China: Where Has the Enthusiasm Gone?

Wednesday, June 1, 2011

 

Over the past five years China has been a darling amongst investors. China had growth, size, an awakening entrepreneurial
spirit and a one party government, that in stark contrast to the U.S. Congress, seemed to get things done. But lately
investors have seen the China glass as being “half empty”. So what has changed and what of the opportunity still remains?
 
What has changed:
• Fear has increased about a fixed asset bubble in China, particularly in housing (despite 30% plus down payments required on average for home purchases).
• In an effort to thwart inflation, China’s monetary policy has tightened and investors don’t like to fight the government in China.
• China is transitioning from an export dominated economy to one better balanced between exports and domestic consumption. Generally speaking investors don’t like the uncertainty such structural changes can mean for the economy.
• Several high profile corporate governance blowups in Chinese companies have shaken investor confidence (e.g. Alibaba,Mecox Lane and China Media Express). Once again, investors don’t like uncertainty.
 
What hasn’t changed:
• Developmentally, China is where the U.S. was several decade ago.While it paid to invest in the U.S. over the last 50 years there were periods of correction and setback.
• China’s fiscal situation is much stronger than other developed nations in our opinion. Consequently investors in China are likely, in our view, to benefit from an appreciating Chinese currency.
• The Chinese population is large and growing in affluence aided by government policy supporting domestic consumption. Many experts indicate China’s middle class will be larger than the entire U.S. population by 2025.
• China has created a “right of first refusal” on much of the world’s natural resources after years of funneling profits generated from U.S. consumer spending into resource investments around the world.
• China has efficient,modern infrastructure that prepare it well for future growth. Infrastructure investment continues at a brisk pace especially in many rural cities where the next wave of growth is expected.
• China is just starting to establish a service economy to address the needs of its more urban and affluent base.
• China’s single party system gives clarity to government policy so that capital allocation decisions can be made with an adequate time horizon.
• China’s role in global economic influence will continue to expand.
• China has unrivaled manufacturing capability from a price and scale standpoint. Increasingly this capability will move up the value chain as China shifts more of its low cost manufacturing inland to rural cities, leaving its more sophisticated port cities to focus on highly engineered and branded products.
 
So what is the major difference between what has changed in the China story and what hasn’t changed?
The changes impacting the market today all appear to be temporary in nature and will correct themselves in time. What has not changed are mostly long term competitive advantages. To be clear, China is far from a perfect economic engine. Its rule of law, restricted markets, currency manipulation and reliance on exports all need to be improved. In addition the volatility and risk associated with China related investments is high. Another interesting point is that when investors buy an emerging market index fund, they often don’t get as much China exposure as they might think. For example iShares’ Emerging Markets Index Fund ETF symbol EEM has a current China weighting of only 16.9%. If the typical investor has 5-10% of their portfolio dedicated to emerging markets that translates to only a 1-2% exposure to China.We will leave it up to you to decide if that is enough.
 
In closing, I am reminded of the famous Warren Buffett quote, “In the short run, the market is a voting machine. In the long run, it’s a weighing machine.” To put it more succinctly I will offer my own opinion, “Invest in China, your grandchildren will thank you.”