USA and China trade war. US of America and chinese flags crashed containers on sky at sunset ... [+] background. 3d illustration


A better strategy might be to push US companies to produce China segment MD&A, income statements and balance sheets. Index makers may want to consider marketing indexes ex China and ex Hong Kong. Otherwise, any kind of divestment plan, voluntary or forced, is not even fully implementable.

Rep. Jim Banks, R. Ind., has just introduced a bill titled, “Protecting Americans’ Retirement Savings Act (PARSA),” to block ERISA governed retirement plans from making new investments in companies controlled by or based in our foreign adversaries. The bill also requires pension fiduciaries to disclose existing investments in other foreign adversary and sanctioned entities. “Foreign adversary” refers to Iran, North Korea, Russia, and China. So, if I understand this correctly, the bill asks ERISA governed retirement plans to avoid new investments in countries based in or controlled by these countries.

How is this freedom of choice?

I have no explicit position for or against investment in these countries. I simply point out that this is inconsistent with what I thought I heard over and over from the Republicans in the ESG II hearing that they were for freedom of investment but against surreptitious imposition of social and political values by the asset manager on investors. If Congress wants to ban investments in these countries, so be it. Why are we asking state run pension funds to take a decision that Congress should?

Parallels to the conflict minerals rule

I could not help but note the connection to the conflict minerals rule that was vehemently opposed by the Republicans back in the day. In 2012, the Securities and Exchange Commission (SEC) disclosure rule on conflict minerals broadly required that certain companies submit a filing that describes their efforts to determine the source of their conflict minerals—tin, tungsten, tantalum, and gold. Republicans strongly opposed the rule claiming that corporate reporting of such information is burdensome and costly while producing information that most investors don’t need. Instead, I am asking for corporate reporting of a company’s own business operations in these so-called, “adversarial” countries. Surely, that is not burdensome or overly costly.

The need for disclosure

Rep. Banks’ proposal is not even implementable unless firms tell us the scope of their operations in these countries. Attention then gets narrowly restricted to companies listed in these countries, which I will come back to towards the end of this piece.

Critics will argue that such disclosure will open a market for regulatory arbitrage whereby Chinese and Russian companies, on the margin, will simply locate their legal domicile elsewhere. Potentially yes. But manufacturing and supply chains are relatively deeply entrenched and movement out of these areas is likely to be expensive and time consuming. Disclosure is a better strategy to enable indexers and fund managers design portfolios ex-China and ex-Russia, should their clients demand such products. Otherwise, Rep. Banks’ divestment plan itself cannot be effective. Of course, one can ask deeper questions related to whether divestment even hurts the company. I have my doubts, as argued before but we will set that aside, given that there is a sentiment in some part of the investing market to divest from Chinese and Russian stocks for whatever reason.

The state of current disclosure

If the intent is to ban companies controlled by China and the so-called, “adversarial” powers, what about new indirect American investment in especially China by virtually every major multinational? China is surely the most important country to consider here. I will devote a sub-section to Russia related disclosure later. Consider, for instance, the top 10 most capitalized companies in the US as of June 20, 2023: Apple, Microsoft, Amazon, Nvidia, Alphabet (appears twice on the top 10 list), Tesla, Meta and Berkshire Hathaway and Exxon.

To assess the extent of involvement of these companies in China, I pulled up the latest available 10-Ks of these firms. Start with Apple. We all know that Apple is hugely dependent on China for its manufacturing and revenues. The risk factors in Apple’s 2022 10-K mention China extensively. Apple reports that its sales in greater China amount to an eye-popping $74.5 billion out of total revenues of $394 billion in fiscal 2022. Apple reports operating income of $31.1 billion from China in fiscal 2022. Apple discloses that long term assets owned in China fell from $7.5 billion to $7.2 billion in 2022. How does Apple China generate revenues equivalent to 10 times long term assets and operating income equivalent to five times its long-term assets?

Clearly, outsourced operations and sales, indirect investments in contract manufacturing infrastructure, the extent of cost of goods sold that comes from China, and the portion of the SG&A attributable to China is not fully disclosed. Arguably, a bulk of Apple’s hardware is assembled in China, but we don’t know how much. Ideally, we should see a China related MD&A section (management discussion and analysis), a China income statement and a balance sheet in Apple’s 10-K. Having said that, what I found was far better disclosure than I was expecting before I looked at the 10-K.

Ironically, Apple’s China revenue of $74.5 billion is as big as the $77 billion of revenue reported by Tencent in 2022, which is the largest company held by MSCI’s international index (ACWI), as detailed later. Hence, ignoring Apple’s Chinese investment seems inconsistent with what the PARSA bill is intended to accomplish.

The word “China” shows up 11 times in Microsoft’s 2022 10-K. No financial information of any kind is disclosed. Amazon’s 2022 10-K mentions “China” five times with no financial information of any kind disclosed as well. I don’t know for a fact but have a hard time comprehending how Amazon and Microsoft’s China exposure might be immaterial. I suspect a large portion of the products sold on Amazon’s website are of Chinese origin.

