4. Investing in Politicized Markets
Over the next 20 years, the international capitalism of the West will be increasingly joined by the state capitalism, “godfather” capitalism, and other politically infused forms of capitalism that are prevalent in many other countries. What the West calls crony capitalism, much of the world calls business. And as China, India, Brazil, and others become more potent forces in global finance, successful investors will learn to take advantage of the opportunities afforded by their forms of capitalism.
In these countries, companies cater to both customers and bureaucrats. Deals are combinations of commercial and government interests. Political power is often held by a privileged few, so economic opportunity is similarly concentrated. And the invisible hand of the market is paired with the heavy hand of government.
Societal implications aside, these systems can be very attractive for investors. A mixing of commercial and government activities can skew the markets, create large inefficiencies, and enable increased creativity in deal-making. I am certainly not asserting that these systems don’t have large problems (economic and political freedom being top of the list), but that they are prevalent and do contain attractive value opportunities. If Mr. Market creates opportunities for investment by driving prices away from true value, his giant cousin, Mr. Government, can have an even bigger effect. Mr. Government can move prices but can also create large increases (and decreases) in the economic value of enterprises. If Mr. Market is bipolar in the short term but generally wise in the long term, Mr. Government is generally heavy-handed in the short term and slower to learn in the long term.
Government-skewed markets can also vary more widely than free markets—swinging between rapid growth (Dubai and Macau) and stagnation (much of Central Asia). This is a significant contrast to the Western markets, which, with the exception of occasional boom and bust cycles, have been fairly stable and dynamic over the past 50 years. Government-skewed markets and government-directed economic initiatives, usually structured to drive development or some other objective, also create competitive situations that can vary between monopoly (Qatar) and hypercompetitive (China). For value investors, the wider spectrum of market and competitive behavior creates lots of opportunities.
But if Mr. Government can create attractive opportunities for investors and deal-makers, he can also create risks. The rules can change on taxes, tariffs, and even private-property ownership. The government can take sides. And an investor who lacks political connections can make a tempting target for entrenched local powers. A rabbit on the savannah doesn’t have to do anything wrong to be attacked. Being there is enough. The same could be said of foreign-owned companies in some government-infused markets.
Still, the investment and deal-making opportunities in government-skewed markets are in many ways larger than in the more efficient free markets of the West. Holding one of the few approved bank licenses in Saudi Arabia can be a guarantee of exceptionally high returns. Buying the shares of a Chinese petrochemical monopoly is a no-brainer at the right price.
Assumptions about the role of government represent one of the biggest differences between traditional investment approaches and a multipolar worldview. Traditional value investors view an active government as increasing uncertainty overall. And within industries, it varies between something that can decrease profitability through regulation (government-regulated entities often have less pricing power) or can increase it by limiting competition. Additionally, acute government actions such as regulatory changes are viewed as either events to be predicted in a short-term strategy or a source of long-tail risk.
In contrast, value point investors see politically inflected economies as opportunities for creative deal-making, and they aggressively target the market inefficiencies that government actors create. In many emerging markets, government is not just an actor in the market; it is the single largest player. We see government actors as partners for deals, and this can have very attractive results. An investor can secure land rights, redistrict property, obtain government contracts, receive bank licenses, borrow at low rates, and gain regulatory approvals (or, in the case of Carlyle Group’s attempted purchase of Xugong in China, regulatory denials for competitors). The next section details some of the more effective strategies for capturing the inefficiencies of politically infused markets and adding value with a political access approach. The power of this approach in many economies cannot be overstated. It is not just a way to make outsized returns; it is frequently the best way.
The large returns possible in government-infused markets are responsible for many of the large companies and cash-rich investors we are now seeing on the global stage. These rising stars often first make headlines as bargain hunters for brand-name Western assets. It was an unknown young Saudi prince who shocked the United States with his investment in a distressed Citigroup in 1991. Carlos Slim’s Mexican holdings propelled him past Bill Gates as the world’s richest person and into New York to buy a large stake in the New York Times Company. From state-owned enterprises out of China to oligarchs out of Russia, we are increasingly seeing companies and newly cash-rich investors from government-infused markets entering Western markets.
