The third quarter 2018 issue of Columbia Business School's Graham and Doddsville magazine contains an interesting interview with Tweedy, Browne Company. Founded in 1920 and still following the principles set out by Benjamin Graham and David Dodd today, the company is a pillar of the value investing community.
The interview, with Tweedy, Brown's Roger De Bree, Andrew Ewert, Jay Hill and four other members of the firm's investment committee, covered multiple topics, including investing in China, specifically, in the country's technology stocks.
De Bree said that while the firm does not traditionally invest in tech companies, it has made money in the sector in the past (particularly with Google). Having this experience behind it, the team was more comfortable diving into China.
But China's tech stocks are not the same as those of their Western allies. There are several fundamental differences. For a start, Western investors can't buy the underlying equity of these businesses because they are deemed "strategically important companies" by China's government. This means foreigners cannot own them. As Ewert explained, what Western investors are actually buying today is a "contractual arrangement:"
"The shares listed in the US represent companies that have contractual arrangements with Variable Interest Entities (VIE) in China. For example, Baidu BIDU has contracts with the VIEs to receive Baidu’s economic rights instead of direct ownership in the company. So you, as a shareholder, own a structure with a contract. You don't actually own the underlying business."
An interesting side note -- one of Graham's most important lessons for investors is that shares are not pieces of paper and do represent a piece of a business. This understanding has been crucial to Warren Buffett (Trades, Portfolio)'s success over the years, and that of many other investors like him. The debate is: Do these China-based VIEs qualify in this respect? All U.S. shareholders have is a "structure with a contract" effectively controlled by China's government. Is this value investing, or is this derivative trading?
Ewert went on to say that this structure is a sort of "synthetic company," and "It’s not the real business." The whole structure is set up to "attract capital without giving up direct ownership or control of the companies because the Chinese government sees these industries as strategically important to their country’s development."
Is Tweedy, Browne worried about the Chinese government's involvement here? It seemed not. In the interview, the team said, "If the government were to take actions that would jeopardize the VIE structure, they would severely limit the ability of these companies to raise capital and also undermine their international credibility. That is not an outcome they want."
This is an interesting debate. On the one hand, you have attractive investments in the form of China's tech companies, but on the other, you have the risk of not owning the stock directly. Tweedy, Brown might believe that China's government won't jeopardize the VIE structure, but there is no guarantee.
I would not be comfortable owning such a structure, although I can see the attractiveness of holding a piece of China's rapidly growing internet economy.
But the ultimate question is this: What is the real underlying value of the shares (or contracts) available to buy today? Is it realistic to assume these contracts have an underlying value? Or, when the going gets tough, will investors be left to fend for themselves? China can quite happily finance its own expansion. Unlike so many other emerging economies, China does not require foreign direct investment to continue growing after years of explosive economic growth. If the Trump administration's trade war leads to further economic saber-rattling, the viability of these VIE structures could come into question.
Is the risk worth the reward?
Disclosure: The author owns no share mentioned.
Read more here:Â
Tweedy Browne Fund 3rd Quarter Shareholder Letter
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