There are a lot of fund managers/investors who subscribe to the Graham theory that you should consider yourself a part owner of the business when you buy shares. I would fall under this camp and I think more investors should.
However a lot of the time I see these same managers who subscribe to this theory owning and assessing overseas Chinese shares. This I struggle to reconcile.
China restricts foreign investments in certain critical industries to protect these industries from foreign competition. To work around this restriction Chinese companies have been using Variable Interest Entities (VIE) structures. Most of the Chinese companies that are listed on US exchanges are done using the VIE structure. These include companies like Tencent, Alibaba, JD and Alibaba to name a few. This VIE structure has been used for a number of years.
VIE’s can be complicated but the basic idea is that you do not own the voting rights of the underlying Chinese parent company, rather contracts are established so the new structure (ie the US listed version of the company) owns the rights to the economic benefits of the Chinese business. In short you should own the cashflows, assets and liabilities of the business but not the voting rights or control of the underlying business in China.
How this plays out in theory I am not so sure. We see a lot of Chinese companies listed on foreign exchanges that have a lot of cash on their balance sheet but the reality is that is stranded cash, it never makes its way to shareholders. With capital restrictions are you really a part owner of the cashflows of a VIE listed business?
We are all taught early on that a company’s value is the discounted future cash flows of the business. But can you really value a business if the cash flows will struggle to make it out to shareholders?
If you are not sure of the risks of VIE’s here is an extract from the Tencent Music’s prospectus lodged late last year:
“If the PRC government finds that the agreements that establish the structure for operating some of our operations in China do not comply with PRC regulations relating to the relevant industries, or if these regulations or the interpretation of existing regulations change in the future, we could be subject to severe penalties or be forced to relinquish our interests in those operations.”
A famous investor uses the following rule when thinking about his investments:
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain”.
To me the VIE structure makes the possible loss potentially zero so it is too great a risk for me. Who knows what will happen in China. Maybe the government will open up the capital markets and the cashflows of these business will flow to investors according to their DCF models. Or maybe not.
I think some of these Chinese business are fantastic and would love to own if I was a part owner of the business and could have access to the cashflow. But for now it is a pass.