Why Investors Should Avoid State-Owned Companies

My advice is to never buy stock in a state owned company. This admonition at first seems absurd. After all, there appear to be many fine companies in which a sovereign government owns the majority of shares or controls the company.

Why wouldn’t you want to own shares in the Industrial and Commercial Bank of China (HKG 1398 SHA 601398), the world’s biggest bank? The world’s largest telecom operator is China Mobile (CHL), in one of the world’s fastest growing market. Who would not want the safety of a telephone company in a dynamic market? The combination of oil and China seems irresistible, especially for an investor in PetroChina (PTR), a company that is only slightly smaller in size than ExxonMobil (XOM). There is no life insurer anywhere larger than China Life. The Chinese economy has been growing at over 10 % for years, as have the profits of these companies. It appears to be a no-brainer.

It is not just China. Other countries have state owned companies that you can invest in. In Russia, there is the almighty Gazprom (OGZPY.PK). Gazprom is not only one of the world’s largest oil companies, it has the world’s largest reserves of natural gas.

This is not just reserved for emerging markets. If you have more of a taste for something French, there is Électricité de France (Euronext Paris: EDF). The government owns 85%, but you can buy shares. Enel is Italy’s largest power company, and the third largest energy company in the Europe. The Italian government owns about 30%, but retains control.

All of these companies have the backing of their respective governments. Not only can their CEOs call on their governments for help, if necessary, they can call on their government’s foreign ministries and presidents to help them accomplish their strategies. If they get into trouble, they can just turn to the government for cheap loans. Nothing could be safer for a long term investment. Not.

In the United States, I have heard talk show hosts often ask the question, "why can’t government run like a business." The answer is simple. They have the wrong incentives and disincentives. It has to do with game theory.

Principals have to hire agents to run things. Principal are the owners, employers, shareholders and citizens. Agents are the employees, managers and government officials. Agents are supposed to act in their principals’ best interests. Employees are supposed to do their jobs. Managers are supposed to run their companies with shareholder value in mind. Politicians of all countries are supposed to implement policies that benefit all of their citizens. Often they don’t.

In the US, we are now being treated to the spectacle of AIG and Merrill Lynch bonuses. This is generally viewed as some sort of moral failure, but it is nothing of the sort. These agents are just acting naturally. They are looking after their own interests. They did not really care if the owners of their firms, either shareholders or now the US government, lost. In game theory, an agent’s best move is to act for themselves, not for the principal. The principal knows this and attempts to offer economic incentives and disincentives, to get the agent to perform.

In addition to the economic incentives and disincentives, there are legal disincentives. The judges at common (US/UK) law knew that agents would prefer their own interests and so imposed upon them the highest duty under the law. Agents owe a fiduciary duty to their principals. A fiduciary duty is the highest standard of care under the law. The agent must put the interests of their principal before their own. The law came down hard on any deviation. A breach of fiduciary duty almost amounted to fraud with penalties to match. So if the agent followed their best interests, the law was there to punish them for minor deviations.

The money and the law were supposed to solve the central issue between agents and principals: information. The agents had it, the principals didn’t. This is known as a game of imperfect information. Since there was an asymmetry of information between the principal and agent, it was easy for the agent to cheat.

In law and economics there are six categories that are supposed to keep managers of corporations in line. The first is business failure. If a manager does not manage his company well, the company will go bankrupt and the manager will be out of a job. The second reason is the market for corporate control. In an open market where companies can be taken over by other companies, a firm that is inefficiently managed will become the target for other firms. The incompetent managers may find themselves thrown out as part of the takeover process, which is often why hostile takeovers are such bitter battles as managers fight to retain their positions. Both of these categories rely on economic disincentives.

A category that relies on economic incentive would be to align the manager’s interests with those of the shareholders. While this should work, the problem is to come up with a method of doing so. For a variety of reasons, including change in the US tax code, managers’ interests were supposed to be aligned by giving them shares or options. Of course, managers, being self interested agents, have often been able to use these in inappropriate ways.

