Lunar New Year Special: Investing in China
Navigating the world's second largest economy with a clear mind
If you’re reading this, chances are you’ve been flooded with scary headlines on all the problems facing China, perhaps even on a daily basis.
A quick Google search reveals just how negative the news flow is, and the entire first page (captured below) reveals that every single item is negative:
But before you jump to the conclusion that the Western media might have an agenda, do a similar search on the United States, Europe, or any other continent/ country, and you’ll quicky find that 99.9% of the news items skew negative.
And that’s exactly the problem.
News publications, in an effort to attract eyeballs, must select topics that have sensational potential, and nothing grabs our attention more than the negative, the dangerous, the controversial, the scandalous.
This is a function of our innate “negativity bias”, which we’ve developed through evolution in order to react to threats. News publications simply play to our instincts, and Google (outside of paid searches) simply organizes information by what we tend to click on/ search the most.
Only when we understand we have a negativity bias, can we then begin to effectively parse the information that comes at us, and separate between noise and substance.
Which brings us to investing in China.
99% of “investors” who trade in Chinese stock are not really trading Chinese stock. They are trading in China news flow. And when investors start trading on news flow, they begin to clog their minds with maximum noise and minimal substance. Chances are, they will lose a ton of money.
Let’s jump straight to the issues, and perhaps the Q&A format works best. We’ve avoided yes/no questions, because the world is very rarely definite, and we don’t have a crystal ball. And while we’ve put great effort into assessing the various issues with a clear mind, at the end of the day, these are our opinions and nothing more.
How Bad is China’s Property Crisis?
It’s bad, but primarily for the real estate developers who financed their expansion with aggressive leverage. Several of these developers will have their entire shareholder’s equity wiped out, and bond holders will suffer a haircut. Depending on specific bond terms, several bond tranches may also get wiped out. Contrary to mainstream belief, this isn’t a concerted action by the Chinese authorities to discriminate against certain classes of bondholders; liquidation will be determined by the specific covenants of each bond.
Before any creditors gets paid, all cash flow will be prioritized to suppliers/ contractors for completing property projects, and delivering it to end consumers. Whatever is leftover will then be divided amongst creditors based on specific covenants.
Property sales will be muted until consumer confidence recovers. Unlike the 2008 financial crisis in the US, consumer confidence has been dented not due to excessive leverage and bankruptcy, but due to lower net worth (on paper) and negative headlines. Chinese consumers on average have a very high savings rate (because of lack of a broader social net), and down payments for homes were 30% on average for first homes. That figure is even larger in the Tier 1 cities (i.e. Shanghai, Beijing).
Property developers who are reliant entirely on sales will struggle to survive, and will only do so with minimal leverage. Property developers who have multiple sources of income outside of home sales (rental income, management income, hotel income, etc.) will be able to operate with higher levels of debt, and capitalize on lower interest rates in China to expand.
China’s property sector as a whole is likely to get smaller in the short to medium term, but simply because bad actors/ speculators will get flushed out.
How bad is the contagion?
Not that bad. Banks with significant real estate exposure (primarily the biggest Chinese banks) will face some large write-offs, but high provisions and strong capitalization more than adequately covers this specific risk bucket. Some smaller banks that may not be as well capitalized, or are focused in only a few troubled cities will shut down. This should be manageable, as the private sector financial system in China as a whole is very well capitalized, and can step in to absorb failing counterparts.
As long as credit lines remain open in the economy (i.e. as long as lenders don’t freeze up and stop lending), contagion will be limited.
Trust funds and certain wealth management products that focused exclusively on generating high yield through property bonds will shut down. However, because the derivatives market is relatively nascent and tightly controlled in China, this is unlikely to magnify to multiples of actual exposure like it did in the 2008 financial crisis. Investors will simply lose some money, and hopefully think twice next time before chasing yield.
How bad is the manufacturing downturn in China?
Manufacturing is a key industry of China that is under siege, but has largely remained resilient.
With the entire global supply chain undergoing a tectonic shift due to politics and protectionism, China has had navigate this new complexity and adapt. While it’s impossible for the world to cut out China entirely from their supply chains anytime soon (see here, here, and here), there has been tremendous effort (particularly by the US) to wean itself from China manufacturing dependency.
