In a Million Dollar Nutshell ?How to Invest in Chinese Stocks ?
China has gone from nothing to something to everything. After it’s lightning-fast rise with free market principles, it’s been left with a lot of loose ends. Time will heal those. Unfortunately, there are 3 systemic hurdles investing-wise. Weak reporting standards, management teams of low quality, and most importantly the Chinese government’s control on our businesses. Never invest just for the country, but choosing stocks that face a direction that relieves China’s social and environmental pressures might be a shrewd way to flip the risk and diversify your stock selection internationally. Remember, China is the second largest economy on earth. Don’t bet against it. That’s how you invest in Chinese stocks. Good luck hunting for value on the Shanghai Stock Exchange in this current recession.
Let’s Take an Investment Journey Around China!
介绍 (That Means Intro… ?)
China is a buzzword. But no matter what your emotional reaction to hearing the name, 10X-ing wealth per head in 20 years is an unmatched feat of leadership for a country that was once just a rural marshland. This guide will break down an enormous country into bitesize chunks. This guide tees you up with China’s industries of the future. It untangles the trade war, and investigates the risks and payoffs of Chinese stocks. We also explain the Chinese consumer; who they are and why they buy.
This guide to investing in China might sound harsh or hyper-critical at times, but it’s good practice to try and kill investing ideas instead of to make excuses for them. Let’s get into this.
How an Investor Should Analyse a Country
Okay. You want to by a stock or a bond. The stock is from a country other than your own. There may be issues overshadowing business as a whole in the country. Those issues may be uncertain. Think of them like clouds hanging over you. When there are clouds, there’s always a chance of rain. Rain can wash away the seeds of your investment, something we had expected to grow. Bottom line: clouds overhead spell danger, risk.
If you to the USA or the UK to make your stock investment… it’s pretty clear skies. Less risk. This primer helps you go to China, look up, and make a judgement about what you see. What are the clouds? Is a storm brewing? Are there areas you can find where the clouds part? Read on.
What Are We Looking For?
You’re judging things that are all very country specific and subject to change. The key question you need an answer to, if none else, is this:
How well is the country unleashing it’s people with free market principles?
You can make it more niche’d to people who work in the specific sector you wish to invest in. You may also want to know the wider macro threats that could impact a stock investment.
But that’s it. All the many factors that go into answering this main question are stretched out and aggregated. I’m helping you make sense of them.
In short, the country used to be ruled by empires who formed dynasties to fight over provinces. The country only started moving out of poverty after communist rule became more socialist, and general free market principles were introduced to the country in the 1980’s. The country has grown exponentially since then into a modern day superpower. This image below depicts the ridiculous transformation of Shanghai since 1990.
China is not a finished product today, it’s still a little rough around the edges and they’ve never been able to shake off their geographic disadvantages over their 3000 year history. Let me unpack some of China’s present day financial details for you.
Chinese Numbers (中国数字)
No matter where in the world we invest, like laws of physics, some laws of finance always endure. So if China was an investing top trump card here’s how they would read. Let me disclose, these numbers should be viewed with a bit of scepticism. We are trusting Chinese officials with their macro reports because they’re the best we’ve got. They are the best out there today (20/03/2019).
|Stock Market||Recession (1 year in)|
|GDP Ranking||2nd (behind the US)|
|Unemployment Rate||3.1% (globally competitive)|
|Chairman||Xi Jinping (big time power bearer)|
|Interest Rates||4.35% (for a long time)|
|Return on a 10Yr Chinese Government Bond||3.1% (-1.9%=1.2%)|
Demographically Getting on a Bit…The population is aging.
That means more people to care for and less people to tax. That makes this trend a tough one on the Chinese checkbook. It’s a Chinese social factor entering the mix. Think of the skin care and cosmetic industries whose profit making prospects are extended by this aging population. Or how the health sector will soon be called into action. There are also more women than men, as well as social and cultural norms that are vastly different from what you’ll find in the west . It’s hard for non-natives to grasp some of these differences. But they matter for our stocks that are expanding overseas or making Chinese acquisitions , be aware.
China Ain’t Growing at Lightspeed Anymore
Given all the numbers I’ve shared, you might be surprised that China isn’t the overclocked, rapid, emerging market growth engine that it’s brand is known for. That emergence is slowing, and arguably, it already has emerged as the global competitor that it threatened to be. But ’emerged’, doesn’t mean ‘matured’.
China is not a finished product. Every country on Earth has it’s issues and China’s mostly result from it’s period of rapid emergence.
Unluckily for us, those issues hamper investing in the country. Let’s touch on some of those key factors.
Bribe The Judge
The legal system is perceived to be unfair. A big bureaucrat can influence a judge.
The IP laws protecting our stocks is lacking. Laws around online piracy, counterfeit manufacturing, and theft of trade secrets are weak. This doesn’t make the country a fair playing field and the poor legal system adds a speculative element to many Chinese stocks which we can’t shake off. But a positive legal improvement is inevitable given long enough, and it would dispel a lot of risk for these stocks. It will reduce discount rates and allow stocks to trade at higher multiples of earnings.
Compounding these legal hazards, in 2015 Chinese auditors opened the books of some of China’s biggest companies and dozens of false profits crawled out! That alone will rule out Chinese investment for many readers. It’s hard to justify investing in or with dishonest managements.
As for our due diligence check, a A3 rating from Moody’s only scratches the surface. For every yen (¥) of GDP there’s 2.6¥ of debt layered on top. Most of this mounting debt sources from local governments.
