A Tale of Two Indices – Discussion with Steph Gan
June 9, 2020
Seafarer Capital Partners
Navigating the Complexities of SOEs in Emerging Markets
Hello, and welcome to Seafarer Capital Partners’ discussion of state-owned enterprises in the emerging markets. I'm Daniel Duncan, Managing Director of Business Development and Client Services at Seafarer. I'm happy to be joined by Nick Borst, Director of China Research; Paul Espinosa, Lead Portfolio Manager of the Value strategies here at Seafarer; and Andrew Foster, Founder, Chief Investment Officer and Lead Portfolio Manager of the Growth and Income strategies.
In our conversations with investors, we’re often asked how, when looking for quality companies and good management in the emerging markets, you can avoid investing in state-owned enterprises. While there's a lot of truth to those questions, it really is much more complicated than that, and so we're going to discuss how to take a deeper dive and truly understand what it is you're investing in.
So, Nick, if you can get us started by talking about what a state-owned enterprise is, and what risks investors may be looking to avoid when investing in them.
Great, thank you, Daniel. Well, unfortunately there's not a clear definition of what constitutes a state-owned enterprise. It would be a lot simpler if that was the case. So when investors are looking at companies in the emerging markets, by definition, they will have some level of private ownership if they're listed publicly.
But the question is, what is the important threshold for when a company becomes private versus state-owned? So, many investors will look at a company and say if the state owns more than 50% of the shares, then it's a state-owned enterprise. Some investors will put that threshold much, much lower, saying that if the government owns 20% of the shares, it could be considered a state-owned enterprise. Some investors will even look at who the controlling shareholder is, or the combination of controlling shareholders. Unfortunately, it gets very, very murky and it requires a lot of judgment and there are no clear and fast rules.
One approach I try to take, given that uncertainty, is to look more at the actions and behaviors that investors would be concerned about. And in my mind, it's more a matter of what a state-owned enterprise or non-state-owned enterprise is being forced to do that may be contrary to the interest of the underlying shareholders. And so it's really an issue of state control, rather than looking at traditional state ownership. So, if we look at the example of China, there's a core of listed state-owned enterprises, there are some completely private enterprises, and there’s actually a lot of companies that are in the middle. I call it the murky middle, where there's some state ownership, some private ownership – it's not entirely clear where this company would be categorized.
So, in that case, what I try to look at is what levels of state influence a company may be subject to, and really more than ownership, it's often the industry that a company operates in. If it's a sensitive industry, if it's an industry that the government thinks is strategic, it really doesn't matter whether they're state-owned or privately-owned. Companies in those strategic industries are going to face a lot more influence from the state and a lot more pressure that might force a company's management to do something that might be contrary to the interest of the private shareholders.
So, Andrew, from the CIO point of view, if you're leading the team on researching companies that may have a good deal of state ownership, what matters in that research process? What aspects of those companies are you're looking for?
Well, as Nick has already explained, I think it's quite difficult to parse companies’ ownership structures in some sort of binary way – state-owned or non-state-owned – because even within those ownership structures, there's varying degrees of percentage ownership, for instance. As Nick has also stated, I am a strong believer that what matters are the behaviors and actions of the company, because I construe them as being manifestations of the control structure of the company, which is far more important to me than the ownership structure. A lot of times, ownership and control go hand in hand, but that's not always the case. And so what matters most is not the question, is this company state-owned or not? But rather, is this company state-controlled or not? Or, frankly, for even private sector companies, who is the control party and what is their agenda in running this particular company?
So, to explain the idea of control party analysis a bit further, to my mind it rests on the idea that you should begin analyzing a company without a clear perception of who controls it. You may be able to identify readily, in theory, the largest owning shareholder, but you may not actually know who the control party is that actually pulls the strings in the company.
So, what instead you should do is look at the behaviors of the company and particularly three key behaviors I tend to zero in on.
First, which party or entity makes major decisions about the company's decisions to enter or exit new lines of business or add or delete an existing product from its product lineup or service lineup? So, those major strategic turning points about: we're going to enter this new business line, or we're going to divest from this business line, or shut down this product. Those decisions tend to be taken by the control party.