The last three categories involve legal disincentives. They include legal duties required under corporate law, corporate governance by the board of directors, including in some countries non executive supervisory boards, and, finally, votes by shareholders. The problem with all types of legal disincentives has to do with the asymmetry between the managers and the individuals who are supposed to enforce the disincentives. As the Madoff incident shows, the regulator who is supposed to enforce the law is sometimes either incompetent or unable to do the work necessary. Boards of directors lack the time and often the economic incentives to independently second guess management. In addition, their independence is often diluted since they either are or were selected by management. Supervisory boards are often staffed by former executives and worker representatives whose interests are in maintaining jobs, not in creating shareholder value. Finally, although the shareholders as owners do have the final say, mounting a proxy fight is an enormously expensive proposition and it is simply easier to vote with your feet.

Obviously, the limits set by either economics or law are not always adequate. In the past six months we have had numerous examples of corporate managers who were exceptionally well compensated in industries that were highly regulated take unconscionable risks that not only brought their companies down, they almost brought the entire global financial system down. Still despite their imperfections they are still better than state owned companies.

None of the limits on private companies apply to state owned companies. So state owned companies are not even subject to the few limitations that force managers of private companies to toe the line. Start with the economic disincentives. State owned companies cannot go bankrupt. If they experience losses, the state just bails them out. In China, often the solution to an insolvent state owned corporation is not bankruptcy but a forced merger with a healthy company with disastrous results.

State owned companies are also not for sale. Any shares in private hands are not sufficient to change control in any takeovers hostile or otherwise. Insulated from the market, it is often the state owned companies that are voracious predators. With unlimited funds, they often buy other private firms.

Even worse, sometimes for reasons only known to the government, entire sectors or managers can be reorganized and not for the benefit of minority shareholders. In 2008 the entire Chinese telecommunications industry was reorganized. The three firms, China Mobile, China Telecom (CHA), China Unicom (CHU), swapped operations and merged with smaller carriers. It was China’s fourth reorganization. Also in China, round robins of executives in different companies in the same industry are not uncommon. In 2004, China’s three top telecommunications providers, China Mobile, China Unicom and China Telecom, all swapped senior managers. Among China’s airlines, China Eastern Airlines (CEA) got the Chairman of China Southern Airlines (ZNH). China Eastern also received a new president from Air China. The old president went to Air China as deputy president. Since many of the managers of state owned corporations are or will be bureaucrats, it may make little difference. The president of Chinalco (ACH), Xiao Yaqing, was kicked upstairs to become named vice secretary general of the State Council, China’s cabinet.

Not only are the economic incentives and disincentives ineffective, any legal disincentives are diluted by the conflicts. The state, which is supposed to provide those legal disincentives, is also the owner. It is rather difficult for the state to either sue or arrest itself. By definition, the state is either a majority or controlling shareholder. The managers are appointed and removed by the state for reasons that the state does not have to divulge. The state determines whether a manager has violated any duties and controls the prosecutors, regulators and courts, so it is impossible for any minority shareholder to effectively assert any form of corporate governance.

One result is often massive corruption. According to Li Chengyan, head of Peking University's Anti-corruption Research Institute, as many as 10,000 corrupt Chinese officials have fled the country over the past decade, taking as much as $100 billion of public and company funds with them. In Russia, Russian Venture Company, a state-controlled company created two years ago to fund technology startups, deposited more than 85 percent of its $834 million capital in banks and in the accounts of overseas corporations rather than using it to spur investment and innovation. Gazprom’s operating costs and investments are so high that it does not always generate positive cash flow.

Of course some would argue that state owned companies in former communist countries and emerging markets with less developed legal systems might be expected to be inefficient. Their existence and actions might be considered to be part of a stage of economic development. The same cannot be said for Electricité de France. According to an article published in The Economist in 2004, after examining EDF’s finances the magazine concluded:

What emerges is a picture of a group that has used some questionable accounting practices; that has never really made a profit; that has made imprudent use of funds set aside for nuclear decommissioning and waste-management; that lacks transparency over the level of its nuclear provisions; and that has indulged in a reckless and costly strategy of international expansion.

Sounds a bit like a description of Fannie Mae and Freddie Mac.

In France at least there are two main checks on state owned industries: voters and a free press. The French electorate could elect a government that would privatize EDF. The press can and does criticize the management. Other experiments with public ownership like Credit Lyonnais that ended in disaster resulted in a change of government. State owned companies always have powerful protectors. They provide jobs for powerful unions and often perks for government officials and bureaucrats. They also can act as an instrument of national policy. State owned companies are an example of the free rider problem. There are powerful groups that have large interest in keeping them afloat and it is just the taxpayers, consumers and citizens who would be better off without them. In other countries, even the checks of free speech and free election are not available.

