The Price of Democracy

Would you rather invest in a democracy or a dictatorship?

Before you answer, consider that businesses in the former ostensibly have freedom from persecution, secure property rights, and recourse to the courts in the face of regulation. Businesses in dictatorships, on the other hand, are subject to significant government scrutiny and regulation, have no legitimate due process, and could be forced to take action that is against their best interest.

Given that framework, the answer is a pretty easy one: We'd all like to invest in democracies.

But we don't
The data, however, show that investors actually prefer dictatorships over democracies-- or at least one major dictatorship over one major democracy.

Market

2009 Democratic Institutions Ranking

October 2009 P/E

China

100

40.7

India

36

14.6

Data from Motley Fool Global Gains research and the Legatum Institute.
That's right: When investors are voting with their wallets, they pay a significant premium to invest in the efficiency of China's communist dictatorship. That's the only feasible explanation for why the valuation spread between the stocks in these countries is so wide.It's not the dictatorship, per seNow, you may say that the reason there's a valuation gap is because China has superior infrastructure. Well, that's because the Chinese government can order people to move out of the way of any proposed construction project.Or you may say that the reason there's a valuation gap is because India suffers from rampant corruption and bureaucracy. As it turns out, according to the Legatum Institute, China (No. 93) ranks below India (No. 41) when it comes to governance.Or you may say that China deserves a premium because it's such a big market. And while it's true that China's population of 1.3 billion is the larger, India, with 1.1 billion heads, is not a small country.Is this right?The fact is that as much lip service as we pay to democracy, investors at the end of the day crave certainty. And with its five-year plans, the policy trial balloons it floats via state-run media, and the need to maintain economic growth in order to maintain power, China provides investors with more certainty than any other emerging market.But investors should think long and hard about why they're paying more than 40 times earnings to own stocks in a dictatorship.Here's whyTake Baidu.com (NASDAQ:BIDU), for example. This company dominates the fast-growing search engine space in China, and it's extremely profitable. However, one reason it's so dominant is because the government casts favor on it, since Baidu limits its search results to comply with China's Internet censorship regulations. And the Chinese government is trying more and more to regulate the Internet. If Baidu goes along, it risks alienating users. If it doesn't, it risks the government's wrath. Investors, however, must be overlooking this very real risk when they pay 70 times earnings to buy the stock.Contrast that reality with Indian Internet portal Rediff.com (NASDAQ:REDF). Like Baidu, Rediff carries a high valuation, but unlike Baidu it struggles to grow sales and profits. That's because Internet penetration in India -- at just 7% -- is so much lower than it is in China because of the inability to proceed with infrastructure projects in the country.What about this scenario?Or consider the mobile phone industry in the two countries. China -- because the industry is heavily regulated -- has three players: China Mobile (NYSE:CHL), China Unicom (NYSE:CHU), and China Telecom (NYSE:CHA). India's telecom landscape, on the other hand, is much more diversified, with carriers including Bharti Airtel, Reliance Communications, Vodafone (NYSE:VOD), Tata DoCoMo (a joint venture between India's Tata Group and Japan's NTT DoCoMo (NYSE:DCM)), and many more. Further, while state-owned China Mobile dominates China with nearly 70% of the market share, the biggest player in India is Airtel, with just 27% market share.And while China Mobile does not look like the more expensive stock, remember that its results are being skewed by one benefit of being a state-directed giant with limited competition: the world's best profit margins.

Company

EV/EBITDA

EBITDA Margin

China Mobile

4.8 times

52%

Bharti Airtel

7.8 times

41%

Global Telecom Average

6.0 times

39%

Data from Capital IQ (a division of Standard & Poor's).
Investors, however, should not expect those margins to be sustained over time. See, the Chinese government is actively working to make China's telecommunications industry more competitive. Those efforts continued this past year with the government awarding China Unicom rights to a superior 3G network and could culminate in forcing China Mobile to share its network, which has the best nationwide coverage, with the competition.Should there be a dictatorship premium?The fact is that no one can know what the Chinese government will do next, and that's particularly true when it comes to highly regulated sectors. Indian companies, on the other hand, are more likely to be governed by natural competitive forces.So I ask: Do Chinese companies deserve the wide valuation premium they're being awarded today?We're not sure they do, and that's why our Global Gains research team is traveling to India at the beginning of December. We believe the market is overlooking significant opportunities in the country, and we'd like to increase our exposure to this promising emerging market.If you're interested in getting the scoop on all of the ideas we dig up, simply click here to sign up for our free, real-time dispatches from the field.

Tim Hanson does not own shares of any company mentioned. Baidu.com is a Motley Fool Rule Breakers selection. The Fool's disclosure policy is hoping it has to disclose a few more investments in India in the future.


Read/Post Comments (7) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 16, 2009, at 5:52 PM, MrsCathyGF wrote:

    I'd rather support democracy. Hands down. Period. End of story.

  • Report this Comment On November 16, 2009, at 6:18 PM, a65fc wrote:

    Jeez, this is as easy as a wiki:

    http://en.wikipedia.org/wiki/Economy_of_Nazi_Germany

    Or as Benito said:

    “Fascism should more appropriately be called Corporatism because it is a merger of state and corporate power”

    Market timing, anyone?

  • Report this Comment On November 16, 2009, at 6:31 PM, a65fc wrote:

    ... and by timing I mean get out of Krup just before Stalingrad and get out of market meaning petrol stations in Milan if you can exchange for anything Allied.

  • Report this Comment On November 16, 2009, at 6:38 PM, starbucks4ever wrote:

    Irrelevant question. It all depends. The real matter is, what kind of dictatorship you have, and what kind of democracy.

  • Report this Comment On November 16, 2009, at 8:52 PM, ET69 wrote:

    It isn't about Dictatorship or Democracy - that doesn't matter here. This is about capitalism! Forget everything else ...this is about profit! Hell most people would invest in Attila the Hun if the margins were better.!

  • Report this Comment On November 16, 2009, at 11:48 PM, dc46and2 wrote:

    Democracy, unfortunately, is not a synonym for "a good and just government."

    "... the first step in the revolution by the working class is to raise the proletariat to the position of ruling class, to establish democracy." --The Communist Manifesto

    In the case of China, I think there has been so much potential held back for so long, that now when given a little breathing room, they can't help but prosper in spite of the government. I'm not avoiding China completely, but I'm wary, since those stocks have large future growths priced in already. Whether not that growth materializes or not, depends largely on the caprice of the government.

  • Report this Comment On November 20, 2009, at 8:47 AM, sofpan wrote:

    I believe that in economy, its better if you have an efficient head, making policy.

    The head of China (government or China's Communist Party) is proven in the last decade that is more efficient than India's governments over the same period. It is proven by the GDP growth.

    India in the whole decade succeeded high GDP growth rates of about 8% but China succeeded higher (about 10%).

    If the numbers of GDP growth rates from China are real (and I assume they are), then a 2% plus annually, over a decade or more, is creating a huge differance in GDP value. It is the way compound interest working.

    So according to this logic, India after 20 years would be as today, just a very large economy. But China after 20 years can be the Biggest economy in the world, surpassing the US.

    That is the scenario that investors bet on, giving to China a big premium over India.

    Anyway, the more essential question is for an investor to find the better ctocks - companies between China and India and build a strong balanced portfolio that will give him huge returns after, lets say, 20 years.

    Speaking of that, I believe that for a long term investment TTM is better than Buffett's choise (BYD).

    The key is to finf the best companies with the best growth potential, between both countries.

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