What's the winning strategy in China's "low-trust" society?

And does "Guanxi" just mean networking and enjoying Moutai together? - China's "low-trust" society - Part 2

In Part 1, I laid out the distinction between a society where someone is “trustworthy until proven otherwise” and where it is “untrustworthy until proven otherwise”, and I believe the Chinese society by and large belongs to the latter, at least when it comes to dealing with strangers. I also listed some major caveats a few days ago.

Today, I am going to focus on the more practical stuff. How this “low trust to strangers” culture form the particular kind of business landscape of China?

There are many problems because of “trust deficit”, as all business essentially is built on trust. But a “low-trust” background also provides unique opportunities for those who know the game, which will be the focus of the second half of this article.

Problem #1: Inefficiencies

One obvious negative consequence of low trust is that it creates massive inefficiencies in businesses. Because of these inefficiencies, business activities that should have taken place, fail to occur. The many meetings and Baijiu binge sessions that it takes to build trust, as I wrote about in Part 1, is just one of many aspects that slow things down. But the problem goes deeper and wider and manifests itself in many distinct features of our business life. I will name just a few examples here, but I am sure I am missing hundreds more.

Vertically integrated giants

One enduring aspect of China internet space is that top players all tend to become vertically integrated players, which is really just a fancier way to say: everyone wants do everything themselves. When you think of Google, you think of search. When you think of Meta, you think of Facebook and Instagram.

But when you think of Tencent, you think of WeChat, and WeChat Pay, and WeChat Games, and Tencent Cloud, and Tencent Meeting (China’s Zoom), and Corporate WeChat (a CRM software).

When you think of ByteDance, you think of Douyin/TikTok, and Douyin E-commerce, and Douyin local coupons, and news-reading app Toutiao, and even business collaboration software Feishu/Lark.

When you think of JD, you think of e-commerce. But recently, they just announced they were breaking into food delivery, traditional turf of Meituan. While Meituan, for its own part, had a long history of breaking into other people’s backyards, such as hotel bookings.

And almost every Internet company of some size has its own cloud computing unit and its own payment service. I am not exaggerating here. You know Alipay and WeChat Pay, but you probably don’t know that Pinduoduo, JD, Meituan, Didi, Trip.com, Xiaomi, and many others all have payment subsidiaries and offer all sorts of incentives to entice their users to use their own payment services.

This landscape is a by-product of a do-everything-on-my-own mindset, which is obviously not the most efficient, but because of our “low-trust” nature, it’s the most optimal in the Chinese context. After all, why should I trust other people to manage my payments, or cloud computing? What if my data is stolen to hurt me? How can I manage them if their service delivery is suboptimal?

Lack of merger & acquisition (M&A) activities

If you watch China’s business and investment landscape long enough, you will notice that compared with the US market, there are far fewer M&A activities in China. I don’t have precise data, but I imagine it’s something like a whopping 1:1000 ratio between the two countries, despite almost parity in terms of GDP.

The trust deficit is still to blame here. M&A is an inherently sensitive moment in which at least one party is going to open up its books for the acquirer to have a complete look. Can the acquirer be trusted to open up the books? Can the books be trusted? If there is a degree of fishiness in the books, can you trust that the remainder is still okay? Even if the books are good, how can the acquirer stop the seller from engaging in competing businesses after exit, which would fundamentally impair the value of the acquisition target?

You can see that when trust is insufficient, M&A activities can quickly get stalled. It’s a high-stake game where instant trust among strangers matters a great deal. But because of lack of such trust, instead of a constant stream of M&A news every day, we only have sporadic cases here and there, most are too small to be meaningfully risky ( so even if all acquisition money is lost, it wouldn’t be too painful.) In other cases, it’s done by parties who have already known each other for a long time.

Corporate succession dilemma

Another reason that M&As are hard to find is that willing sellers are also hard to find.

Many corporate owners are first-generation entrepreneurs, some of whom are looking to retire. In a high-trust environment, it’s natural for them to hire professionals to run their business and/or to sell to buyout funds or bigger peers.

But in our culture, it’s always a first instinct to pass it down to their own children. But because your parent is a successful entrepreneur doesn’t necessarily mean you can be successful as well, and it’s always inefficient when your choices for a successor are restricted only to the limited gene pool of yourself.

Eventually, the successful ones will find the right way to trust outside professionals in order to continue their family legacy. One such example is home appliance and manufacturing giant Midea Group. Today, it’s one of the very few businesses in China where the founding family not only doesn’t run the company anymore, but doesn’t even join the board either. But I imagine the majority of companies who can’t build such a level of trust will eventually fade away as first-generation founders inevitably leave the scene.