Perhaps the worst part about state owned companies has to do with information. Information has value. It is traded only for an economic incentive, consideration or a legal disincentive like the full and fair disclosure rules of the American Securities and Exchange Commission. Since the state controls the watchdog the regulator has little incentive to be sure that adequate information reaches the market. The reverse is true. Often the state has large economic incentives to ensure that the market does not receive information. Even worse, the managers themselves have little incentives to provide their government masters with accurate information. So even the state may not know exactly what is going on in its own company. For example, in China the state owned banks were requested to stimulate the economy with new loans. They did just that on a large scale. They made $147 billion in new loans. Just exactly where this money went is anyone’s guess.

Information about the operations of state owned companies is not the only problem. Often it is difficult for investors to even figure out which company is state owned. The state controls the corporate records and sometimes does not like to give out even the most basic information. Huawei, one of China’s showpiece global telecom group, has a structure and links to the state are so convoluted that no one really knows who owns it. Even the most basic information is often not available. Like the US, China does not have a central corporate registry. Information about a company, including its current shareholders, registered capital, legal address, and legal representative can be kept at the district or township, municipal, provincial or national level. These offices have different standards as to who can see the information. In some registries, an ID is sufficient while others require the company’s permission or a court order.

Without sufficient information, it is difficult to determine the real status of any Chinese mainland company. It has been estimated that over 98% of the companies listed on the Shanghai A are in some way owned or controlled by a government entity, either municipal, provincial or national (FXI). This is logical if you look at the economic benefits various governments accrue from these entities. Things like jobs, taxes, revenues, growth and managerial perks. As a result, they have large economic incentives to monopolize as much capital as possible. Of course, without complete access to the information, no one really knows.

The current economic crisis has now reversed the trend of privatization of many state owned firms all over the world. The perception of the failure of capitalism has made nationalization more acceptable. Firms from China to Russia to Dubai have received injections of capital from the state. Bolivia and Venezuela have resorted to old fashion nationalization. In China, airlines, power generation, car companies and banks have all received capital from the state. One of China sovereign wealth funds, China Investment Corporation, having been burned by investments in the west, is now focusing its attention to buying companies in China. It seems that no politician can resist expanding not only political power but economic as well.

Finally, it comes down to one thing: state firms manage for political reasons, not for profit, whether those reasons are to try and increase access to natural resources for national security or to find jobs for the unemployed. Either way, it makes little difference to investors or minority shareholders. Value and efficiency will always take a back seat. Although some growth may occur, it will only last until the needs of the state take priority.

Disclosure: For reasons stated above, I have no positions

Comments

[Dana H.:]

Thanks for another great article -- a well-articulated argument and a pleasure to read. You're my new favorite author on Seeking Alpha.

Mar 18 11:11 AM

[William Gamble:]

Thank you. One trys

Mar 18 01:38 PM

[Ricard:]

This is a well-written and sober reminder to those that invest in government owned corporations.

However, I will play devil's advocate. Currently in the US, we are seeing who is ultimately the owner with responsibility in any sector deemed vital to national interests. Right now, those sectors happen to be the auto industry because of its massive presence in manufacturing, and finance, because of its pervasiveness in the entire economy. The owners are you and me. It is hard to distinguish between private and public ownership, when public corporations owned by private individuals are deemed as providing a vital public good.

Also, the case between Unocal and CNOOC comes to mind. I admit, this is a weaker example, given that CNOOC is a government-owned entity. However, CNOOC tried to purchase privately owned assets in the South China Sea. This is hardly the Gulf of Mexico. These assets were deemed by Congress as vital to national interests, and so the ultimate owners with responsibility (you and me through our elected government) exercised our rights and denied the asset purchase. However, Unocal is a private corporation...or is it? Why did the government get involved in this transaction?

After seeing the CNOOC purhcase fall apart, I looked at the US auto industry and saw a crisis forming, and surmised that this sector, although seemingly privately owned, is in fact a public entity, owned by you and me through Uncle Sam. This is true of any industry deemed vital to US interests. Sure enough, I was proven right this year.

So, the only difference I can see between state-run corporations and publicly listed corporations in the US is the degree of overt government control. In one hand, it is clear that electricity in France and Korea, aluminum in China, and oil and gas in Russia are deemed vital to national interests and are too important to be subject to the whims of the market. In the US, this has been true for decades in key sectors, but we have been able to conceal this fact by allowing the private sector to gamble with the fate of America until the failure is too great for words. Hence, our current predicament with nationalization.

