Chinese Disruption Around the World - Weekly Blog # 524

Introduction

Most of those who think about the future of the Global economy believe that China at some point will probably replace the US as the global leader, until perhaps after a generation it is replaced with India. Based on current population trends,  Nigeria will have more mouths to feed in the future than India.

China Influences all Markets

Size, in and of itself does not guarantee a good place to invest. At this point investors, no matter what they invest in or where they invest, need to understand the ability of China to heavily influence, if not disrupt, almost all investing in stocks, bonds, commodities, real estate, art, and racehorses. While I intuitively agree with Charlie Munger that there are more investment opportunities in China than in the US, I lack sufficient confidence in my understanding as to how the winning game is played.  Nevertheless, I feel compelled to invest in China and Asia. The way I do it for my clients and myself is through selected Asian specialty funds.

The inclusion of some of the “A” shares in the MSCI indices is in response to demand from institutional investors to put money to work into China very quickly. There is more than the normal amount of risk being created, for the list of included stocks is based on size, not quality or other investment factors. This is particularly significant to what is likely to be a rash of China ETFs. When the financial reports become available there could be a positive fleshing out of how business is done in China.

Racetrack Influences

On Saturday the South China Morning Post, which is now essentially a vehicle for the Mainland government, published an entire section devoted to Horse Racing, with the kind of statistics we used to see in the US in the popular press and specific publications for racing fans. What is impressive to me is that the paper had extensive records of the leading jockeys and trainers. What is notable is that neither the leading jockeys nor trainers win over 20% of the time. This highlights my reluctance to embrace the most popular stocks most of the time.

The Chinese interest in both racing and more important breeding future champions, was again highlighted on a sloppy track Saturday afternoon when Justify won The Preakness. This is the second title to the Triple Crown after Justify won The Kentucky Derby for its largely Chinese syndicate owners. Competitors are labeling Justify as a “super horse.”

The newspaper has the same type of mutual fund price (NAV) listings one sees in London. These are paid placements which often represent the key profit item for the paper. Recently I co-chaired a panel at the International Stock Exchange Executives Emeritus conference in Hong Kong. In our lead off session with the Chair of Value Partners, I was somewhat surprised to see a good sized list of Value Partners funds and their classes in the newspaper. They even had some funds quoted in New Zealand’s currency. Most of their competitors are UK and Swiss groups. For historic and cultural reasons, only a few funds appear to be offered in the US.

Xi Jinping Cites People’s Liberation Army “Principles”

On Thursday the same paper had a front page article with a headline “President calls for stronger military science studies.” In the article Xi Jinping, as chairman of the Central Military Commission said, “Innovation has to be practical and closely based on warfare and combat issues to create advanced military doctrine suitable for modern warfare and embodying the PLA’s unique characteristics.” (Bear in mind the People’s Liberation Army has not been at war in a generation. During that period the US has almost constantly been in small wars.) Notice there is no particular emphasis on defense, which suggests offense is important and could be in the President’s plans.

The leading economic thinkers viewing China internally as well as externally are very conscious of developing economies running middle income growth to the limit. There is a fear that they become old before they become rich, as on balance China has an aging population. Japan and most of Europe  are laboring under demographics that reduce the proportion of productive human labor and an increase in the portion of the nation’s wealth spent on healthcare. (With US fertility rate at an all time low, we hope that US leaders see a similar long-term risks that needs to be addressed quickly.)

A number of funds investing in China have been shifting their emphasis away from exporters and basic industries, investing instead in consumer-oriented stocks and services. Many global and international portfolios cover their China bet with one or two stocks, such as Alibaba and/or Tencent. From a stock price standpoint, most of the time their prices parallel the so-called “FAANG” stocks, not China-focused developments.

Balance Sheets More Useful than  Income Statements

My old Securities Analysis professor David Dodd might have enjoyed my late conversion to paying initial attention to balance sheets rather than income statements. In the class (taught by the co-author of our text book) we had discussions on the proper methods of security analysis. I had the temerity to argue with him in favor of the primacy of income statement analysis. He shut me off once when we were discussing a specific security, which just happened to be in Graham and Dodd’s portfolios. He ended the discussion by informing the class and this doubter, how much money they had made on that position. Thus, it is ironic that I bring up balance sheet and related cash flow concerns in dealing with Chinese investments.

The very successful export drive that led to China being the fastest growing large economy for a number of years was based on exporting industrial goods and consumer products. On my visit to Hong Kong and Shenzhen* I was very impressed with the new infrastructure that has been put in place in under a generation. At the same time the US and most developed countries experienced deteriorating infrastructure, Hong Kong is expected to require an additional airport in 2019. (Our returning flight was slightly delayed in leaving as it had to coordinate with flights from nearby Chinese airports.)

*I would be happy to share by email the field notes of my visit to the fascinating BYD headquarters in Shenzhen.

China Experiencing Downsides to its Growth

However, there are a couple of downsides to the growth in the Chinese economy. After the farmers flocked to the cities, they used their savings to buy apartments, quickly followed by a cars, resulting in crowing and auto pollution. For this reason, the government is heavily subsidizing the production and sale of electric and hybrid cars. Thus China is the manufacturer of half of the world’s electric vehicles. This led to BYD leveraging its flows and balance sheet to a point where liabilities equaled or exceed assets. BYD is not worried however, as its loans are from state controlled banks.

One Belt, One Road Linkages

A further extension of debt was used to finance infrastructure in Africa and along the promoted “One Belt, One Road” connections from China to neighbors on the way to European markets, which will probably make use of the excess steel and cement capacity that is not being used internally in China. I am not predicting the future but rather asking prudent investors to study the history of debt-driven expansions in railroads in North and South America, and the financial history of the car business.

I will be happy to learn from subscribers about prudent ways to invest in China.

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