Investing in State-Owned Enterprises

The Risks and Rewards of Buying into SOEs

Businessman on the terrace

Most people think of Apple Inc. (NASDAQ: AAPL) or Alphabet Inc. (NASDAQ: GOOG) as the largest companies in the world, but in reality, Saudi Aramco is by far the largest company in the world with a market capitalization that’s estimated to be between $1.5 trillion and $10 trillion. Of course, Saudi Aramco is majority-owned by the Saudi Arabian government, which means that investors treat it a little differently than a publicly-traded company.

So-called state owned enterprises – or SOEs – are legal entities that undertake commercial activities on behalf of a national government. In some cases, these companies are an actual branch of the government that is operated by appointment. In other cases, SOEs are autonomously operated stock companies with the state acting as a regular stockholder – although the government typically maintains a majority controlling stake.

In this article, we will take a look at state-owned companies and whether or not international investors should get involved with them or not.

State Ownership 101

The most popular state-owned enterprises are natural monopolies and infrastructure related, since these are areas that most governments have an interest in controlling. These types of companies are most common in frontier and emerging markets where governments rely on natural resources for gross domestic product (GDP) growth or political influence.

However, there are some developed countries that still operate SOEs in key industries.

The most popular natural monopolies deal with energy and minerals that may be strategically important to the country. Saudi Aramco is the most prevalent example of a natural monopoly that houses the country’s substantial crude oil reserves.

In Brazil, Petroleo Brasiliero is another great example of a state-owned enterprise that controls substantial off-shore crude oil assets, while Russia’s Gazprom controls the country’s natural gas resources.

Infrastructure is another strategic area where countries like to retain control over what is built and operated. Railways and telecommunications are the most popular areas of focus for SOEs, since railways can be used to transport military equipment and telecommunications controls public perception in many ways. For instance, the Venezuelan government operates state-run media companies including 244 radio stations and 34 television stations.

Investment Considerations

International investors may be tempted to purchase state-owned enterprises for their portfolios, but there are many important risk factors to consider. In simple terms, investors should remember to discount the risks associated with a SOE when determining a valuation since these risks are often significantly higher than privately held companies.

State-owned enterprises appear attractive on the surface for many reasons. First, these companies tend to have a monopoly over an industry, which is a strong competitive advantage.

Second, these companies are well-capitalized and have a low risk of default on the surface. And third, these companies tend to trade at compelling low valuations as institutional investors tend to discount the political risks and potential for mismanagement by the government.

The downside is that state-owned enterprises are often mismanaged by national governments and face unique political risks. For instance, Brazil’s Petroleo Brasiliero was famously involved in a political scandal in 2015 and 2016 that resulted in impeachment hearings. Some other countries have nationalized assets that were sold to investors in a power grab that resulted in steep losses, although these moves are risky given the growing reliance on investment.

Investing in SOEs

There are many different ways that investors can gain exposure to state-owned enterprises, including both stocks and funds.

Most country exchange-traded funds (ETFs) include exposure to both publicly-traded state-owned enterprises and publicly-held and traded companies. If these indexes are weighted by market capitalization, the exposure to SOEs may actually be greater than normal since these companies tend to be larger in size. This is an important risk factor that investors should consider when analyzing these funds for their portfolios.

The Bottom Line

State-owned enterprises represent large investment opportunities for international investors in terms of market capitalization. However, investors should keep in mind that these companies face a number of unique risks that shouldn’t be discounted. The best approach to investing in any country is constructing a diversified portfolio that includes a limited number of SOEs and a greater number of publicly-held companies that often face fewer risks.