Many arguments I have heard regarding the ability of investing into China are mostly very low resolution, and whilst some of these arguments touch the surface, there is a failure to get to the underlying core of China, and deep philosophical and atomic reasons as to why China is bad for investments.
I am a proponent of qualitative factors when analysing companies and nation states, and within my recent writings, I have highlighted the importance of understanding qualitative analysis, and why intangible factors are often leading variables of a company’s financials.
Whilst studying intangibles, game theory and structure, I recognised that not only does this notion apply to teams and companies, but it also applies to nation states too. When you recognise that at the deepest atomic level teams, companies and nations are solely the collection of individuals towards a set goal, one can recognise that there is severe utility within the idealistic ways in which those atomic individuals are organised and structured.
The most important innovation for companies can often be the company itself. The way in which people are organised and structured. And the same applies for nation states too. The ways in which incentives are subconsciously aligned, game theory is managed, and information flows, makes up the underlying atomic forces of successful companies and nations.
Throughout this article, I will argue that China is purely un-investable. Now, not for the low-resolution arguments pushed forward by the masses, namely the fact that China is not democratic and COVID lockdowns are pushing China into a severe plunge – but instead for the atomic reasons. These deep reasons are that of structure, human organisation, information flows and game theory.
Structure Of Radical Innovations:
Structure explains the ways in which the humans and individuals within a company, nation or team, are organised. To understand the inability of investing in China, firstly you must understand structure and human organisation. I believe that structure and human organisation are both the most important principles to analyse within a company, team or nation state.
The reason as to why these principles of structure and human organisation are important, stems from the atomic understanding of what a company actually is. To explain, a company is solely the collection of individuals towards a set goal, and thus via definition the ways in which these individuals are structured and organised is of upmost importance. The same applies for nation states.
Steve Jobs famously stated that the most important innovation within a company is often the innovation of the company itself. The way people and humans are organised.
There are two main necessary functions to ensure that good structure within an organisation, or nation state can prevail. These two factors are:
- dynamic equilibrium, and
- phase separation.
It is vital to separate the phases. The two different phases within a company are referred to as soldiers and artists. The soldiers are those who are working on the franchise, or the more conventional part of the company, whereas the artists are those who are innovating at a drastic pace and are coming up with new and often absurd ideas.
There is a necessary reason as to why there must be a separation between soldiers and artists. Early-stage ideas are fragile and can fail easily. Think of early-stage ideas as a young baby. The baby must be nurtured. The baby must be taken care of. The last thing you want is an early-stage idea being shot down early, without time to nurture and grow.
There are probably thousands of early-stage ideas that have been shot down early on, and thus failed, because of poor structure. These early-stage ideas may have become revolutionary to the way humanity operates. But, because these ideas never had the chance to grow, they failed and were buried.
Leaders within successful franchises so commonly dismiss new early-stage ideas, via picking apart their weaknesses. This occurred in the case of Nokia, IBM & Pan Am. All had poor structure and therefore proceeded to fail dramatically.
Dynamic equilibrium speaks towards the balance between loonshots, and franchises.
It is necessary that neither phase overwhelms the other. Artists working on loonshots, and soldiers working on the franchise, must both equally feel loved.
“No division, department, brand, or group can be either ignored or favoured at the expense of the whole without unbalancing the whole”.
Teams and companies need both artists and soldiers to survive and thrive. Both need to feel equally value and appreciated.
Often, innovative leaders try to anoint themselves the judge and jury of loonshots. Instead, create a natural process for projects to transfer from the loonshot nursey to the field, and for feedback to cycle back from the field into the nursey. In other words, act like a gardener, tending to the flow of information and the touches and balances of incentives.
Steve Jobs within his prior companies failed continually until he learnt this lesson of dynamic equilibrium. Jobs famously referred to the soldiers, or conventional workers in the company, as bozos, and losers. Job’s openly favoured the artists whom were working on the radical new innovations. What Job’s at the time did not recognise is that both artists and soldiers are fundamental for each company, and therefore the role of the leader is to maintain the touches and balances between soldiers and artists, instead of being a dictator and demanding which products fail or succeed.