This has led to the rise of manufacturing in Southeast Asian nations like Vietnam, Malaysia, Cambodia, etc.) and India. While this “shift” is occurring, the reality is that many of the factories being built in these countries are in fact owned and operated by Chinese companies. These Chinese companies not only have the resources to expand, but also the manufacturing know-how and expertise.
That said, while moving supply chains to other countries may diversify exposure, it adds tremendous cost to the end consumer. No single country can match the sophisticated, well-oiled supply chain that exists in China, both from an infrastructure and labor perspective. While one country may have their unique specialty/ advantage, none can offer the comprehensive suite of value-add that China does (infrastructure, skilled labor, critical resources supply, energy, experience, etc.) Decades acting as the world’s factory plant has entrenched China deeply across the entire manufacturing supply chain, and there simply is no alternative.
However, that won’t stop countries from trying to do so anyways, as they are driven by fear mongering. This will cost consumers in the West dearly, as politicians pay the price of “protectionism” with high inflation.
That said, as more manufacturing jobs are relocated to other countries, Chinese domestic workers will suffer job losses - even if the factories overseas are owned by Chinese. This is the main challenge for China’s economy as it relates to manufacturing.
Which is why the Chinese government has put in an enormous amount of effort and resources to develop new industries and promote domestic consumption - to stem these job losses.
For better or for worse, this dynamic will force China to evolve and reach the next level.
How can China’s capital markets flourish again?
Charlie Munger once said, “The safest way to get what you want is to deserve what you want.”
Trust is earned, and while the current narrative in the West is that China (and Chinese companies by extension) cannot be trusted, it is their actions and how they treat investors that will determine whether or not their capital markets flourish.
If Chinese companies continue to produce solid earnings, pay good dividends, engage in value accretive share buybacks, and remain laser focused on widening their moats and growing intrinsic value, no amount of noise and fear mongering will stop them. Eventually, capitalism gravitates towards where the money is.
Nations may try to create false narratives and distort the rules (eg. delisting Chinese shares and barring US citizens from owning), but it only ends up hurting their own people. For example, since delisting China Mobile from the NYSE on January 2021, US investors had to sell shares in a dominant business at an absurdly low valuation, and forego a 90%+ return (including dividends) over the last 3 years. Meanwhile, domestic Chinese investors have been able to enjoy these gains uninterrupted.
So while the initial intent was to punish China, US “protectionism” in fact punished its own US population. Among the most foolish things in the world of finance, this definitely ranks near the top.
The fact of the matter is, if a company is self-sustainable, competitive, and have good ethical stewards managing the ship, capital markets will reward their owners one way or another. And as a whole, if the Chinese capital markets are filled with such companies, they need not the kindness of strangers (i.e. foreign funds) to prop up the market. Internal cash flows and domestic investors will be enough to create price discovery. Barring the most extreme black swan events, self-sufficiency (which many Chinese companies are today) will allow them to create their own destiny.
What happens if US decouples from China?
The range of outcomes here is far too wide, that it would be impractical to give a precise answer. That said, the only certainty is that an outright decoupling would be devasting for both countries.
As much differences as the two countries may have, their economies and markets are intricately linked. There is no advantage to decoupling (for either side), and it would be in the best interest for everyone to find a harmonious path forward.
The US feels threatened by China’s rise, and China feels threatened by US containment.
The truth of the matter is that they’re both correct, and the fact is that it doesn’t really matter. Both countries are far too powerful to collide. The ripple effects for the rest of the world would be too great, and we would likely lose decades (if not centuries) of progress.
There would be no “safe harbor”, only mutual destruction.
But I’m optimistic this won’t come to pass.
For one, the benefits of mutual cooperation are far too attractive, on a global and individual level. Yes, there will be imperfections, and some individuals may fall in between the cracks. It will be each country’s duty to help those that fall in between.
The reward for genuine cooperation would be the greatest wealth our world has ever seen, unparalleled global security, and an opportunity to share in our rich cultures.
The exchange of knowledge, people, and ideas would open the doors to new frontiers we haven’t even thought of. We would have the combined resources and capabilities to tackle our generation’s greatest challenges head on (climate change, healthcare, poverty, technological advances, energy, etc.)
Warren Buffett has said that “the babies born in America today are the luckiest crop in history”.
I agree. But I would go even further.
In a world where the US and China works hand in hand, the babies born anywhere in the world are the luckiest crop in history. The world would have won the ovarian lottery.
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Happy Lunar New Year. May 2024 bring you prosperity and success in your investing endeavors.