Published: September 22, 2009

XIAN, People’s Republic of China -- During the politically charged period in the late 1980s and early 1990s -- when China believed it really needed friends -- a small number of Western companies ignored the controversies and refused to abandon the market.

Global investors will recognize some of the names: The Coca-Cola Co. (NYSE: KO), Johnson & Johnson (NYSE: JNJ), and ABB Ltd. (NYSE ADR: ABB). In the years since, their courage and commitment has been rewarded with hefty market shares, growing profits, and a position of trust that’s very tough for an outside firm to obtain.

These firms also have guanxi.

Loosely defined as “connections,” guanxi is actually a Chinese word that refers to the very fabric of how relationships work, and how business is conducted in this growing Asian nation. In fact, trying to better describe just how important this concept actually is, some sociologists have actually likened it to “social capital.”

While the definition itself may seem a bit hazy, one fact is crystal clear. The best relationships and biggest profits in China are built upon the trust and long-term interactions embodied by this deceptively simple term. Global investors who take the time to understand what guanxi means -- and to identify the companies that actually have it -- can expect to reap the biggest windfalls from their China-focused profit plays.

A Different Point of View
Talk about “connections” to a Westerner, and the odds are good you’ll get a negative reaction. In the West, a connection can come down to one person owing a second person a favor. But in China, guanxi is about increasing one’s personal standing, about getting respect and about giving it, too. It literally encapsulates every aspect of Chinese society.

Contrary to beliefs here in the West, guanxi has nothing to do with bribery or corruption -- although there is admittedly a very fine line here, just as there is anywhere in the world where power, money and profits intersect.

And while some forms of guanxi can be built up immediately, as my example involving Coke, J&J and ABB demonstrates, the most powerful and profitable benefits of guanxi can take considerable periods to amass.

The same is true for individuals, which is why most Chinese seem to spend inordinate amounts of time and money establishing, cultivating and maintaining their guanxi networks. Needless to say, once these connections are forged, they are nurtured, treasured and even guarded, for they can last a lifetime.

Guanxi starts with decency and fairness. If a company delivers their products on time -- and honors its promises to the governing authorities and its workers -- that firm is demonstrating “trustworthiness.” The company is reliable, dependable and can be counted on. Those qualities all enhance the firm’s guanxi.

Companies that didn’t stick with China, that seemed to pass judgment on the country and its precepts, or that tried to push a Western agenda, very rarely experienced any kind of overt or official rebuke. Instead, these companies discovered that they’d been shuffled aside. And their chance to be a real “player” in China was gone.

Guanxi’s New Role in the “New” China
Westerners who are still coming to terms with modern China will likely attribute this to what they believe is Beijing’s centralized authority. As state-operated enterprises decline in number, so-called “government guanxi” is losing its influence. And with good reason: The growth in entrepreneurship here has created legions of companies that are no longer dependent on state sponsorship for profits.

As China continues its emergence as a global economic superpower, even a social norm as old and established as guanxi is finding a new role. Properly constructed guanxi relationships will help global investors identify future trends, potential profit opportunities and even the players best positioned to pursue them.

In that sense, it’s a bit like the proverbial “old-boys network.” The companies with the connections will be best positioned to capitalize on the new projects, markets or potential partnerships. The companies that lack guanxi will read about the new deals in the newspaper after they’ve been finalized.

With their finely tuned sense of “fair play,” it’s not surprising that many Westerners will want to cry “foul” when it comes to this aspect of guanxi. But here’s the thing: In China, connections are fair play. They’re completely legal. And it’s been that way for 5,000 years.

If anything, my experience in Asia over the last 20 years suggests that people without guanxi are the ones who should be worried.

So that begs the question: Absent traveling here three or four times a year and spending as much time as I have here in Asia over the past 20 years, how do you go about developing your own guanxi? Even better, how do you identify the companies with the powerful connections and the best profit potential?

When searching out investments, look for companies or profit opportunities that manifest the following three qualities. As we’ll explain, the presence of these three qualities makes it a near certainty that guanxi connections are present, as well. Those three things to think about are:

Consistency: Look for companies that have been in business here for a long time, and whose management teams have a strong track record. Western investors have a well-chronicled fixation on startups. And there’s a real temptation to concentrate on the newly formed companies in the potentially hottest new industries. But here’s a stunning fact: Most of China’s fastest-growing and most-profitable companies right now are the ones transitioning from a purely state-owned status. These firms either want to become private ventures outright, or to become new companies that are aligned with major national initiatives focusing on large infrastructure projects, environmental issues and pollution control and energy. It’s no surprise that the companies with guanxi will have the best success landing business in areas the government has deemed to be so important.

Investors searching for more-aggressive, smaller companies should look for companies that have locked up special licenses, operating contracts or market franchises. These usually come about as a result of the collective guanxi of that company’s executive management team. One great example is a small, educational company that I discovered recently. It’s one of only a small group of firms granted an ultra-rare license that allows it to stream its Internet content all across China.

Patience: Here in China, executives often work for years before they are trusted enough to manage their first major deals. When I first came to Asia, a senior executive bluntly told me that he wouldn’t even begin to trust me until after we’d met at least three times. Even then, he said, that trust would be superficial, at best. When I asked why this was so, he informed me that “we Chinese see so many hotshots who come here expecting to get ahead and we only get to know them on the surface. There is no use for that.”

In his view, “we must see each other over a period of time to get to know one another.” Only then, he informed me, would our “truest character” emerge. And that would put in place the building blocks for a relationship built upon long-term trust.

It was a bit of insight that I’ve never forgotten. And neither should you.

When it comes to picking investments in China, you can’t learn everything there is to learn about a company from a “tip sheet,” or from an initial public offering (IPO) prospectus. It’s important to review management and even meet senior company officials, if possible. And if you can’t meet there in person, establish your own guanxi with someone who can.

The important thing is to learn what makes them tick over time. Just because a company is new doesn’t mean it’s the next sure thing -- particularly in China.

Deliberateness: Thanks to its commitment to market reform, China has made more economic progress in the last two decades than it did in the previous 2,000 years combined. Despite the still-accelerating pace for change, however, the investors who succeed here will be those who tackle this process in a steady, measured manner.

To better understand what I mean, compare what’s happening here in China with what’s taking place in the United States. China is right now weathering the global economic storm by spending the money that it spent years saving for a rainy day. And with foreign reserves estimated at $2.3 trillion, it can rain for a long time before China’s economy gets too soaked to function.

What’s more, China’s outlays might well be better described as investments as opposed to expenditures. Beijing is spending money on expanding capacity and infrastructure that will help its economy grow for the long haul, even as it creates wealth in the near term. To a trained eye, it’s clear that the plans were put in place in a way to capitalize on the connections in business, industry, finance, and government. The country’s actions have been very deliberate. And very shrewd. Given all these considerations, the payoffs will be substantial for the country in general -- as well as for investors who are shrewd enough to participate.

On the other hand, the U.S. is trying to borrow its way out of a problem that was created by debt in the first place. And it’s compounding that error by using that borrowed money to create “work” programs and to finance voter-appeasement bailouts. Neither of these actually fixes the problems at hand. Even worse, however, is that neither creates any long-term value. But both will end up sticking us with the mother of all credit card balances.

It’s no surprise to us that China is still on track for 8% economic growth. It proves that old adage that says “it’s who you know that counts.” Especially in China.

-- Keith Kitz-Gerald
Investment Director
Money Morning