The second key behavior that I pay attention to is large capital expenditure decisions. Smaller ones are typically routine, but almost every board has a level at which the board forces the corporate management to present major capital expenditure decisions and sometimes there are major decisions where some party that may not even sit on the board gets another layer of review. And so I'm most interested in those layers of review – who's conducting the decisions over large capital expenditure.
And three, I look at the incentive structure for management and particularly who's designing that incentive structure.
Typically, the same party or entity is behind those three key types of decisions, because they're so instrumental to the success or failure of the company. And so once I know or have at least a working idea of who pulls those three strings, then I have a working hypothesis as to who actually controls the company, regardless of who the largest shareholder is in the company.
The next key piece of control party analysis is then to say, based on what I've observed the company doing, and based on what I can glean about the potential control party, what is the likely agenda that the control party has for the company? What are they intent to do with it? And this is critical, regardless of whether the largest owner is state-based or maybe ostensibly coming from the private sector. Because there's a tacit assumption among many investors – which I think is entirely wrong – that companies are run primarily for profits or for growth, or things that might create a higher share price or create shareholder value.
And that's just not true. Companies are run for all sorts of reasons, including by private sector individuals. They're run sometimes to burnish their personal image, or maybe they're run just simply to expand market share and they don't pay much attention to the bottom line of the company. Maybe it's being run as a vehicle for intergenerational wealth transfer and not necessarily to maximize profit. Maybe if the control party is a state-based actor, they may have certain broader social goals that go well beyond what a profit-oriented shareholder might expect.
So, in the control party is vested the control, and they have the right to determine the corporate agenda. Or at least maybe they don't have the legal right, they have the de facto right, to control the company's agenda. And so it's essential to start imagining or hypothesizing what that control party is up to.
The last piece of control party analysis, the third piece, is to just simply – once you've figured out who the control party is using those three different types of transactions, and then started to hypothesize what the control party might be up to – the third step is to then try and figure out how well does the control party's agenda or corporate purpose align with my objectives as a non-control minority shareholder.
And anyone who is thinking, you can find companies where there will be complete or near complete alignment is, I'm afraid, not really working in the real world, and I would say that about developed countries, emerging market countries – it doesn't really matter where your lens of analysis is. It's very, very rare that the control party is really working for and is completely aligned with minority shareholders’ objectives.
But that stated, there are control parties whose objectives generally are oriented towards goals and objectives that minority investors might share. And the most obvious ones are making sure the company is being run in a sustainable manner that promotes the company's social and corporate health, and that leads to hopefully a strong bottom-line profitability and hopefully profitability that grows and expands over time.
So, to the extent that the control party has those objectives, that can mean the governance of this organization is already aligned with what I want to achieve, or, at least, it appears to be, based on the transactional record of the company – and then there's always risk, but you're probably in better grounding to make a sound investment.
To summarize all this, it's really critical to look at the behavior and motivations of the people controlling the company and to make sure they align with your own objectives – that's really what corporate governance analysis is about in my view. And not so much looking at an ownership structure and making binary, often facile, judgments over the motivations of the largest percentage shareholder.
It makes sense that the control party doesn't always wear a name badge that says control party on it, so you have to do some work to figure out who that is. Could you kind of put this into some real-world examples and provide some examples where state-ownership was involved, and we figured out who the control party was, and what their incentives were?
At the risk of overly reducing the complexity of this kind of work – for the first thing I'd say, often when the state is the control party, those objectives that I mentioned that the state has, are typically not well aligned with minority non-control investors. And so, I would concede many times – not all the time, but many times – it does not make sense to invest alongside a state control party. But there are three archetypical exceptions that I think – again, not to brush aside all the nuance and complexity of each individual case – but there are three archetypical exceptions where I think it can make sense to potentially invest alongside a state control party, at least, based on my experience so far.
