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Understanding China and the Investment Thesis

We have been meaning to support our China bull case for a while but have been indolent. But here it is.

China is a better investment vehicle than the US.

Executive Summary

  1. Scale
  2. Government Efficiency
  3. Favorable Labor Force
  4. Diaspora

We especially like China right now because asset prices have retreated in the face of concerns over a potential trade war the Trump Administration has started to please its voter base. This is both in common currency terms (major Chinese stock indices have declined) and due to the quick depreciation of RMB/CNY relative to a basket of global currencies. So as a Canadian dollar or US dollar based investor, the upside may be meaningfully larger.

Last time we discussed that China exposure is attractive to us because of higher growth coupled with cheaper relative valuations (and much cheaper now owing to trade war jitters). Today we outline some of the structural considerations that have convinced us that these two investing elements will be around for some time to come.

Scale Advantages of the Chinese Economy

Scale, and by scale we mean population and favorable landmass. A large reason why the US has flourished in the 20th century is because of its large population and somewhat meritocratic society. As an extreme example, if you have a country of 100 people it is pretty much mandatory for the smartest person to be the doctor otherwise people will not live very long. The more people you have, the more you can specialize and exploit competitive advantages inherent within society, allowing for gains from trade. Now the smartest people in the country can be investment bankers.

When people think about technology they think about hubs – the most prominent one is Silicon Valley. There is a strong clustering effect that contributes to SV’s success that causes it to succeed in spite of headwinds such as high taxes or poor civic planning. If you are a strong software engineer, it makes sense for you to go to Silicon Valley where there are the jobs, the information sharing and the network. When one engineer leaves to go across the street they cross-pollenate knowledge and a virtuous circle refreshes.

China has the sheer volume to replicate this in Shenzhen and other planned cities – with the difference being that the initiative has the full weight of the omnipotent government behind it.

This scale advantage also allows for China to have a sustainable business model for automotives, industrials (aircraft – possibly no longer a Boeing and Airbus duopoly going forward) – strategically important industries such as semiconductor engineering and foundry will continue to be developed as geopolitical winds change.

The most visible representation is the success of large scale engineering projects in China that have improved the welfare of hundreds of millions. The high speed rail network, which is effective in China owing to concentrated population centres along the east and center have made transport affordable for the masses and efficient. It is peculiar that most people from Toronto have not seen Vancouver and vice versa but even the peasantry in China has seen Beijing.

At the civic level, rapid mass transit (i.e. subways and skytrains) is commonplace across all major cities and now prevalent in secondary cities – again with the population density to support it. This is an extremely replicable model that Chinese engineers have mastered and greatly reduce carbon emissions, traffic gridlock and save millions of man hours of productivity – shocking (actually not really) that these best practices cannot be implemented across public infrastructure in the West.

The gigantic domestic market potential as the average Chinese becomes wealthier will act as an excellent absorption conduit for China’s progression up the value chain from a secondary industry/manufacturing leviathan to a fully knowledge backed economy. Rising incomes have already been coupled with rising domestic consumption. Young and old Chinese are beginning to enjoy the fruits of their labor with shopping malls, infinite food options and entertainment spending.

The only country with comparable scale is India – and India similarly has immense potential, and one advantage in that English, the current lingua franca of global affairs is already widespread across a meaningful subset of its population. However, it is not apparent that India can harness its scale advantages in the same way as China owing to the following factors.

Centralized Planning and Absolute Control of the Party

If an all-powerful government is determined to operate in the national interest, necessary infrastructure projects will be approved and quickly developed while vested interests in businesses that do not serve the people will be nixed. Of course, the reality is not that simple as there are still influential clans/factions in the system that have less than altrustic intentions – however overall the country has been moving forward as evidenced by the growth rate in terms of GDP as well as rising living standards. Chinese life expectancy has increased to 76 years while the US is steadily declining.