That said, a politically focused strategy should never imply doing anything that is less than aboveboard. The intersection of commercial and government interests can be a fairly disreputable place, and one should tread carefully. In politically infused markets, we strictly adhere to the core value point philosophy that investors and deal-makers search for the opportunity to add value. We capture wealth by building economic value in projects and by helping our partners. By adding value, we chart a strictly honorable course in any situation.
In the previous chapters, I outlined a value framework that adapts Graham’s Method to the increased uncertainty and instability that are inherent characteristics of many politico-economic systems. Politicized markets and active governments strike to the core of the “going global” problem. What would Graham have done in a market like China or Qatar?
Mapping the New Political-Economic World Order
A simplistic worldview to orient the microfundamentalists (and offend the macroeconomists)
To better understand different political environments, I have sorted national economies into four categories: godfather capitalism, state capitalism, advanced international capitalism, and developing international capitalism (see Figure 4.1). This is simple “cloud naming” that will surely offend economists and political thinkers of all types. But it is just for orienting direct investors and deal-makers. I am focusing on only those factors that matter for direct investing—the role of government, the degree of competition, the level of local management ability, and so on.
Figure 4.1. A simplistic investment worldview
The next section describes the first two clusters in detail and explains some of the opportunities and challenges that each presents. The other two, developing and advanced international capitalism, are not as politicized and are not discussed at length.
Liar’s Poker and Liar’s Dice
The arrival of surprisingly high-performance state capitalism
Go to any bar or nightclub in any Chinese town, and you will likely encounter people playing Liar’s Dice, with dice-filled cups slamming down on the tables and hand signals flashing back and forth. The game (which is great fun) often perplexes foreigners, because every player lies about what he has at every turn. The game is raucous and can be somewhat overwhelming for the uninitiated.
In a game with two people, each player slams down a cup with five dice hidden underneath. After checking your dice, you give a hand signal for what you think you and your opponent have collectively. If he flashes 7-2, it means he thinks that in his hand and yours are at least seven dice with 2s showing. You must then say this is a lie or raise the guess (such as eight dice with 2s, or seven dice with 3s). The game quickly becomes a sequence of falsehoods. Because I lied about this, his subsequent lie was likely about that, so my next lie should be....
Liar’s Dice is similar to the Wall Street game Liar’s Poker, described in Michael Lewis’s book of the same name. Players bet on the combined numbers of the serial numbers of bills (but in Liar’s Dice, you can’t cheat by carrying special bills in your wallet for the occasion). And the Chinese game is faster and louder, the falsehoods are more complicated, and a lot more drinking goes on. All in all, it’s an excellent analogy for the differences between doing business in state capitalist China versus international capitalist America.
For value investors and deal-makers, China is something new. It is autocratic, with no consistent rule of law, no separation of commercial and government activities, direct state control of many aspects of business, nebulous regulations with shifting implementation, and, most importantly, different rules for local and foreign businesses and investors. This is a system where who you are matters. It’s also state capitalism of a scale and sophistication never before seen.
China’s population is three to four times larger than any other globally competitive country. Chinese markets are almost always described by their very impressive aggregate sizes. But it is enlightening to divide that number by the 1.3 billion population. For investors, the key factor is that it’s overwhelmingly a very low GDP per capita environment. The second key factor is that the growth story is actually more impressive than it first appears. Historically China has constituted about one-third of the global GDP. Even after 20 years of 10% GDP growth, China is at only 8% of global GDP. It’s only directional analysis, but at the macro-level, lots of future growth is likely still possible. But if you look at the micro-level, at various local industries and markets (say, auto sales in Chongqing), the growth story is truly impressive. For value investors, China represents an interesting mix of high-growth, large-volume, low-income state capitalism.
However, in stark contrast to virtually all other large-population/low-income economies, China has a robust physical and government infrastructure and a history of fairly effective bureaucracy dating back several thousand years. You can look back 1,000 years and read about the Treasurer of Beijing or Nanjing. This unique strength in physical infrastructure and government bureaucracy makes China a particularly attractive landscape for investors. It doesn’t suffer from the chaos and dysfunction of many developing economies.