Those exceptions would be the following:
The first is when you can identify what I call a hidden or emergent control party, where the state may be the largest owner of the company, but where, for whatever reason, the state has ceded control either explicitly or implicitly to a key corporate manager, typically the managing director or CEO, and that person has de facto control over the company and you can trace that that person has clear commercial motivations to lift the company's performance and profitability.
This is often a wonderful happenstance if you can find it because many investors summarily reject analysis of state-owned enterprises. They choose not to own them. The shares of the company can be cheap. And yet, you have a corporate actor who is de facto in control of the company and who is pushing for a greater degree of performance and profitability. So you might be able to acquire the shares cheaply and invest in a stronger corporate performance that the market is not expecting. And that can be very powerful because often that state company, having come from presumably state origin, often sits with a high degree of control over their given market, they might even be a monopolist or near monopolist in their given market space, or they might have certain advantages with becoming a long-standing incumbent in that marketplace. And so, when you have this strong position in the marketplace, combined with maybe a cheaper valuation, potentially, and a corporate actor who has clear commercial motives – that's a pretty powerful setup for investment success. This is a rare case, though, and it's hard to find.
The second archetypical case that I can point to is where the state is in control, but the state has almost no alternative but to turn around the otherwise poor and problematic behavior of the company. This typically happens when the company is being run very poorly, maybe run into the ground, and if the state wishes for the company to survive and prosper, it has really almost no other alternative but to modify its behavior to run the company better. And so, you're effectively investing in – I hate to put a shorthand jargon on it – but you're investing in something of a turnaround scenario where the company, its corporate performance, will hopefully be lifted, but you've got to monitor that situation carefully to make sure the state is making the right decisions to actually turn around the company.
And I think one also has to be wary about how long one holds the company in that instance because if the state remains in control, maybe they can turn around the company and you can invest in that turnaround, but that doesn't mean if the turnaround is successful that it will lead to compounding growth over time, because the state may return to its bad behavior post the turnaround.
The third instance that I would point to, the third exception that we've seen in the past, is the relatively straightforward case where the company is being run on a fairly clearly governed and transparent basis. Maybe it has a clear operating agreement in place, a clear set of rules and regulations that dictate how the company should behave and perform. And this is frankly most evident in the utility sector, where minority investors may not exhibit real control over the company, but the company has been set up with a clear particular strategic purpose, maybe to provide power at a certain rate and with a certain rate of return, that when priced properly may be attractive to you as a minority investor. And it really comes about from clear operating principles and clear transparency about how the company is being conducted. There are still risks that the state control party might abuse those operating agreements or act in some way to countervail them, so I'm not suggesting that you can simply trust and forget. You've got to trust, monitor, and continue to verify the performance of the company, but it's a relatively straightforward situation.
Paul, we've talked about some of these instances in the past, where we made these kinds of investments, do you want to talk about a couple that you made? Maybe I’ll offer one, too.
I think China Foods is quite relevant to the case number two you were describing earlier. This is a Chinese Coke bottler and distributor. And before going into this company, let me just add that everything we've talked about is not only relevant, but particularly so these days, in China, because, as we all know, we have an administration that has, at least for now, prohibited investment in certain Chinese companies that are linked to the military, the People’s Liberation Army. And in the case of China, the added layer of complexity here is to distinguish between government and military ownership – not easy in China. And in addition to the usual distinction between control and ownership, which is also a murky area in China as well.
Now with that said, in the case of China Foods, we have a very interesting case because this company is 74% owned by COFCO – this is the largest Chinese state-owned agricultural trader and food manufacturer. And it's particularly interesting because the stock trades at a historically low valuation because it indeed has been a poorly performing company for decades. Now, why do we invest, despite it being owned by the state, effectively, and despite it having a poor track record of performance? And that is because we saw very visible and tangible changes being made on the ground.