Nvidia, in an effort to respond to the US Government’s export restrictions to China states in their latest 10-K for fiscal 2022: “we are required to transition certain operations out of China (including Hong Kong), which could be costly and time consuming, and adversely affect our research and development and supply and distribution operations, as well as our revenue, during any such transition period.” Nvidia discloses that China accounts for revenue of $5.7 billion out of a total of $26.9 billion in fiscal 2022. There is no disclosure of expenses, income, taxes, assets, or liabilities or indirect exposure in China.

The word, “China” does not seem to show up in Alphabet’s 10-K for fiscal 2022. The word, “China” appears 62 times in Tesla’s fiscal 2022 10-K. Tesla reveals that $18 billion of its $81 billion of revenue comes from China. Tesla’s long-lived assets went up from $2.4 billion in 2021 to $2.9 billion in 2022, which technically means Tesla’s “investment” in China increased during the year although we do not know enough about their Chinese liabilities to comment to true net investment. Tesla reports a subsidy from China to build its factory there and extensive list of what look like sales offices in various Chinese cities. There is no disclosure of income and details of other expenses, other assets, and liabilities in China. All told, should Rep. Banks’ bill require US state pension funds to sell Tesla?

Meta’s latest 10-K lists “China” six times but there is nothing financial that is disclosed. Berkshire’s latest 10-K lists “China” around 15 times but again there is no financial disclosure. Exxon reports that they have a 25% interest in Fujian refining project in China but do not share financial details. Technically, the 25% interest would qualify for “equity method accounting” which does not require detailed disclosure of the investee company. However, if Congress feels that our citizens’ interests do not coincide with our shareholder interests, it might want to mandate disclosure of US companies’ China involvement in their financial statements.

What about Russia?

Note that any Russia related disclosure potentially appears to tell investors about the impact of US government sanctions or the financial cost of withdrawing from Russia. Hence, whatever we find in the latest 10-K arguably overstates Russia related disclosure. On top of that, I suspect the economic materiality of Russia to top US companies I looked at is much smaller than that of China.

The 10-Ks of Apple, Amazon and Microsoft’s make no mention of Russia. Berkshire talks about the how EXSIF and Marmon, two of its subsidiaries, have exited their Russia business and Marmon took a hit of $900 million to its earnings. A couple of other subsidiaries also reported lower margins due to Russia-Ukraine conflict. The word, “Russia” appears only twice in Tesla’s 10-K and that too in the discussion of macro risks. Nvidia reports that they had to stop selling products to Russia to comply with US Government sanctions, but the actual sales number was not material.

Meta reports lower user engagement as access to Instagram and Facebook was restricted in Russia but does not go into specifics. Alphabet reports that operations ceased in Russia, but the financial impact thereof is not material. Exxon latest 10-K reports a $3.4 billion write down of its Sakhalin project in Russia.

Although the ex-post or after the attack disclosure is not all that great, the more important benchmark for the investor to consider is whether these losses could have been estimated even crudely before the Russian conflict and sanctions began.

What about firms controlled by or based in “adversarial” countries?

Most international investing by pension funds follows well known equity and bond indexes. Consider the international equity index offered by the Indiana Public Retirement System: MSCI ACWI ex US. It turns out that 8.51% of the index invests in Chinese stocks and 1.64% of the index is in Hongkong shares. China is the third largest country in the index following Japan and the U.K. I found four Chinese companies in the top 50 holdings of this index as of June 16, 2023: Tencent Holdings with a market capitalization of $52 billion, Alibaba with a market capitalization of $35.5 billion, AIA group with a market capitalization of $23 billion and Meituan with a market capitalization of $16.3 billion.

I wonder whether the Indiana Public Retirement Systems forced their funds to offload the MSCI ACWI ex US index because it contains Chinese stocks. If yes, why is the fund being offered as an investment option to the state’s workers?

Of course, MSCI markets a version of ACWI ex China. Ironically, the MSCI ACWI ex China index seems to include Hong Kong stocks.

What would excluding China have done to performance? Hindsight is 20/20 and I fully agree this exercise is not predictive of the future but it’s still interesting to look. Ironically, Chinese stocks have done poorly. The gross returns of the MSCI ACWI ex China are 6.12% per annum since December 31, 1998 relative to 6.03% per annum on MSCI ACWI. Of course, the US accounts for a disproportionate 61%-64% of the market value of both these indexes and the investor did not get much by way of diversification. Perhaps it might be time for MSCI to market an ACWI index which is both ex US and ex China.

So, what is the bottom line?

International divestment is harder than it looks in today’s intertwined capital and product markets. Index makers might want to come up with international indexes that exclude both Chinese and Hong Kong stocks.

Congress might also want to ask US firms to produce China segment income statements and balance sheets so that the fund management industry can credibly come up with indexes or portfolios that can implement divestment from adversarial countries, should investors so desire.

In particular, investors interested in assessing the financial impact of the US-China trade war on individual firms will be left scratching their heads given the opacity in today’s disclosures.

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