Most importantly, the Chinese economy can perform at a surprisingly high level. After 20 years of consistently high GDP growth, it is undeniably successful financially. China is now the world’s second-largest economy. The government reports over $2.4 trillion in official reserves. Beijing’s banking system is now larger than Australia’s. And China’s infrastructure, which direct investors care a lot about, is in many situations world-class (phones, Internet). In other situations it is leapfrogging developed economies (high-speed trains, continental integration of shipping).
For value investors, the primary issue is, as always, competition. And in China, the competitive dynamics are fascinating. The business and political environment is constantly shifting at the same time new capabilities and competitors are rapidly emerging. And all this occurs while talent shortages and information asymmetries abound. Chinese competitive dynamics are an entire subtopic of value investing in themselves.
In his book Competitive Advantage of Nations, Harvard professor and competitiveness guru Michael Porter argues that at the country level, competitive advantage is the ability to add tangible value to locally based businesses. This can be accomplished by deploying infrastructure that benefits companies or creating specialized clusters (Silicon Valley, Hollywood) in which a critical mass of customers, specialized labor, and specialized support companies can be concentrated. Both beneficial infrastructure and specialized clusters can give local businesses a competitive advantage domestically, regionally, and sometimes globally. China’s rapidly improving continental infrastructure is a big part of the competitive dynamics I consider in direct investments. A big market for consumer products such as Coca-Cola is only valuable if you have the roads and logistics to move the products within it. In a developing economy, the ability to deploy infrastructure is a big invesment factor.
China’s government has shown a truly impressive ability to create specialized clusters in areas like finance, technology, and manufacturing. The world’s next Wall Street, Hollywood, and Silicon Valley are already being built, and at a truly staggering pace. Next time you visit Shenzhen, across the border from Hong Kong, keep in mind that this modern city of 9 million people, with its airport, subways, parks, and skyscrapers, did not exist 30 years ago. And Futian, Shenzhen’s main commercial district, went from empty land to modern thoroughfares lined with skyscrapers and parks in about six years. China’s high urbanization rates combined with an ability to rapidly deploy large-scale infrastructure may turn out to be its most powerful competitive advantage in the long term.
Consider Shanghai’s deepwater port. It connects the Yangtze River to the Pacific, but it also effectively connects China’s exporters to the world’s markets. As recently as 2003, the shipping from Shanghai’s deepwater port was approximately 4 million TEU—roughly equal to the throughput of the Long Beach and New York ports. By 2008, Shanghai’s throughput had increased to 20 million TEU, five times that of any Western port.
During the same period, the products being transported through Shanghai went from shoes and bicycles to cars and laptops. The market share of Chinese manufacturers is both surging and moving up the global value chain. This is mostly a story of infrastructure providing a competitive strength to locally based companies.
Even for newer products like solar panels, Chinese companies such as Suntech Power Holdings are both gaining market share and pushing down global prices (decreasing by 50% in the last year alone). Suntech, based in Wuxi, is now set to overtake Q-Cells of Germany and become the world’s second-largest solar panel supplier. From an investment viewpoint, the unique Chinese landscape with its high-performance state capitalism, ability to deploy infrastructure, and critical mass in manufacturing is now critical to understanding the competitive dynamics of many companies and industries.
When I review individual investments and industries in China and other state capitalist systems, such questions related to competitiveness come up repeatedly. How do companies win on the hypercompetitive Chinese landscape? How does a large low-income population change the competitive dynamic? In acquisitions, is it better to target a highly scalable company, or does that make a buyer too dependent on infrastructure? Doesn’t a truly sustainable competitive advantage require political support? How does the dynamic differ between local and foreign companies? Does Coca-Cola still have a competitive advantage in places like China? (Yes.) Is it the same as in the U.S.? (Sort of.)