These two principles are necessary to understand the latter half of the article.
The interesting thing about recent discussions regarding China, is that these discussions are solely repetitions of prior debates and arguments made back in the early 1940s.
Needham’s Question simply asks, why all scientific advancements occurred within the West, despite the fact that China & India were prior leaders in formal education, inventions, science, and almost all domains. In fact, some of the impressive breakthroughs actually occurred in China & India 100s, or even 1000s of years prior to mass success within the West.
As an alien species from out of space, who is reading through a script of humanities existence, you would have undoubtably concluded that China & India would have been nations that achieved all the scientific achievements, in comparison to the West, due to the supposedly obvious and clear advancements in formal education, technology, and science.
However, this never happened. China never led the path in scientific advancements, despite having such a lead in formal education, scientific studies and inventions.
The question is why? Why isn’t China responsible for all the scientific advancements? Why did the West take the lead so dramatically in scientific advancements? What happened?
To understand this, let me tell you a story of Tycho Brahe, and Shen Kuo.
5 years prior to Tycho Brahe building the best astronomical observatory in Europe, Shen Kuo assumed command of the best astronomical observatory in China. Shen was commonly described as “perhaps the most interesting character in all Chinese scientific history”. Shen contributed to, studied, and wrote about a stunning breadth of academic fields, including: astronomy, mathematics, geology, meteorology, cartography, archaeology, medicine, economic theory, military strategy. anatomy, and ecology. Shen was the first to describe the magnetic compass and identified the difference between true north and magnetic north (transforming navigation). He developed the earliest known examples of trigonometry and the mathematics of early calculus in China.
Shen was curious regarding the bizarre motions of planets in the sky, and like Tycho, he insisted that only more accurate measurements could provide a deeper understanding. He designed the best astronomical measuring tools of his era, just like Tycho. Shen proposed to the emperor a program to measure the position of every planet, to high precision, three times a night every day for five years.
Shen understood that this program would be costly, thus proceeded to gain political support. He eventually, similarly to Tycho, lost that political support. For Tycho, his political support was lost after King Fredericks 11 died, and a feud proceeded with his son, a 19-year-old King. Tycho wrote a letter to the young king, explaining why he should continue to support Tycho. However, the King replied and was totally stunned at Tycho’s audacity and want to sense. Thus, Tycho’s funding was cut.
In Shen’s case, he was ousted from Government, a casualty of similar political turnover and battles.
However, here is the important difference. After Tycho left Demark, he hunted around Europe for a new patron. The King of Prague eventually raised his hand, and Tycho moved his observatory there. This continuation of work ultimately led to the reformation of all of astronomy.
However, after Shen left the Government, there was nowhere for him to go. There were no other rulers who could support astronomy. Private support for astronomy was illegal. Shen spent the rest of his life under house arrest, and as a recluse.
When a script is killed inside Paramount or a Universal Studio major, it dies and stays dead. When an early-stage drug project is killed inside a major global pharma, it stays dead. In China, when the supreme ruler quashed promising new ideas about astronomy, as the emperor quashed Shen Kuo’s ideas, they stayed dead.
Meanwhile within China, there was a period of industrial miracles occurring. Steel and iron production grew exponentially, money and exchanges proliferated. Technological innovations rapidly occurred, from guns and cannons to transportation and manufacturing.
These productivity and technological innovations were not matched until six centuries later in Europe. China was ahead.
So, although China achieved critical mass, it failed to ignite. It never created phase separation, and dynamic equilibrium. Political battles, and the emperors’ own prejudices would regularly override the conclusions of early-stage scientists. Seven years after Shen began work on his astronomical system, the emperor decided that it was good enough. He terminated the project and fired Shen’s assistant.
In other words, the emperor failed to quarantine his loonshot group, and failed to maintain the balance between loonshots and franchises.