It is interesting that the Coke Company is also playing a role here. The Coca-Cola Company is a partner with, in this case, the state-owned Chinese enterprise COFCO, and is a JV partner, effectively, in this company. In my view the Coca-Cola Company has prodded the Chinese government, or at least parts of the government that are in charge of this company, to improve performance. It is striking that China Foods has one of the largest target customer populations of all Coke bottlers all around the globe, and yet it has one of the lowest profitability of all Coke bottlers all around the globe. Clearly the Coke Company is dissatisfied with this, and in my view, without having confirmation, but in my view, it's clear that there is some private sector influence over the future management of this company, and so this has resulted in China Foods making very visible improvements towards better management.
Specifically, it has divested of non-core businesses, specifically these relate to a confectionery business and an oil business. It sold those subsidiaries, and it's now fully focused on being a Coke bottler. Furthermore, not only did it divest from non-core businesses, it used the proceeds in excess of $800 million to pay over 40% of this amount as an extraordinary dividend. This is very good treatment of minorities – it wasn't the state just gathering all the proceeds for itself. It shared them with the shareholders, including private and foreign shareholders like [the Seafarer Overseas Value Fund].
And at the time, this equated to an over 20% dividend yield, so, very important, very substantial, and the right thing to do. So that already points to a change in corporate governance. In addition to being more focused, it has restructured its territories, such that it should, from now onward, extract better operating performance and profitability from its territories.
The stock continues to trade at a valuation corresponding to that of an SOE, a state-owned enterprise, that is poorly managed. Yet we, at Seafarer, see that changing and that's why we invested. And it's a very interesting example because it's a live example of the process of change within China. And it's taking place in real time.
And I’d like to chime in with another example in the instance of Ping An, a financial holding company. Ping An is often cited as one of China's most successful cases of a private sector company in financial services. It’s a financial services conglomerate centered around insurance, but also with reach into banking services and many other types of financial services within China. It's probably, or at least arguably, the best and most well-rounded financial conglomerate in the country, and it's often vaunted as being an exemplar of private sector management skill, because it was founded by Mr. Ma Mingzhe in 1988 – but actually that's not true.
It was actually founded by – it was actually a joint undertaking by – three state-owned enterprises, made up of one of China's largest state-owned banks and two shipping-related entities. And the three of them came together and injected assets to create the original company in 1988, and Mr. Ma was rather a key manager that was put in charge of running the company. The history has blurred over the years, to the point where people refer to him as a founder, but that's actually not true.
We own Ping An in the Growth and Income Fund today, and it is an example of success, but it really is an example of a state-owned enterprise that had, while under state ownership, a private and commercially motivated key manager, who had been ceded, for the most part, control over the enterprise.
And yet still, one can detect even now, today, certain vestiges of the control from those three enterprises in Ping An’s behavior. So, it is not clearly a private sector company, even today, and this goes back to this issue, this binary classification that some investors seem to want to make between state-owned and non-state-owned. Even today, Ping An, which is held up as an example of private sector enterprise in China, is actually not truly free of state influence, and particularly those original three state shareholders in its control structure.
So, I'd say that that's an important understanding, but it is an example of that first exception I talked about – an emergent or hidden control party. Mr. Ma effectively had control over the company from its earliest days and he led it to a much stronger corporate performance. I doubt – had those three state entities retained control as their ownership structure would have suggested – that the company would have performed as well.
And that's critical to me, particularly in the context of emerging markets, because you want to invest in that kind of change. You want to invest in companies that are seeing their state control decline over time – and more commercially motivated actors taking greater control of those companies and leading to the kind of growth that can come from that sort of shift. So, while these sorts of situations are rare, they are, in my view, exactly what you want to try and find in the emerging markets – rather than outright exclude because of some sort of facile binary sorting mechanism.
I think Andrew is exactly right on that. Ping An fits this example perfectly of a company starting out with heavy degrees of both state influence and state control. If an investor had applied a very rigid binary approach to screen out a company like Ping An, you would have missed one of the greatest transformations in corporate Chinese history. And there are many companies that have failed to successfully make that transition. Some have backtracked.
But I think it's important to keep your eyes out because as Andrew mentioned, those can be some of the greatest unlocking of value possible – when you take a very poorly run SOE and turn it into something very different.