The key takeaway for investors and deal-makers is that high-performance state capitalism is a new landscape on which they will have to learn to operate. It is a large part of the present and future. And this means understanding the inherent political aspects of these markets and how they impact individual companies, industry structures, competitive dynamics, factors such as infrastructure, and investment strategy.
An Aside on the China-Versus-U.S. Question
I teach at business schools in China, the UK, and sometimes the U.S. My courses cover global and cross-border investing, the competitive dynamics of different economic systems, and private deal structuring. These discussions frequently segue into a more general conversation about U.S.-versus-China competitiveness. It’s an important question, but as I’m strictly a micro person, I generally leave this question to wiser people.
But this topic comes up a lot, so I thought I would address it briefly by pointing out three events that caught my attention this past year.
The first was the collapse of General Motors. One can make an interesting (not totally accurate, but interesting) analogy between U.S. and China competitiveness and the competition between GM and Toyota. As recently as 1991, American GM was the world’s largest automaker and had been for as long as anyone could remember. It was inconceivable that it was not number one. But it was taking on sizable debt in the form of pension and healthcare liabilities. Japanese Toyota at that time was still fourth in the world but had the highest operating margins in the industry. And it was investing its high cash flow in technology and processes. Its market share both globally and within the U.S. was slowly and consistently increasing. From that point, it took just ten years for Toyota to surpass GM as the leading car company and for the symbol of American automotive leadership to be shattered. And not long after that, a suddenly shrinking GM (all business cases had assumed continued growth) collapsed quickly under its large debt obligations. Too much of this story strikes me as similar to the current situation between leading but cash-poor and increasingly debt-ridden America and rising, market-share expanding, and cash-rich China. My general and completely simplistic takeaway is that in globally competitive industries, Debt + Competition from Asia = Defeat.
The second event that caught my attention was actually a nonevent. It was something that didn’t happen. I watched the 2009–2010 U.S. political fighting (budgets, healthcare, financial reform) from afar in my home in Shanghai. What caught my attention was the absence of any competitive considerations in any of the discussions on spending and debt. It just never came up as a topic. This is a sharp difference from the Chinese government’s fairly consistent focus on building infrastructure, acquiring resources, and saving money, all with the stated purpose of making the country and its industries more globally competitive.
The third event was the groundbreaking for the approximately 1,900-foot Shanghai Tower in the Liujiazui financial district. The fascinating aspect is that this skyscraper is almost identical in size and ambition to New York City’s under-construction 1 World Trade Center (originally named Freedom Tower). Both are the same height, both have similar designs, and both carry deep symbolism. The Shanghai tower is set to be completed by 2013. 1 World Trade Center is finally under construction after a 7-year delay and is set to be completed by 2013–2017—maybe. That one country can build its symbolic tower in 4 years and the other in 12 to 16 is symbolic. And certainly the ability to deploy (and upgrade) infrastructure has a direct impact on the competitiveness of companies in certain industries (manufacturing, logistics, natural resources, etc.). I have no real, solid conclusions from these U.S.-versus-China anecdotes, but they did catch my attention.
Rise of the Arab and Asian Godfathers
Pragmatic elites dominate smaller, often slower-growth economies
A number of investment landscapes in Asia, Africa, and the Middle East can be described as “godfather capitalism”—capitalist systems dominated by a small group of people. Author Joe Studwell, in his book The Asian Godfathers, originally used this term to describe the economic systems of Hong Kong, Singapore, Malaysia, Thailand, Indonesia, and the Philippines, but you can see similar systems across the emerging markets today. Because we are not primarily concerned with the real macro nature of politico-economic systems, but instead with how to do direct investments within them, the defining characteristic of such smaller systems for us is companies and who you do deals with.
Continuing my simplistic and offensive-to-every-macroeconomist worldview, such godfather economies typically are smaller than the so-called BRIC economies of Brazil, Russia, India, and China. They are sometimes little more than city-states and are often located far from larger, more stable economies such as Europe and the U.S. A sense of isolation or of being more exposed is a significant part of the psychology of companies and investors in these economies. Although it is common to describe most of them by their size and their politico-economic system (autocratic, benevolent dictatorships, a few democracies), I tend to characterize them as “mostly pragmatic.” The political leaders, business heads, and other decision-makers are overwhelmingly concerned with growth, protecting a critical resource, or surviving in a perceived exposed situation. They exhibit an overriding pragmatism when it comes to business and investing. This is sometimes a nice contrast to the more complex political forces of international and state capitalist systems. For investors and deal-makers, the godfather economies are particularly attractive and straightforward environments in which to operate.
