ADSs is a bet that these contracts will not leak value. Whatever they own, equity holders have no control.
The second sense in which you don’t really own anything when you own Chinese tech stocks is not so explicit, and is true to widely varying degrees of any security anywhere. You only ever own what the relevant governments say you own. This is as true in the US as it is in China; we just expect the two governments to behave quite differently.
In certain times and places this nasty fact becomes more visible than others. In the case of US-listed Chinese tech shares, we were all just reminded that the Chinese Communist party has an absolute say on companies’ use of personal data, and that the CCP has no compunction in drawing hard lines.
Here is what George Magnus, of Oxford university’s China Centre and former UBS chief economist, wrote to me on the topic:
Among the motives for the crackdown on many technology platforms, quasi-finance and data-intensive companies, two stand out in particular. First, the government has a well-founded angst about financial instability, and it sees egregious or controversial financial and data practices, which conflict with its own control, as threats to the order and integrity of the state’s financial system . . .
. . . Second, there is no question that the government, which craves control, is also determined not to allow private firms and entrepreneurs to build up their own power, derived from their ability to collect, pool and use data. It is a policy issue about which many of us fret nowadays, but China’s response, highlighted by the Didi case, seems clear. Public ownership or control over platforms in the digital economy is the only way to tame capital and ensure it’s politically subservient.
This clearly does not mean the CCP means to crush Didi’s US aspirations, as it did those of Ant Financial. As Jason Hsu of the asset manager Rayliant points out, if this were true, the party would not have allowed the Didi initial public offering to take place at all. From a research note:
An obvious indicator of the difference between these two is that the Chinese regulator halted the Ant Financial IPO in its tracks. By contrast, it politely waited until one week after the Didi IPO before announcing a formal investigation. If the Chinese regulator believed Didi’s deficiencies could not be resolved to its satisfaction or would jeopardise Didi’s operations in mainland China, it would have asked Didi to pull its US IPO — and Didi would have complied . . . Didi’s IPO was allowed to proceed precisely because, unlike Ant Financial, Beijing believed the company’s deficiencies can be remedied.
Hsu, like Magnus, thinks that stability is the key CCP goal. And the party does not trust market forces to take care of it:
. . . this intervention is not driven by senseless bureaucracy or a desire to punish success. The China regulator intervenes because it has a foundational (and sensible) lack of trust in its own inefficient capital markets. In China, the invisible hand wears a red glove.
China’s government is more likely than America’s, at this point in history, to assert its control over the companies you “own” when you hold shares. So how much less should one pay for a Chinese tech company than for a US one with a similar financial profile? What is the right CCP discount? It won’t be a fixed number, of course, and will vary across industries and so forth. But what is the right way to think about this?
I really don’t know where to start. So I crunched some basic numbers on the valuations of some Chinese and US tech firms, all listed in the US (sharp-eyed readers will note that the Google and Amazon numbers look a little different than the last time I ran them; I used 12-month rolling numbers this time rather than annuals). Here is what I came up with (working with company financials compiled by S&P Capital IQ):
The problems here are that historical data are a poor guide to the future of fast-growing companies, and that the US and Chinese groups, though in similar industries, are different. Didi ain’t Uber, Baidu ain’t Google, and so on. These are just a few simple numbers and you need to look at a zillion other things. But I think, for example, the yawning valuation gap between Alibaba and Amazon (in their price/earnings ratio, for example) tells you something important, given that both are vast, fast-growing ecommerce companies. Yes, Amazon has its great web services business, but Alibaba arguably has an even more impressive revenue growth record and even more room to grow in the future.
I have more work to do on this, but I suspect the China discount — the “you don’t own it” discount — is really big, and growing.
One good listen
The New York Times has put together an absolutely fantastic interactive audio piece celebrating the 50th anniversary of what is, in my view, one of the greatest records ever pressed: Funkadelic’s Maggot Brain. It lets you listen to each of the album’s tracks alongside songs that influenced it, and songs it influenced in turn.
I do not think it is a mere coincidence that Maggot Brain and I were both born in July 1971. Can you get to that?