The economies of many of the world’s most important developing nations operate under a system often referred to as state capitalism, an economic paradigm in which free market outcomes are “managed” by the state in order to promote national interests. In these state capitalist societies, strategic companies are likely to focus upon the promotion of national interests rather than profit maximization - to the detriment of their shareholders. Successfully investing in state capitalist economies therefore requires a shift in the mindset of western investors more familiar with analyzing profit-maximizing corporations.
One of the central aspects of state capitalism is that private corporations are often directed by the government to act in the national interest. These “national champions” are still interested in profits, but only to the extent that profit maximization does not conflict with the goals of the state or the stability of the government. As Ian Bremmer has said, “governments embrace state capitalism because it serves political as well as economic purposes – not because it’s the most efficient means of generating prosperity.” As such, the analysis of state capitalist economies and their leading corporations represents an ideological shift for the average Western investor accustomed to allocating capital among economies and firms which operate relatively free from government interference. Broadly speaking, large Western companies primarily focus upon maximizing profitability for their shareholders. Large firms in state capitalist societies primarily focus upon advancing the interests of the state.
This is not to say that firms such as Gazprom in Russia or China Construction Bank in China are not interested in making money; they are, but it is not their primary goal. Initiatives aimed at advancing national interests (picture Chinese firms seeking to acquire commodity reserves), grabbing market share, or increasing national prestige may at times supersede profit maximization. For a painful reminder of the possible consequences of such an approach, investors need look no farther than Japan. For decades, Japanese companies pursued market share gains rather than profitability. Once viewed as a miracle, Japan has instead proven to be a morass for investors.
There is nothing wrong with a corporation that seeks to serve the greater good (however that may be defined) but it seems likely that over time profit-maximizing companies will provide superior investment returns than companies at which the profit motive is a secondary concern. Because of this, many of the largest and most prominent companies in the world's most rapidly developing economies are likely to provide relatively poor investment returns in the coming decades. On the other hand, smaller companies, accountable to their shareholders and free from government intervention, are likely to provide superior investment performance.
The implications of such a scenario are enormous. The vast majority of western capital flows into developing market equities are currently concentrated in the largest, most well known entities, either through ADRs, direct equity holdings, or ETFs and mutual funds focused upon large capitalization companies. However, if one accepts that national champions are unlikely to provide superior investment returns over time, it becomes apparent that a large proportion of emerging market equity flows are currently misallocated.
To correct this misallocation, investors should underweight large-cap, state-sponsored companies in many developing markets and put a larger emphasis on smaller firms that are less likely to be pressured into pursuing the goals of the state. Of course, by their very nature national champions are likely to receive preferential treatment from their governments. Therefore, investors would also do well to avoid investments in companies that must compete with state champions and focus instead upon industries that are traditionally not considered vital to national interests. Ultimately, state capitalist economies might provide increased possibilities for generating alpha (as opposed to indexing) as savvy active managers seek out those corporations relatively insulated from government intervention.
One final implication of the rise of state capitalism is that investors might consider avoiding western multinational firms whose long-term profitability is tied to competition with national champions. Although in the short-term developing market nations often benefit from western companies’ expertise, at some point the technological transfer will be complete and these firms may find themselves no longer needed or wanted.
The financial crisis has accelerated the rise of economic systems in which prominent corporations are no longer primarily focused upon maximizing profits. Investors need to carefully consider whether the optimal long-term approach to investing in developing markets involves overweighting companies whose primary goal is the advancement of national interests. Investors may determine that their developing market investments are currently misallocated, and that focusing on profit-maximizing entities rather than national champions will provide opportunities to generate emerging market alpha in the years to come.
(c) Chandler Asset Management