An easy way to tell the story is: had the emperors understood incentive structures and human organisation, the industrial and scientific revelations might as well have taken place five centuries earlier, and we would all now be speaking Chinese.
A crucial role when creating radical breakthroughs in technology is the notion of life support. Often brand-new ideas and radical innovations are ugly, and do not look anything like the beautiful adult they will later grow up to resemble. Instead, these early-stage ideas are ugly, have multiple warts, and are extremely fragile.
For example, the most exciting approach for treating cancer today – via triggering the body’s immune system to fight tumours – was rejected by every large pharma company. Most biotech’s fail. A few succeeded and changed the treatment of cancer forever. The vast majority of the most important breakthroughs in drug discovery hopped from one lily pad to another. until they cleared the last challenge.
Only after the final jump to the final lily pad, would these ideas gain wide acclaim.
Within the case of Tycho, when he lost support from the King in Demark, this was equivalent to hopping or jumping onto lily pads, and thus eventually flourishing. The flourishing loonshot nursey of local rulers wiling to fund far out research rescued Tycho’s observatory. This was not the case in China.
Europe had created a brilliant loonshot nursey, Let’s refer to this as phase separation (#1).
But, there was also another major advantage of Europe over China, namely the regular exchange with the large empires (dynamic equilibrium #2). Without the mathematics borrowed from Indian scholars and Islamic astronomers, many innovations & theories would have never come into fruition.
These two principles alone of phase separation, and dynamic equilibrium both contributed to Europe gaining critical mass, and eventually taking lead in the scientific revolution.
Europe created a bubbling stew of innovations, in which later ignited and led to ripple effects of innovation after innovation. In China, this never occurred.
The fascinating dynamic about technology is that the top 1% of talent, creates literally all of the company’s value. This is why I commonly look for company’s that are renowned for world class talent, as a leading variable into the future potential financials of that specific company.
According to McKinsey, there is a dramatic relationship between quality of talent, and the business performance. The productivity gap between low and high performers is shown below:
The most staggering statistic of them all is the fact that for very high complexity jobs, there is an 800% difference in productivity between average and high performers. When translated across a whole organisation, evidently there is a rapid increase within productivity – if the talent is exceptional.
It turns out that exceptional talent does not want to work for a radical, non-democratic, tyrannical state, and thus will reflect into the lack of utility associated with certain products from these areas.
Furthermore, why would a talented individual want to work hard to create a brand-new innovative product, with full knowledge that once the product starts to bear fruits, the product will be taken away by the Government. This is the innate advantage the West, and all democratic states, have over China.
Furthermore, and leading on from the prior point, incentives matter.
I often use a fairly basic framework to understand and compute as to the utility of an organisation. This equation can also be used to understand the incentives of nations. Let me firstly explain via a story:
Imagine you are a middle manager at Pfizer. You attend a meeting to evaluate project, an early-stage new drug. Like every early-stage idea, it has warts. Some vital experiments have not been done or have been done poorly. Keynote speakers at the conference dismiss the idea, but you like the idea. Something about it captures your imagination. What do you do?
You have two main decisions:
- You could pound the table, make a case, and begin a slog up the ladder with each meeting of each committee. You might be turned down. But suppose you win that battle, and the next few. You may make it all the way to the top of the ladder, get the green light and go ahead. The next seven years will be spent surviving the three deaths of each loonshot. Every time the project stumbles, people want to bury you and your project. They want your budget. They want you out of the way. The odds are that this loonshot will not succeed. An outstanding drug may achieve $50B in annual sales within the first few years of launch. This means that the success will move the needle for your 100,000 person, $50B company roughly 1%. If the project does succeed, even with that tiny percentage benefit, 99,999 other people will be rushing in to claim credit. If it fails, 99,999 people will point at you laughing. They will mention those early-stage warts you dismissed, your career will be tainted, and you may be fired.
