Why Investors Should Avoid State-Owned Companies

by: William Gamble

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 (NYSE: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 (NYSE:PTR), a company that is only slightly smaller in size than ExxonMobil (NYSE: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 (OTCPK:OGZPY). 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 (NYSE:CHA), China Unicom (NYSE: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 (NYSE:CEA) got the Chairman of China Southern Airlines (NYSE: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 (NYSE: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 (NYSEARCA: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