These smaller, godfather-type economies have also shown fairly dramatic improvements in their domestic investment and management capabilities in recent years. It is getting easier and easier to operate as a foreign investor in places such as Qatar. The events in Dubai, Abu Dhabi, Macau, and other locations that have caught the world’s attention—the meteoric rise of Macau’s gaming market, the creation of the Middle Eastern mega real estate industry, and the rise of sovereign wealth funds—have a lot to do with the increasing combination of godfather capitalism and professional management. Meetings with the Abu Dhabi Investment Authority now likely entail talking with ex-Goldman Sachs and Morgan Stanley bankers. This is a fairly dramatic change from just five years ago. Indeed, many of these godfather economies operate more and more like sophisticated investment firms. For example, Kuwait recently received a report titled “Kuwait Vision 2035,” detailing a clear development strategy for the country and prepared by an international, professional team including former British Prime Minister Tony Blair.
In general, godfather economies catch my attention as an investor when one of two things happens.
First, they tap into the global capital and trade flows. They capture a position in a global value chain and begin to benefit from an inflow of foreign capital and/or trade. Singapore achieved this in logistics in Asia; Dubai in logistics, tourism, and capital markets; and Macau in gaming and entertainment. In some cases, this can result in dramatic economic booms, especially if the capital or trade flows are large compared to the economy.
Second, they have a valuable resource, such as Saudi Arabia in oil or Qatar in natural gas. This tends to create both significant wealth and significant needs, resulting in opportunities for alert global investors. In the best cases, growing wealth and a growing need for foreign expertise are matched with effective management and execution. More often, the valuable resource tends to breed complacency. There is a reason why Dubai, the GCC city that ran out of oil, has been so effective in its execution, and why oil-rich Riyadh in 2011 looks pretty much like it did in 2001. These are all attractive investment situations, but not all are necessarily growth stories.
Deals in such environments can often be done with a single person or group. For example, just about any real estate deal in Qatar can be done through Qatari Diar, the real estate arm of the sovereign wealth fund. One deal can result in access to an entire industry, and all permits and regulations can sometimes be approved in one meeting.
In addition, the overwhelming pragmatism that often pervades the political establishment in these countries means that investments and deals can be discussed in terms of both strategic and financial benefits. In practice, these types of commercial-to-government deals are very similar to commercial-to-commercial deals. Singapore, Macau, Qatar, and others have clear strategic plans, making deals easy to discuss. An investor can propose a new high-speed ferry from Hong Kong to the Cotai Strip and cite its potential to increase traffic for the casino industry. The more a discussion includes strategy and business aspects, as opposed to purely price, the more room there is for creative deal-making.
Finally, godfather economies are rarely self-sufficient. American businesses can use American capabilities and American financing to create American companies that serve American consumers. Qatar does not have the technology to develop its natural gas, and its customers are overwhelmingly overseas. The country has strong needs for foreign capabilities, whether it be management, capital, brands, products, services, or technologies. Cross-border deals and foreign investment tend to happen naturally and quickly in such situations.
The key takeaway is that these economies can be attractive and comfortable environments for investing. And they are often open to dealing with foreign investors in a way that more rapidly developing economies are not.
The purpose of this exercise is to provide a few simple analogies for different landscapes and enough basic language that we can discuss specific value strategies in the following chapters.
The New Political-Economic Powers Are Deal-Makers, Too
Government and quasi-government players are out in force
In 2005 and 2006, when CNOOC and DP World attempted acquisitions of American companies, public reaction was swift—and strong. What surprised me, however, was that these two widely reported “almost deals” were the only two that got noticed. Few pundits or politicians seemed to pay much attention when Google effectively partnered with the Chinese government to enter the Chinese market, or when UK investors partnered, mostly to their peril, with Russian state-backed companies in energy deals. Cross-border deals that mix commercial and government players were occurring every couple of months.