- Or you can choose the other option: you could belittle the loonshot project, highlighting flaws and poking at the warts. You could explain why the world does not need this idea, and why it would fail. Likely, your judgement and summary of where the industry is heading is in line with your boss and what he believes. You both laugh at the idea and nod. You propose instead a modest step along with a favoured research project. It is easy to understand. If you continue to play smart politics, and sound good in meetings, you might just get your boss’s job. This would increase your salary by 30%, not to mention a double in prestige and influence. The boost in title may even help you get an even better role at another company once you start looking around.
So, which do you choose?
Option one of a seven-year slog with a 1% chance of success. Or option two, the franchise project and political pursuit, with good odds of a 30% pay bump.
Dismissal of the loonshot is the obvious choice.
So, for the equation – it is fairly simple. This is referred to as organisational fitness and looks at solely the difference between return on investment for politics, VS project-skill-fit. In other words, from an employee’s perspective, what is going to get you a promotion? Is it internal politics and gossip, or is it working hard on a project, thus gaining recognition from peers?
Obviously, a bad organisation, and nation state for that matter, will focus on internal politics and gossip to garner a promotions and growth. Whereas, a well-structured company, or nation, will focus on hard & smart work, thus garnering a promotion. The point being, within China, due to their dictatorship-styled political structure, with the sole power within the hands of one man, this innately skews incentive alignments.
As an individual, you would slog away countless years of your life building a revolutionary business. Spend hours working with little pay to show. Fear of failure constantly looming ahead. Experience multiple false fails, each coming with a dose of criticism and controversy. Only then to potentially succeed. And then, after all of this, the world revolutionary business is prematurely taken away by the Chinese Government.
From my perspective, the incentive alignment in China for building a world revolutionary business is very skewed. Why put yourself through all of this, only to experience the wrath of the Chinese Government upon completion? This is not to say good businesses cannot be built. However, it is to note that the incentives in China just seem skewed, and thus disincentivises radical technological breakthroughs.
And, if this is not convincing enough, let’s take a look at the ability for debate and discussion in China. Unfortunately, a similar picture is revealed. For successful nations and companies, the use of disagreement, dialogue and discussion is necessary. Without this, one unfortunately lives within an eco-chamber. The case that I am making is that, for truly radical breakthroughs in technology, there must be a field of constant disagreements and debates. However, in China, this is commonly not the case.
Jack Ma provides a perfect example. After the technology billionaire spoke out, and said something mildly controversial regarding China, he totally vanished for many months. Many speculate that the Chinese Government was unhappy with Jack Ma, and perhaps forced him into hiding. There are countless reports of similar stories occurring.
Regardless, the bottom line is if you disincentivise dialogue and discussion, unfortunately once again this restricts one’s ability to create meaningful, world revolutionary companies. Instead, it incentivises politics over hard work.
To briefly summarise, due to the combination of the dictatorship-like-styled political structure in China, as well as the limited dialogue and debate allowed in China, this holistically is another data point as to why investing in China doesn’t seem appealing. In other words, the thwarted incentive alignment structures in China results in the emphasis on internal politics and gossip, in comparison to innovations and radical change.
To conclude, looking back at history can give us evidence of the inability of scientific innovation propelling meaningfully. Whilst China was ahead for many years in comparison to Europe when it came to formal education, innovations and science, Europe took the unexpected lead.
The reasons as to why are based on phase separation, dynamic equilibrium, and critical mass. Few of which occurred in China.
“An easy way to tell the story is: had the emperors understood incentive structures and human organisation, the industrial and scientific revelations might as well have taken place five centuries earlier, and we would all now be speaking Chinese.”
Furthermore, when looking at talent, the odds are not in China’s favour. Unfortunately, the best talent does not want to work for an undemocratic Government, but instead prefers to bear the fruits of their labour.
If one combines this with the dictatorship-like-styled political system resulting in an inability to speak out, the incentive for Chinese innovation is heavily skewed.
Regards, Christian M Darnton x.
Let me end with a quote from Jordan Peterson:
“God is the spirit you emulate in order to thrive”.