Management Team Quality in China
Knowing how effectively our stocks’ corporate boards get things done this is a central pillar of investment analysis. Unfortunately, Chinese management teams can only rank in the bottom 20% worldwide for quality.
Investors protection and investors rights are a little better, but not much so. This is partly because the authoritarian government has its mitts on some of the country’s biggest business powerhouses. His is an extremely big issue with investing in China.
If I could only tell you one thing about Chinese stocks, this would be it:
Xi’s government effectively sits on the board of every Chinese business you could buy stock in.
President Xi Jinping wields the power to get anything that suits him, not necessarily investors like us. This issue is for life as he’s a president literally for life, an indirect manager of any business we buy. So, yet another element of unshakable speculation layered on top of a Chinese investment thesis.
With a committee armed full of allies, he’s got the leverage to pursue whatever he says he plans. He wants to polish off China and doing see he feels, will create a ‘Chinese Dream’ for young people. How will that compare to the good old ‘American Dream’? That question marks the line between investment and speculation. So what does Jinping plan?
- Ending corruption
- Shutting down inefficient manufacturers
The hurricane like force over China that is President Xi could blow some industries, and some stocks, into bigger and better business. Well the GDP zoom that President Xi has witnessed and continues to contribute to – is nothing short of a miracle. It’s moving most business from the rural, agricultural areas to the big cities. So, urbanisation has intensified.
Let’s take a road trip around the cities and see what China’s most important industries are going to look like over the next 10 years.
Made in China
25% of China’s GDP comes from only 4 cities. The first is Beijing. Here we find a manufacturing hotbed. Xiami are making electronics. Costco (different Costco!) are a food maker, and CWC make rail locomotives that run on a Chinese rail network that could span the globe three times.
There’s actually a really fast growing transport sector here thanks to urbanisation in such a big country.
In China’s huge manufacturing sector though, technology is the key driver. A.I. has rocketed productivity to make country’s mega competitive as a place to build things (as if it wasn’t already!) and there’s an intolerance from the government for any slower factories. The manufacturing sector is expected to grow at a rate close to the S&P 500, all in spite of the end of an era of cheap Chinese labor. The era has passed because of how well-educated the modern Chinese population has become.
Improved education has been the major driver behind the services sector too. Any business like China Mobile or Beijing’s postal service where there isn’t a financial or physical good changing hands, belongs in a service sector that accounts for half of China’s GDP. A hindrance to China is how many young and talented students do stay abroad after studying away from home. This is something Mr. Jinping plans to solve with a fully developed nation. The timeframe he gives us, is 2049. In the long-term, talented young people leaving the country won’t last as a permanent issue. How many young people opt to stay in China is like Xi’s scorecard for how well he is building a finished China.
Next stop is Jang Su. This province is the focal point of pharmaceuticals: the invention of drugs. China is biggest emerging market for pharmaceuticals. It’s taken off because of firms are able to offer lower prices per patient than elsewhere, due to the expansiveness of the population. That’s a real international competitive advantage.
What about Guangdong? Huge tech firms. The best known is probably Tencent. Tech is a muscle for China (some would say even a weapon). In investing, the catalyst for some firms could be a legal obligation on Chinese students to return to China. This will happen, most likely in time as I’ve said. It’s what the tech sector needs on a national level and obviously, the services sector would benefit from this too.
The country is still a fast runner though with sights set on being number one in semiconductors and biotech.
Shadow Banking (Financial Services)
Finally in Shanghai, we find the country’s financial services. The bullet point here is shadow banking. If your bank suddenly stops taking deposits it can get away with less regulation and start shadow banking so to speak. That means excessive risk and over speculation in the financial sector. It’s something that President Xi has on his to-do list, and he admits as much. The problem is how rampant shadow banking has become, with a growing presence in their system.
The Chinese Stock Exchanges
Most of these firms and all of these industries are investable on the Shanghai Stock Exchange (SSE). The Shanghai Stock Exchange is in a bear market right now with investors having slashed off a quarter of all prices from the index over the past year.
If you go hunting for bargains in this Chinese recession, consider the yen, the Chinese currency. Hypothetical scenario:
You buy Petro China stock (a Chinese oil and gas company). You buy Petro China at its price of 7.5¥ which (as of today) is equal to $1.9.
- Over your investment time frame, the ¥ falls in value.
- You sell at the same seven point to five yen price. The stock didn’t go up or down.
- You think you’re getting $1.9 nine cents back but because the ¥ is worth less now you only get $1 for it.
I used a very big fall in the ¥ to show you what I mean. They ¥ is also an investment, with the stock itself.
So the way around this is to buy Chinese stocks with ADR versions. This qualifies most large Chinese stocks. An ADR version of the stock allows you to keep things in dollars.
If you’re a Chinese consumer and the price of an American car shoots up because your president, Xi Jinping, has retaliated with a tariff. You might think twice about buying that car. So the trade war delays the recovery of the Chinese economy, and thus the Chinese stock market.
But don’t worry, trade wars are always temporary. They’re a race to the bottom, direct self harm between the U.S. and China, and eventually one side will buckle to new terms of trade. This appears to be what Trump is hoping for.
The Chinese Consumer
Many are members of a new millennial middle class. They love online shopping, and they often buy products to elevate and showcase their position in society.
Like their government they also have quite a lot of personal debt hanging over them. Chinese households have debt amounting to about 106% percent of disposable income, built up through credit card debt and other types of loan. That’s very significant.
Even the physical Chinese households themselves are in a real estate boom.
The stock market’s already fallen, but these facts suggest the debt cycle has more left to burst.