Government and quasi-government entities are now active investors and participants in markets around the world. And this is a completely expected result of the rising wealth and prominence of many economic systems in which government has a much more direct, active role. Sovereign wealth funds, state-owned enterprises (SOEs), development banks, and government-supported companies are numerous and increasingly active. At the start of this book I mentioned the world’s tallest tower was in Dubai, its largest mobile company is in China, and its wealthiest person is in Mexico. At least the first two are clearly quasi-government players.
Government and quasi-government players can operate with a strange mix of strategic, political, financial, and other interests. Sometimes the interests are clear, such as Chinese SOE resource acquisitions in Africa and Australia. Sometimes the interests appear mixed, such as Chinese loans against oil deliveries for Venezuela. And sometimes the interests just appear confused. Why did Dubai build the world’s tallest building? (Why is the U.S. building high-speed rail?) Such activity can clearly benefit private-sector sellers, who can construct deals that appeal to these other interests even when they do not make perfect financial sense. In other cases, the impact of these government players on investments can be fairly mixed.
In 2008, Mubadala, one of Abu Dhabi’s many sovereign wealth groups, partnered with GE to create a strategic partnership that was a clear win-win for both parties. The multibillion-dollar partnership included projects in clean energy, commercial finance, aviation, and corporate learning. The joint investments expanded GE into an attractive market and brought desired skills and technology into the country. A clear win-win on a strategic and ROI basis.
In contrast, Sabic’s purchase of GE Plastics was a significant loss for the competing private Western bidders. Sabic is 70% owned by the Saudi government and operates with an effective domestic monopoly. Its $11.6 billion bid for GE Plastics was well above the $10 billion bids by TPG-Carlyle, Blackstone-Bain, and KRR-Koch. In an increasingly competitive world, it is hard to maintain a private-government separation when your competitors are not.
Deals between state-owned enterprises are another increasing phenomenon worth paying attention to. In 2007, Sinopec and Saudi Aramco signed an approximately $5 billion joint venture to triple the capacity of Sinopec’s Fujian refinery (from 80,000 bpd to 240,000 bpd) and add a petrochemical complex. They also agreed to operate a chain of 750 fuel stations in China. What is particularly notable is that this deal, like many SOE-to-SOE deals, involved industry sectors that are mostly off-limits to private companies and foreign investment. And it had support at the highest levels of both governments.
Where the Visible Hand of Government Helps Investors
When politics skews markets, astute investors can find good companies and great bargains
Jim Chanos, founder of the hedge fund Kynikos Associates, recently claimed that China was “Dubai times 1,000—or worse.” The pronouncement made headlines everywhere and earned him the title of leading “China contrarian.” A review of the Chinese real estate market numbers certainly supports his claim of a very large bubble. But does it matter?
Claiming that China may have a bubble is like warning that a rocket ship may have turbulence. Yes, it’s true but shouldn’t you already know this? China is a rocket ship of a country that is equal in geographic size to the U.S. (with four times its population) that has grown from agrarian poverty to developed superpower status in less than 30 years. Of course it’s a bubble. How could it not be? There are multiple bubbles in China at all times. China is state-directed development writ large.
Government action through state-directed and state-subsidized credit, commercial-state collusion, and dominant state-owned entities is continually altering the economics of China’s markets—particularly real estate, construction, and infrastructure. In this sense, state capitalism is doing what it does best—fueling the creation of fixed assets. The result is not market growth per se (the obsession of the multinationals), nor is it always imminently collapsing market bubbles (the dream of the shorts); it is the rapid development of the country’s assets and infrastructure.