Bias toward hardware instead of software

Chinese people love hard things. We don’t like it to be soft. Hardware is hard. It’s more real. Software? I can’t see it. I can’t smell it. It could be anything you describe to me, or it could be just a pile of garbage. How can I trust it’s real?

This is the fundamental reason why the SaaS industry in China is still tiny compared with its Western peers. In the B2B setting, it’s much easier to sell a piece of hardware, with flashy screens and huge servers, than selling a piece of formless software. For instance, a few years ago, when DeepMind shocked the world with AlphaGo, there was a proliferation of AI companies selling tumor detection software to Chinese hospitals. Today, most of them have faded away, while the surviving ones can only attach themselves as subcontractor of large imaging equipment makers.

Problem #2: “Quick money” culture

Another major problem of a low-trust society is that it helps create a “quick money” culture.

Since strangers are not to be trusted, even if they are doing good things today, who is to trust them to keep doing it for a long time?

Businesses that require years of patient development and investment struggle to thrive. Imagine a biotech startup needing a decade for drug development; investors, wary of the unpredictable future, might favor a quick e-commerce venture instead. This creates a market where rapid returns are prized over sustainable, long-term growth, and is also behind the government’s lament for “patient capital”.

This short-term focus permeates the stock market, leading to dramatic boom-and-bust cycles. Investors chase fleeting trends, creating quick bubbles and crashes.

Just think of stocks like Laopu Gold and POP Mart, two Chinese ten-baggers in the last year (which we at Baiguan also reminded our subscribers of sufficiently early). These two are high-quality growth names. But at ~100x price-to-earnings ratio, do investors piling into them think about what they will become in 10 years, or even just in 5 years? No, they don’t. And they don’t care. 10 years or even 5 years are too long to “trust”. If it’s good, just enjoy the moment today.

I know this kind of short-term behavior is common too in parts of Western capital markets. But in China, it’s the norm. The last decade has actually gotten better, when our market has become more institutionalized. Before that, short-term speculation was actually all there was.

Within such a culture, you can imagine how hard it must be to create a business that requires a long horizon, how many temptations there are for you to make quick money, and how much courage it takes to not to win quick bucks along the way.

Problem #3: Unstable regulatory environment

In Part 1, I mentioned a specific type of “low trust”, which is between the government and the people, and I have also mentioned one particular kind of inefficiency, which is this intentional vagueness of laws.

This is bad for businesses because they always look for certainty and predictability.

Sometimes, such vagueness will also hit a tipping point, when long-simmering structural imbalances erupt into a paradigm shift in policy, or, as I wrote about before, a pendulum swing.

It’s like a bomb. Most of the time, it’s just tic-tac-toe, tic-tac-toe, and people manage to live comfortably with it until the moment it BANGs! The crackdown on the tutoring industry in 2021 was one of such explosions that smashed many people’s goodwill toward China.

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Okay, so much for the problems. For the optimist in me, it’s always the opportunities that interest me the most. Usually, the best opportunities come hand in hand with deep problems. Only by solving the deepest problem can the reward be the largest. For each of the 3 problems above, I see 3 huge opportunities.

Opportunity #1: Building high-trust bonds in a sea of low-trust

One major corollary of a “low-trust” society is that once trust is obtained, this trust can be extremely strong, and even stronger than the bonds formed in high-trust societies.

This mechanism is similar to what I described in the last post, about Chinese people’s “over-trust” of those we are close to, as much as the under-trust of strangers.

Since trust is so scarce, it becomes a kind of coveted resource. Your best strategy is to try to form high-trust bonds in a sea of low-trust. It will be your secret weapon and can help you build incredible moat. The payoff can be huge.

China itself offers ample case studies for this strategy. Within China, there are many sub-cultures, notably in Chaozhou/Teowchow (where Li Ka Shing was born) and Wenzhou, which are famous for building incredible business empires. Their secret ingredient is forming highly robust high-trust networks among the clansmen wherever they go. I personally know quite a few people from these regions, and often times they can borrow money from each other with just a few words, and their words become gold. You can easily imagine what an incredible competitive advantage this can be over most other Chinese, who mostly live in socially atomized forms.

By now, you should rethink what you previously understood about the much-loaded Chinese phrase “Guanxi”. Many people confuse Guanxi with networking, or gift-making, or just happily drinking Moutai with each other.

The real meaning of Guanxi can’t be understood without putting it in the context of our “low-trust” society. Guanxi is just another name for this high-trust bond in the sea of low trust. Because trust is a scarce resource, it takes time and effort to win it. Common bonding, like coming from the same school, making gifts, or drinking baijiu, are only means to this end. It’s all about making guarded people accept you as one of their own.