Especially if one affords patience and time to the investment. These kinds of changes that Nick is talking about – or that Paul mentioned – don't happen within a year. And sometimes our timeframes for judging the success of how a company is being measured are too short, particularly for either formally state-owned enterprises or entities that are changing how they're being run. So it doesn't excuse bad decision-making at the corporate level or extended poor performance, but it also suggests that one needs to be patient for that unlocking of value to happen, because sometimes it's coming from very difficult beginnings or structurally challenging beginnings where the state may have held a great deal of influence over the company, but it's being either turned around, or a new control party – a more commercially oriented one – is running the company better.
Certainly, thank you. It seems that embracing the complexity and understanding what you're investing in is the key here.
Possibly adding another layer of complexity is regulation coming from the United States, where recently we've had the Chinese Military Company Executive Order [Executive Order 13959] that has banned investment in certain Chinese military-connected companies. Nick, could you provide us a little bit more of an insight into what that ban means and what it can mean for investing in state-involved companies in China going into the future?
So, just to recap, last November, the Trump administration released a new executive order on what they refer to as “Communist Chinese Military Companies.” This was a list of companies that had initially been identified by the Department of Defense over the summer. That list has been updated a couple times since then. It is a list of companies that investors, starting this January, are no longer permitted to make acquisitions of, and eventually – if the rule is not altered by the end of this year – we’ll actually have to divest from these companies.
And so the motivation outlined in the order was that these companies identified specifically – even though they may be private in name, private in ownership – are subject to some level of state control that in the viewpoint of the U.S. government means they are actively, directly, or perhaps even indirectly supporting the military modernization efforts of the People's Liberation Army. And so, in that way it's interesting that the executive order seems to be adopting in some ways a viewpoint toward ownership and control that is similar to our own. It's not looking explicitly at “Chinese companies with ownership thresholds above this percentage point level will be allocated to the Communist Chinese Military Company category.” It's something that's more complex than that. It's trying to get at deeper issues of control that go beyond ownership.
That said, I think there are some issues for investors raised by this order. Number one, of course, it can always be difficult to divest from a position. But even more important is the way that it's been rolled out, with a lack of transparency. There's not much information provided on why these specific companies have been added to this order. Some of the companies may make sense, as they are apparently connected to sectors that have a more strategic nature. Some have frankly come as a surprise, where they don't seem to be directly related to any sort of military endeavor. So, it's something that we pay very close attention to. We continue to adhere to the order and take steps to respond to it.
But going forward, as you mentioned, Daniel, it's this new layer of complexity of regulation now coming from the United States government on this issue of state control, that we will have to adapt to and respond to as part of our investment process.
I’d chime in, I think the CMC order definitely complicates investment into China by a compliant U.S. entity, like a mutual fund. The government's actions are by no means random, but they are at this stage not predictable. I mentioned what I zero in on to determine the control party, again: large or major strategic decisions, large capital expenditure decisions, and the entity who designs the compensation and incentive structure for the company management.
Once you know who does those three things you have a pretty good sense of the control party from a corporate perspective. But what our government is doing is highlighting which entities in China might be controlled or linked to the Chinese military, and they have not, at least yet, made clear what factors they are looking at. They haven't identified their three, their two, three, ten items that they're paying attention to. And quite understandably, this stuff probably needs to remain confidential in most instances, but it makes the landscape very unpredictable today, for investors. So, we're trying to be very wary and cognizant of the kinds of factors the government may be applying in this instance, but it really isn't predictable to us, at least not yet because of the opacity of how the order has been implemented – the understandable opacity with which it's been implemented.
If there's one thing that I share, though, with the government – it's a real clear understanding that control matters, more so than ownership.
And as Nick alluded to, there's some companies that are obstensibly entirely privately-owned on the list, and yet they're being singled out as being militarily controlled.
Thank you very much. And Nick, Paul, and Andrew, thank you very much for this discussion. I believe this raises a lot of topics for our clients to think about and understand better as they think about their emerging markets exposure. And for the viewers, thank you very much for joining our session today, please do seek out the market commentary section of Seafarer’s website for more discussions and commentary on these types of subjects.