I see little difference in government-run entities, and corporations deemed as providing a vital public good. Or, do you really think the military-industrial complex is ultimately a private good, and won't be nationalized if in jeopardy? I think not.

Mar 18 01:42 PM

[Ricard:]

One thing I'd like to clarify, and which I struggled to differentiate above, is the difference between private ownership in a publicly traded company, and public ownership. Companies on the S&P 500, while publicly traded, are privately owned by shareholders, and not the government. AIG, on the other hand, is publicly owned by the government, and publicly traded.

In case this was slightly confusing in my prior comment.

Mar 18 01:46 PM

[William Gamble:]

Any investment is an attempt to predict the future. All systems function within a system of rules. The more stable the system of rules the better chance an investor has of predicting the future. If rules provide accurate, timely and complete information then the investor has an even better chance of predicting the future.

There is a higher probability of predicting the actions of managers who function with the set of rules, whose motivations are economic and who are required to provide information.

There is a lower probability of predicting the actions of managers who function in a situation where rules can be changed (for example to support anything deemed strategic, whose motivations are controlled by politics, and who may not have to provide information.

If you have a lower probability of predicting the actions, the risk goes up. If investors know this they should get a higher reward. Instead their assumptions.

All governments create rules or laws. They can be used two ways. They can limit power or extend power of governments. The system of rules or laws in economically inefficient when it extends power.

The US government like all government does through its legal system extend a degree of control over all businesses. Of course the extend of control is dynamic and subject to fierce debate. Designing the most efficient mechanism is an ongoing challenge.

The important aspect is that he process is transparent and subject to limits either law. Government controlled corporations are not subject transparent or subject to law. Worse they are not subject to markets. Not only can governments prevent them from being sold, they can also prevent competition. The result of the unlimited control is an inefficient system.

I believe that when the US government stopped the purchase of Unocal, that it was an unfortunate extension of government power and said so at the time. Not allowing GM to go bankrupt is probably another unfortunate extension of government power. The result with GM will result most likely in a waste of taxpayer dollars and an inefficient allocation of capital.

Since the definition of what is strategic is flexible, the tendency is to expand it along with government power, which is what is happening around the world today. What politician does not relish more power? The result where ever it occurs will not work. Will not help sustain economic growth and more importantly will not, over time, result in an increase of wealth for investors. Government run corporations are run for political purposes. There are no controls, no limits. Private corporations providing a public good are still run for profit subject to the rules.

Mar 18 03:48 PM

[19 years ol...:]

Hello sir,
"PetroChina (PTR), a company that is only slightly smaller in size than ExxonMobil"

sorry but I have to disagree on this one,exxon mobil has advanced gas/oil technologies drilling as well as refining,for example heavy fuel like venezuela's,subsidiary in canada's oil sands, A strong balance sheet(net ca$h: USD 22 billions)despite huge investment recquired in the oil industry.

I don't know what you were referring about when you've used the term "size" ? market cap ? revenue ? "proved" oil reserves ?

it is useless to compare the two companies's annual revenue

as for the symbolic trillion market cap petrochina once achieved,it has a name:speculation.no more no less

XOM is far superior

cheers


On Mar 18 01:38 PM William Gamble wrote:

> Thank you. One trys

Mar 18 05:10 PM

[William Gamble:]

Regarding the size distinction between Exxon Mobile and PetroChina I agree with everything you say. As I pointed out in my book, Freedom, " Kuwait Petroleum Corporation (KPC). One of the largest companies in the world, KPC has an estimated market value of $378 billion dollars. When it was originally formed, its revenue was about $30 billion dollars (1980)— about the same as British Petroleum (BP). BP’s revenues have grown over 800 percent,% to $250 billion since then; . KPC’s revenue has merely doubled to about $60 billion, which does not even keep up with inflation.

My guess is that in 30 years time PetroChina will do about as well as KPC

Mar 18 09:33 PM

[William Gamble:]

Ricard

Sorry for the long winded reply. To simplify

Stalin, Lincoln, Mao, Rove and Obama all share one thing in common, They all wanted political power. Shareholders want something else. They want money. The Chinese government wanted CNOOC to buy Unocal to satisfy what it considered a political necessity, access to oil. (The Japanese had the same issue in 1940). The US Congress had to satisfy the political necessity of the negative image of an American company being purchased by a nominally communist country. Neither government cared that much for the investors in either CNOOC or Unocal. My point is that if you have a better chance of making money if you avoid political incentives of state owned companies and go for the profit of the private companies.