If you are not into this “high trust, low trust” stuff, it’s actually totally fine. Sometimes, the most radical and somewhat counter-intuitive strategies can also win you Guanxi. For instance, being 100% transparent about yourselves and being blunt at the right moment can give you special power since few other people do it this way. If you manage to build a personal brand around these qualities, you will also become a master at quickly obtaining other people’s trust.

Beyond building a strong social network, a low-trust society also offers ample room for technologists. One of the best examples is Jack Ma’s Alipay.

Alipay was China’s first major online payment company. But when the Alibaba people created Alipay, their plan was not to create a payment service per se. Instead, they wanted to solve a problem arising from the fledgling Taobao platform that they had just built.

Now, let’s take a step back and consider this question: If China is such a low-trust society, how come China’s e-commerce market has become the world’s largest? It doesn’t make sense if you think about it. Since if we don’t trust strangers, how did we even trust strangers we never even met in person?

This was the same problem people at Taobao faced, and Alipay was their invention to solve this problem.

Essentially, the main function of Alipay in its early days was an escrow service. The buyer paid money to Alipay/Taobao, which held it for a few days until the goods were delivered and the buyer confirmed to be satisfied, when the escrow money was released. With this simple technology, the Alipay/Taobao teams unlocked the mammoth potential of China’s e-commerce market, and also became one of the most profitable businesses along the way.

CCTV camera is another example, which is essential physical infrastructure that has helped China to obtain globally low crime rates, while also adding to our improving societal trust levels. Proliferation of CCTV cameras are enabled by a whole cluster of successful companies, the largest of which is Hikvision, whose stock price surged 15x in the 10 years after China started to make CCTV cameras ubiquitous.

Opportunity #2: Building highly powerful brands

What’s the biggest opportunity in which most people only have the stomach for quick bucks? Well, refuse the temptation. Focus on building value. Focus on building powerful brands.

Do it relentlessly and unswervingly. The prize can be huge in the end. Because when most people are in quick-money mode, the very few people who think in the long-term can actually have the chance to build something truly incredible.

Although China’s market economy has been around for less than 40 years, we already have enough boom and bust cycles to prove this point.

Think of Evergrande vs. Huawei / BYD / Moutai.

In the go-go years of China’s real estate market, it was all about making quick money. The quicker, the better. Evergrande was only the largest one of the thousands of real estate developers playing this get-rich-fast game. But look where they are now? Whatever they have earned in the past, they gave it back in the end.

Huawei and BYD were much alike, run by founders who have big dreams and seriously care about research and development instead of short-term profits. Huawei, for example, has never been listed and probably will never be. This might not seem obvious in the beginning, when the more glamorous peers took the spotlight. But given time, the compounding effect will be significant, and now they have become two of the largest companies in China, whose founders sat straight across Xi Jinping in the private business symposium recently.

Moutai is another example. In a low-trust society, you would assume people don’t trust brands. To the contrary, it’s precisely because of lack of trust in general, when trust is truly established, the branding power can be incredible. Today, Moutai is China’s Hermes, becoming one of the most profitable companies by selling essentially fermented water. At market capitalization of ~$300b, it’s the largest liquor company in the world, 6 times that of Diageo, all for selling essentially just one product.

Opportunity #3: Taking advantage of the seemingly unpredictable policy changes

I understand that it can be frustrating that there always seems to be policy uncertainty in China. However, the right attitude to deal with it is to accept that things like the 2021 education crackdown do happen occasionally. The key here is to understand that there will always be policy pendulum swings, which I wrote about last October, and a keen observer will try to understand what’s the axis that this pendulum swings around, where the wind blows, and when the moment is for it to swing back. It’s actually not that hard to do. And once you know how to do it, there are many opportunities for policy arbitrage.

One example is the policy pivot around Covid in 2022. After April, when Shanghai was in lockdown and the central leadership seemed keen on maintaining Zero-Covid policy, many people believed there would be no end of it in sight. When asked about this at the time, my response was that, they would change, but it would take a mass social unrest to compel them to change. Look what happened in the end.

Similarly, it was also a wave of shocking discriminate killings by desperate people that partially compelled the government to embark upon a huge policy pivot towards boosting domestic demand and consumption.

The whole education crackdown was another episode. At the time, foreign investors interpreted the unprecedented move as part of some sort of grand plan to crack down on private businesses. But that crackdown never came, and the government eventually walked back from it. In truth, it was only a targeted move seeking to correct the social problems around after-school tutoring, although the way it was carried out was frankly quite a mess.

In each of these events, massive price dislocations were caused in the capital market. But for the people understand the underlying nature, it is also easy to turn into those events into highly profitable trades. For instance, TAL and EDU, two largest tutoring players’ stocks have returned 5 fold since their nadir.

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For Part 3, I will look at how “low-trust” shapes the kind of political system China has right now. Stay tuned!