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.

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 se
Now, 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 why
Take 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.

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.