Perhaps the best illustration of what happens when fractured political jurisdictions impede economic growth is the absence of energy infrastructure to tidewater in Canada. After the veto of several pipelines, there was a political compromise and understanding that the Trans Mountain pipeline would be built. Posturing and emotional arguments meant to solicit votes have resulted in delays where corporates have no confidence and accordingly cannot act. While oil and environmental damages are a sensitive topic for voters due to the graphic nature of accidents that have occurred in the past – albeit not necessarily tied to proposed projects in question – a more laughable example is how liquefied natural gas, a proven and repeatable process where Canada has immense shale gas reserves and little population cannot get out its resources for reasons such as compromising the sanctity of salmon farms and not getting a plurality of votes in a town of less than 100,000 people. This has effectively cost the nation billions of dollars.

Instead of public policy being controlled by single issue voter groups, technocrats that have identified the best roadmap forward will dictate spending and format. Decisions are made based on data rather than emotion while completed plans are evaluated to see what went right and what went wrong. What went right can be a repeatable module – what went wrong will be dissected and avoided. Constant iterations make processes smooth and efficient.

In a way, the government is run like a business but “profit” is measured as total social welfare encompassing various metrics – life expectancy, income equality, absolute standard of living, incomes and social mobility. Officials that can meet their targets in accordance with these metrics are considered for promotion while those who succumb to graft fail.

The CCP acts as a cohesive unit to identify challenges and find solutions – as China moves from a manufacturing country to a knowledge based country there will be a drive to push manufacturing to other developing nations under the same business model that worked so well for China. Chinese foreign direct investment is bountiful across Africa and Southeast Asia.

The Ultimate Labor Force

When joining any organization of record, especially investment banks, senior managements will be quick to say the most important asset is the people. Human capital potential is colossal in China due to an increasingly educated workforce that specializes in STEM fields – this is imperative in an increasingly technology focused world. The graduate population continues to grow and meet demand for quantitative and creative roles.

One element that many observers miss is the participation of women in the labor force. Although not perfectly equal, China is the most meritocratic country for women today with the largest quantity of women billionaires. To not harness the potential of women is to not fully utilize half of your population base. Women hold up half the sky. The destruction of antiquated, repressive gender norms during Mao’s era has made this possible.

Partially cultural and partially structural, expertise of technical subject matter is very strong.

It is cultural because Confucian values promote hard work to achieve success. As a peasant could reach the imperial court in ancient times, so can the lowest socioeconomic backgrounds in Chinese society make it to the upper echelons of the ruling class should they have the qualifications to do so.

While the mindset in the west is that the smart people were born with it, the Chinese mentality is that things can be achieved through effort and sacrifice. While the West puts athletes and entertainers on a pedestal, the Chinese celebrate intelligence and innovation.

It is structural because without a demonstrated track record of success – which begins with academic success – the best opportunities are not available.

The Bamboo Network

One element that many experts do not mention is that China probably has the world’s largest diaspora as well – Chinese people and Chinese food are ubiquitous – and this phenomenon is not recent and owing to recent improvements in wealth and subsequent migration patterns – the Chinese diaspora has emigrated from China over the last several hundreds of years and have established strong communities across the Bamboo network in Southeast Asia to ethnic enclaves in every Western nation.

The Chinese diaspora have succeeded across these various societies in economic terms as developed and relatively meritocratic Western regimes have complemented the pedestal on which the Chinese put education. Chinese-Americans, Chinese-Canadians and other hyphenated Chinese enjoy statistically significant deltas in income per capita and % holding degrees in higher education.

Foreign capital from overseas Chinese has enormously contributed to the rebirth of the modern Chinese economy and we expect more direct contributions to follow as the voracious talent needs of the growing Chinese machine continues to demand computer scientists, software engineers, capital markets professionals and experts in other fields. Mandarin speakers will find a natural fit and the best compensation in migrating back to the motherland, especially has populist policies such as affirmative action (which does not benefit the “model minority”) across education and coveted employers ramp up.

These major factors, coupled with today’s technology, should result in a new pace of growth for decades to come. Given advancements in artificial intelligence/deep learning, big data, and widespread connectivity/the internet of things, the multiplier effect for Chinese progress may be unprecedented. The transition from cavemen to farming and from farming to industrialization in the 19th century has been measured in millennia – however, as world history is far more dense in recent decades of humanity, we can expect the subsequent chapters of human development to be far more robust. Look for China to lead the way and assets with exposure to this trend to rise in-line with growth.

Next time, maybe we will offer our thoughts on the potential trade war.

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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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