3 years ago

Blue Chip Journal - January 2020 edition

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OFFSHORE INVESTMENT Investing in China – caveat emptor? Understanding Variable Interest Entities The success that Naspers has enjoyed ever since investing ‐million in Tencent in 2001 – then a relatively small Chinese Internet company – has been the stuff of legend: this single investment has gone up approximately 4 000 times to an overall valuation in excess of 0-billion in less than 20 years, explaining most of the market capitalisation of Naspers (as well as its recent offshoot, Prosus) today. Some investors may not, however, realise that Naspers doesn’t actually own its stake in Tencent directly. Instead, the group enjoys its lucrative exposure to the Chinese business through a structure known as a Variable Interest Entity (VIE). The same is also true for investors in Alibaba, Baidu, Meituan and all other foreign-listed Chinese Internet firms. In a nutshell, this structure involves setting up two entities: the listed entity as well as the VIE itself. The latter is wholly owned by Chinese citizens, typically the tech firm’s founders, and holds the operating licences required to do business in China. Crucially, however, all the VIE’s economic benefits are transferred to the listed entity via contractual agreements – effectively sidestepping China’s restrictive foreign investment laws (without transferring the “normal” equity or voting rights). VIEs have questionable legal standing in China and they do not give shareholders the rights typical of direct ownership – as such, they entail a very different level of investment risk. In a column entitled “A legal vulnerability at the heart of China’s big Internet firms”, The Economist magazine described VIEs as “the weakest link” as far back as September 2017, for example. Most investors take a relatively sanguine view of the situation in the belief that neither Chinese companies nor the country’s government will compromise the integrity of VIEs: any serious abuse of the structure will clearly damage China’s reputation among international investors. Rob Vinall, founder of asset manager RV Capital, had this to say about VIEs in a recent newsletter: “The structure is elegant In a nutshell, this structure involves setting up two entities: the listed entity as well as the VIE itself in that it squares the apparent circle of China’s insistence on local ownership, Chinese companies’ need for capital and foreign expertise, and overseas investors’ desire to profit from the growth in Chinese companies’ earnings.” It should, however, be noted that there has been at least one case where VIEs were found to have violated Chinese contract law (just Google the “Alibaba Yahoo spat”). Further, over time it is likely to become increasingly difficult for Beijing to explain to domestic investors why it is that foreigners are deriving most of the economic benefits of China’s most dynamic sector; at the very least, investors need to be mindful of this risk. Notably, VIEs are absent from China’s brand-new Foreign Investment Law – legislation indicating that the country is moving to become a more open, rulesbased economy. It comes into effect in January 2020 and seeks to level the playing field for foreign investors, while providing certainty on issues such as the protection of intellectual property rights. The devil will be in the detailed implementing rules expected later, but the law is certainly a sign of positive reform. It would thus appear that investors in Naspers (and/or Prosus) probably don’t need to lose too much sleep over their exposure to a somewhat quirky capital structure. It does, however, continue to be a potential risk that one should not lose sight off completely – especially if you happen to have an “index” exposure to the group (or more particularly, an overweight one), given its increasing dominance of the South African equity market over the past few years. Deon Gouws, Chief Investment Officer, Credo Wealth, London 28

OPINION Rising above the hype 2019: A year to remember – but will you remember it as it truly was? As I sat down to reflect on 2019, I felt, frankly, overwhelmed thinking about everything that has happened in the past 11 months. I was reminded about a book I recently read: Factfulness by the late Swedish medical doctor, Hans Rosling. This insightful book talks about the 10 behavioural instincts that distort our perspectives on the world – two of which particularly resonated with me given how I had been reviewing the year: A single perspective where we rely on media to form our world view and, secondly, the negativity instinct where we notice the bad more than the good, believing that things are getting worse when things are actually getting better. There has certainly been no lack of negative news in 2019 to feed both behavioural instincts to formulate a world view. Internationally, every time President Trump tweets, there is an apocalyptic media storm; the US/China trade wars subside and escalate almost weekly; the Brexit saga keeps finding new chapters to write. Closer to home, we are bombarded with public stories about President Ramaphosa’s inaction, the teetering SA economy with its high and rising unemployment, Eskom loadshedding woes, and the likelihood of prescribed assets, to name a few headline-grabbers. One only has to attend a social event or scroll through social media to get a sense of how these stories are formulating opinion and perspectives. Negative news headlines have created uncertainty and scepticism for investors and a sense of impending doom. South African investors have responded by investing in money market and income unit funds due to poor equity and balanced fund returns over the past five years. But is this a balanced perspective? Actually, no. Let’s look at the facts. Had investors remained invested in a globally diversified portfolio, like the Nedgroup Investments Balanced Fund, they would have experienced a 12.4% return compared to the average money market fund return of 5.6% or average income fund of 8.4%.* As at the end of November, global equities were up 22.5%** in US dollars for the year to date, despite all the news covering US/China trade wars. Meanwhile, SA equities*** were up 8.5%, albeit concentrated in the performance of the platinum and gold stocks. South Africa’s euro bond issue was 2.7 times oversubscribed. What do they know that we don’t? Another misconception is that the markets have been extremely volatile. In reality, it has been close to a multi-year low as shown by the US Volatility Index (VIX) and South African Volatility Index (SAVI) in the chart below. Source: Bloomberg based on weekly data to from 2 October 2000 to 15 November 2019 Clearly, we need to nurture a more balanced, fact-based view of our environment. The endless criticism of President Ramaphosa’s inaction was put to rest by political analyst JP Landman. In his recently published research note he highlighted all the positive developments and initiatives undertaken by the President including the challenges. None were widely reported in the mainstream media. Recently, national pride was bolstered by winning the 2019 Rugby World Cup and securing R365bn of investment pledges from domestic and international corporations at the second annual South African Investment: Conference in the same week. This sends a positive signal to investors that corporate South Africa is becoming less negative on their expected return on investment. Of course, ignoring the prevailing headwinds and uncertainty would be unbalanced. However, during these periods we encourage clients to remain invested in globally diversified portfolios, not to get distracted by the headlines, focus on reducing costs and demand transparency from their service providers. According to Dr Hans Rosling, the world is improving much faster than the mainstream media would have us believe. Investors who stay poised amidst the hype and noise will benefit in the longer term. Quaniet Richards, Head of Institutional at Nedgroup Investments * Source Morningstar calculated from 31 December 2018 to 31 November 2019. All performance is quoted net of all fees with all income reinvested ** As measured by the MSCI All Countries World Index GR *** As measured by the FTSE/JSE All Share Index TR 29

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