How is China reflected in investors’ benchmarks?

Probably the single most contentious debate in emerging markets is the debate over the future of China.

Views range from China’s economy being caricatured as a bubble, pumped up by excess debt and an investment-driven bubble in infrastructure and real estate, to those who believe the outlook is much more nuanced than the voluble hedge funds would have us believe.

However, while investors have been having a raucous debate about the future of China, the markets have been changing dramatically. For most investors, China looks very different from only 18 months ago. What we mean by this is that the make-up of the benchmark MSCI China Index has changed significantly through MSCI’s decision to include non-Hong Kong listed Chinese internet stocks (primarily Baidu and Alibaba) in its China indices for the first time. Internet stocks represented 9% of the MSCI China Index at the end of 2014 and now represent as much as 33%. This is a dramatic change in how China is captured in most investors’ benchmarks.

The dominant Chinese internet companies are collectively known as ‘BAT’ – short for Baidu (loosely analogous to the ‘Google’ of China), Alibaba (China’s largest e-commerce retailer, often compared to Amazon) and Tencent (China’s social media network provider, akin to Facebook). These companies are a world away from the more traditional state-owned entities that used to dominate China’s indices. They are highly entrepreneurial companies, offering an investor significant growth potential. Alibaba’s Taobao (consumer-to-consumer) and Tmall (business-to-consumer) marketplaces have caught the imagination of the Chinese consumer, and Tencent’s WeChat (a combination of a messaging app and a social network) are purely products of China and its culture, and owe very little to products developed elsewhere. However, as with many of China’s private companies, potential reward is combined with potential risk. China’s internet is effectively barred to foreign investment (only Chinese citizens can hold the licences and technology), so how come foreigners are allowed to invest? ‘VIE’ (variable interest entity) effectively leaves ownership of the asset in Chinese hands, but transfers the economic interest to the listed entity (by means of a number of contracts) to allow foreigners to invest in it.

Of the three companies, Alibaba perhaps is the highest profile name, and in particular, its charismatic and visionary founder Jack Ma. It has also been the most controversial. Since its separation from Alibaba, Alipay has become the hub of a broader financial services business privately developed by Ma, now called Ant Financial Services. One of the more interesting aspects of the BAT companies is their governance arrangements that owe more to the US than any Chinese influence – by this we mean how they remunerate their managers and executives and a focus on adjusted earnings, which exclude share-based compensation. As Warren Buffett so memorably, and correctly, said, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”

For Baidu and Tencent, share-based compensation in the last financial year amounted to 7-11% of operating profit and 2-3% of sales. Remarkably for Alibaba, it amounted to 36% of operating profit and 16% of sales. Share-based compensation per employee at Alibaba was 13x that at Baidu and nearly 5x that at Tencent. Thus some of the core governance issues in the Chinese internet arena are very similar to those our colleagues face when they invest in the US stock market. And that is the point. As bottom-up stock-pickers we find the Chinese market very interesting given the diversity of companies within the market, and within particular sectors. The economy will inevitably go through good and bad cycles, but the ceaseless pace of change will continue, in our view, to throw up numerous investment opportunities in a very diverse and increasingly deep capital market.

Archie Hart – portfolio manager – Investec Asset Management