Keep in mind, we saw a similar Chinese real estate “bubble” just ten years ago. In 1999, Shanghai and Beijing Grade-A commercial property had vacancy rates of 38% and 30%. And the state banks had nonperforming loan (NPL) ratios of 15% to 25%. A clear bubble, or turbulence, depending on your viewpoint. But just five years later, the state banks had reduced their nonperforming loans dramatically, and many had successfully gone public. China Construction Bank went public with an NPL of 4%. And at the same time, the vacancy rate for Grade-A office space in Shanghai dropped from 38% to 6%. Post “bubble,” things quickly took off again and by 2006, 80% of the world’s cranes were again in China.
Looking at China today, I expect we will shortly see the same pattern play out. Real estate prices will fall, possibly quickly. Troubled loans will increase. Banks and state-operated enterprises will recapitalize through the public markets or government support. And the country will continue on its 30-year deployment of new assets and infrastructure. This is government-fueled and -directed development, which goes hand-in-hand with booms, busts, and other forms of turbulence. And all this government-directed activity creates endless opportunities for value investors.
The pervasive role of government in state and godfather capitalist systems distorts their commercial markets, not periodically but continually. Government actors are continually acting simultaneously as regulators, competitors, customers, and providers of credit. The fairly subtle invisible hand of the free market is paired with the heavy visible hand of government. This means that places such as China and Russia offer exciting opportunities—provided that you can manage the uncertainties. That, in fact, is the central investment challenge.
I would characterize Dubai’s spectacular rise and fall not as a bubble, but as a government-directed boom/bust cycle that got out of hand. There is a reason why Dubai built such eye-catching projects like the Burj Al Arab, why it created an international airline with daily flights to JFK, and why it put billboards of sunny Dubai beaches all over Moscow every winter. It was a government-directed “Build it and they will come” strategy—or, more accurately, a strategy of “Build it huge, hype it everywhere, and they will come—and then the economy will grow.”
And it worked. An unknown city located in a problematic part of the world became a brand name with world-class capabilities in logistics, real estate, and finance. But the strategy got away from the government around 2006, and projects went from ambitious to ludicrous, credit went from prudent to risky, and the markets went from development-oriented to speculative. When the financial crisis erupted in 2008, foreign demand abruptly disappeared, and the real estate sector collapsed. This was helped along by the excess debt taken on in recent years, but it was more an income statement than a balance sheet problem.
I am admittedly terrible at economics and really everything at the macro level. My understanding of various markets and the simplistic descriptions presented in this chapter come almost entirely from looking at individual deals on the ground around the world. This sort of state-directed development occurs primarily because government actors, in places like Dubai, structure the rules so that everyone at the table can say yes to the deal. If the project doesn’t have a proven or realistic market (which is the most common problem in emerging markets), or if the economics of the deal just don’t work (usually due to large initial infrastructure costs), a government actor of some type generally fixes the rules so that the deal can proceed. It is the sheikh or the city official sitting at the end of the table that provides credit, provides a sovereign guarantee, or grants additional land that can be sold early on in the project. In practice, it is state actors altering the economics of deals so everyone can say yes that, in aggregate, causes such altered and turbulent markets. And the more tools the state actors have in their tool kit (development banks, state-backed companies, commercial banks), the more room there is for creativity in the deal structuring.
Therefore, in many ways booms and busts are inherent, or at least should always be expected, in developing countries and markets. I just assume that any rapidly developing country is in this state. It is inherent to many of the systems that are now part of the investment landscape.
The key question for investors is not whether China is a bubble but whether it can manage its perpetual booms and busts. A quick review of the past 20 years indicates that Chinese officials are actually quite adept at controlling state banks and credit. They are good at flying the rocket ship. And the local population is also well conditioned to this turbulent environment. They have very high savings rates, purchase property early in life, and develop extended personal networks for security. Per Nassim Taleb, it’s not a black swan if you see it coming.
For investors and deal-makers, these situations are obviously value opportunities. Although the free market may not be as efficient as the efficient market hypothesis advocates hoped, it is relatively stable, and booms and busts are relatively uncommon (the financial sector not included). In government-skewed markets, mispricing is everywhere, and booms and busts are the norm. Recall that in the opening of this book, I argued that the real challenge in going global as a value investor is managing the uncertainties in inherently unstable environments.
