Insights

One of the rules with which we manage our affairs is to not invest in businesses that we cannot fully understand or where our interests are not fairly treated. To this end, we do not invest in businesses that are associated with:

1. 1. 1. Questionable corporate governance practices,
      2. Poor quality of earnings, or
      3. Unhealthy balance sheets.

Over two decades of researching and investigating businesses globally, we have researched several China-based businesses. In just about every one of these businesses, at least one of these rules triggers. Making matters worse, many of them do not even confer ownership of the operating business in the hands of the foreign shareholders. Instead, such shareholders own interests in variable-interest entities (VIEs). These entities in turn have contractual arrangements with the operating business as against direct operating ownership.

As investors, we wholeheartedly agree with Mr. Buffett as he quips “Shares are not mere pieces of paper. They represent part ownership of a business.” Accordingly, before making any investment, we take the approach of a prospective owner. And we like our businesses to treat us in that same way. Not having proportionate ownership in our investees breaks that connection.

Alibaba and its founder, Mr. Jack Ma found themselves in the centre of the news cycle as the IPO of Ant Group was halted by Chinese regulators. Indeed, we have spent considerable time and research effort in analysing Alibaba. It is a business that ticks all of our boxes of being a good to great business.

However, we decided not to invest in Alibaba as we found ourselves with corporate governance and quality of earnings red flags. For one, the ownership issue is present with Alibaba’s ADR listing. The ADR confers ownership of a VIE which has contractual agreements with operating entities. The validity of these agreements, as far as Chinese regulators are concerned, is unclear.

 Another issue was related to disclosures. In 2019, Alibaba stopped breaking out the loss incurred by Cainiao, their logistics arm. Interestingly, our analysis suggested that the losses at Cainiao may have more than doubled in 2019 as compared to 2018. Efforts to contact their investor relations to get clarifications went unanswered.

While we don’t like to generalise, our investment process at times results in avoidance of whole countries. As things currently stand, none of China-based businesses qualify through our filters. It doesn’t mean that we will not be spending our research efforts on China-based businesses. With China accounting for 16% of the global GDP, both China as well its businesses will be relevant to our investment research. What it does mean though is that we will not commit our investment capital while these red flags persist.