Mar 18 09:39 PM

[Ricard:]

Mr. Gamble,

Don't get me wrong - I think you're making an outstanding point. However, I've become rather jaded by the insistence upon a differentiation between nationalized companies and un-nationalized. To me, and in some of my experiences, government control has afforded stability in times of crisis, and IMHO, large discounts to market caps due to the pervasive fear of profit maximization being relegated to #2 priority.

Especially in China's case, they've actually put their money where their mouth is - I owned SNP several years back, and was elated that the government subsidized the price of petrochemicals due to runaway crude oil prices. It was not a small subsidy - it amounted to several billion yuan, or dollars, I forget which.

Your point is 'pure', in that the theory makes natural sense, and seems to be most supportive of the capitalist model. However, I've found that in practice, the theory gets muddied, as does the corresponding profit potential. One can take a good look at Korea's corporate sector, and see that there are many, many more factors at hand than simply profit maximization when it comes to privatization. At one point after their IMF crisis, their stock market was nearly majority owned by foreigners. I'm sure many nations are not envious of that fate.


On Mar 18 09:39 PM William Gamble wrote:

> Ricard
>
> Sorry for the long winded reply. To simplify
>
> Stalin, Lincoln, Mao, Rove and Obama all share one thing in common,
> They all wanted political power. Shareholders want something else.
> They want money. The Chinese government wanted CNOOC to buy Unocal
> to satisfy what it considered a political necessity, access to oil.
> (The Japanese had the same issue in 1940). The US Congress had to
> satisfy the political necessity of the negative image of an American
> company being purchased by a nominally communist country. Neither
> government cared that much for the investors in either CNOOC or Unocal.
> My point is that if you have a better chance of making money if you
> avoid political incentives of state owned companies and go for the
> profit of the private companies.

Mar 18 10:35 PM

[William Gamble:]

Ricard

I was at a conference last fall. One of my colleagues wanted to introduce new ideas in addition to alpha and beta. She wanted to introduce zeta. Zeta is the unknown of government interference.

It is the prerogative of governments to change the rules (which is one reason I believe we are witnessing the end of the golden age of globalization as governments become more protectionist). Companies of course have to adjust as best they can to the new rules, but at least stockholders know that their managers have appropriate incentives to try and make a profit.

State owned companies are all subject to the whims of national policy. China shifted a large portion on the rising cost of energy to its state petroleum companies and its utilities. The results were shortages and power cuts. Russia has forced Gazprom to subsidize its foreign policy with cheap gas to the ‘near abroad’. India also shifted the costs of high energy to its national oil companies. Chinese banks were told to cut new loans last year stifling the source of 90% of their income. Not to forget changing the rules about short selling in the US.

These policy decisions not only dissipate shareholder value, it impacts the rest of the economy. The rise of energy prices in the US forced consumers to become far more efficient. Yes, it increased in stability by resulting in the near bankruptcy of GM, but GM was probably doomed because of dependency ratios. If the Chinese, Russians, Indians, Venezuelans, Saudis etc do not have economic incentives to become more energy efficient, their economies will be damaged along with shareholder value.
Populist politicians love the idea of introducing an industrial policy to satisfy the public’s natural desire for stability. It is short term, gives governments power that is tough to take away and always ends in tears.

Mar 19 10:08 AM

[Ricard:]

Good points, thanks again.

On Mar 19 10:08 AM William Gamble wrote:

Mar 20 01:37 PM

[William Gamble:]

The Children’s Investment Fund, the $9.5bn London activist hedge fund, has liquidated its holdings in Indian state-owned banks in one of the biggest single selldowns by a foreign institutional investor in the country’s stock market.

In the past three months, the fund, founded by former Perry Capital trader Chris Hohn, has sold holdings in eight banks, from state-owned Bank of Baroda to Union Bank of India.

Mar 21 12:03 PM

[maryanne:]

Excellent voice of reason against all this hype of 'Buy China' I now focus on Australia and Canada (part of BRAC which replaces BRIC)

Jun 25 04:36 PM