The negative of this situation at the deal level is that activist governments lead to more regulatory scrutiny, which can easily slow or impede investment. I often think of Robert Fisk’s book Pity the Nation in which he describes a period in Beirut’s civil war when there were so many militias and occupying armies in the city that driving across town meant stopping at 10 to 15 checkpoints in a single trip. You go three blocks and then are stopped and need to show a pass or pay money to proceed. Heavily government-infused markets are similar. There are more points in the process where you need to get approval to go forward, and this can be a positive or negative in terms of competing for deals. If the checkpoints limit you, it’s problematic. If they limit competitors, it’s beneficial. It was Carlyle’s competitor for the Xugong investment that slowed and eventually killed their deal. There is a common saying that doing business in China means successfully partnering with the government. Doing business in India successfully means being able to overcome the government. The multiple checkpoints can play out in various ways, usually depending on who you are.
As described, the heavy hand of government can have a significant impact at both the market and deal levels. But it is at the company level that the effect can be most powerful. The number of bank or mobile licenses can be limited. Industry-wide monopolies can be created. Access to land or development rights can be controlled. Regulatory requirements can drive up overhead or other fixed costs such that smaller firms find it harder to enter. In general, government action and involvement can create numerous types of limited-competition situations at the company level, enabling returns on invested capital to stay well above the cost of capital (and sometimes that cost can be driven down with state support). Politically infused markets can create value investors’ favorite targets—companies with very sustainable competitive advantages.
Limited-competition situations can be cash cows for investors. Until very recently, there were only a handful of bank licenses in Saudi Arabia, a country with hundreds of billions in annual oil revenue. In China today, only three (actually, two) mobile phone companies are allowed in a market with more than 790 million mobile phone users. Owning any of these limited-competition companies can be a gold mine. It’s notable that Warren Buffett’s first major investment in China was in state-owned Petrochina, which operates with a government monopoly. The intersection of a strong advantage at the deal-level and limited competition at the company-level is the holy grail of investing in politicized markets.
On a side note, in the last year there has been a fascinating new collision between such state-created monopolies and free-market competitors. In 2010, Visa fired the “shot not heard around the world” when it took the step of blocking Chinese Unionpay in many international markets as it attempted to expand globally. Without receiving much media attention, Visa had fired the first shot in a new global front between state and international capitalism. Chinese Unionpay, since its founding in 2002, has done exceptionally well under a politically granted credit and debit card monopoly in mainland China. By 2009, it was processing over 1 trillion annual transactions. Visa, which processed $4.4 trillion in transactions internationally in 2009, has long struggled against this monopoly in its attempt to get a foothold in the mainland China market. But as Unionpay began to expand internationally, Visa was finally able to respond in similar fashion. They moved to have Unionpay blocked in many international markets. The fight between international and state capitalism, traditionally within developing economies, is increasingly moving to a global playing field. It will be interesting to see how far the benefits of a limited-competition situation in a home market can be leveraged internationally.
But if government-infused markets can create attractive limited competition situations on one hand, they can create brutal hypercompetition on the other. China’s steel industry is an example. Extensive loans by state-owned banks have created a massive oversupply in iron smelters and other stages of steel production. The resulting hypercompetition in steel production has resulted in falling prices, with the investment returns well below the private market cost of capital. This type of hypercompetition is about the last place a value investor wants to be.
Investing in politicized markets is a core question for the traditional value strategy in a global world. In many cases, such as Buffett buying public PetroChina shares, these types of markets are just offering companies that have another type of competitive advantage. One could argue that a state monopoly is possibly the most sustainable of competitive advantages. But beneath this case, investors can confront a fairly wide variety of investment environments and competitive situations. Rapid booms and busts, slow booms and busts, limited competition, hypercompetition, and others are all inherent to government-infused markets. Generally speaking, this means greater market inefficiencies for value-focused investors to target, but it also means dealing with greater uncertainty and instability. As mentioned, my best answer for this conundrum is to combine traditional value methodologies (for example, PetroChina purchases) with value-added deal-making, which will be discussed in detail in the next chapter.