Beginning of possibly a series on getting your feet wet in Chinese investing
China, despite the well documented decline in GDP growth to 6%, is still the largest contributor to global growth. After all, 6% of $15 trillion US is like growing by more than one Australia every year.
A couple of trends are playing out in the Chinese market – namely an opening up of the economy (for example, global investment banks and brokerages can have fully owned operations) and a shift to domestic consumption instead of continuing to be led by an export driven growth model. All of these are making investors excited.
Here, we outline some thoughts about how to get involved, some observations that may be useful and general ideas.
There are a couple of ways for North American investors to get exposure to Chinese markets.
Buying U.S. or Global Stocks with Leverage to Chinese Markets
Plenty of companies are looking to China as a growth engine as the pie is large and the pie is growing. Probably the most prominent example is Starbucks, which has undergone a renaissance of sorts as their Chinese franchise continues to expand rapidly while mature, legacy markets stagnate. For a lot of the investor community, Starbucks is basically a Chinese stock.
Starbucks has long been a brand for the aspirant class in China, although the cachet has lost lustre due to Tier 1 & 2 cities such as Shanghai, Beijing, Shenzhen, Suzhou and Hangzhou approach or exceed First World standards. However, Starbucks retains its prestige in the less affluent Tier 3 and 4 cities, which are now leading the country in retail growth.
Picking the right exposure is paramount. China has been a graveyard for business models that could not adapt to local customs. Amazon and various other juggernauts have had failed forays into the market.
However, for every failure, there is a LVMH or Tesla that triumphs on the back of a growing China consumer class.
Buying American Depository Receipts (ADR) for Chinese Companies
There was a time when New York battled with Hong Kong, Shenzhen and Shanghai for the IPOs of prestigious Chinese companies. The best known ADRs today are Alibaba, Baidu and Ctrip (now rebranded as Trip.com), as well as an unsponsored ADR by Tencent.
This trend is likely to change as the Chinese government endeavours to make Chinese stocks investable assets for Chinese investors. Also, it is a good way to stop capital flight. The Hong Kong Stock Exchange has loosened listing criteria to help with this.
However, there are still plenty of Chinese companies that are traded on the NYSE or NASDAQ.
Buying a Chinese Index ETF or Chinese Mutual Funds
This is probably the easiest and most liquid way to invest in China. This is a beta bet and eliminates the dangers of security selection. The Chinese market is also sufficiently large so that there is good representation and liquidity for the usual fund providers in Blackrock and Vanguard. There are many ways to play here, whether investing in Chinese large caps, the entire Chinese market, Chinese technology stocks or as part of a broader emerging markets fund.
Chinese mutual funds are a beta bet and an alpha bet. On one hand, it is a good way to outsource the security selection to someone else. However, as with most other mutual funds, they often underperform their benchmarks.
Due to the information asymmetry that exists in the Chinese market and wider dispersion for stock returns versus the benchmark, a good manager can add a lot of value versus in the U.S. where the market is much more efficient. More on this in a later series.
Chinese Government Directives and Equity Performance
The U.S. is portrayed as a laissez-faire market whereas the Chinese is seen as one where the hands of the state are in many pots. In reality, the U.S. is also regulation heavy across telecom, technology, pharmaceuticals/healthcare, and just about everything – but the dynamic is a little bit different.
An oversimplified way of looking at things is that in China, the government controls the corporations while in the U.S., the corporations control the government.
In China, one key thing to remember is that stability is prized above liberties. In the U.S., liberties are prized above stability. This is a trade-off that every society evaluates – where the two philosophies decide where this line is drawn is major cultural difference that must be understood before an investment decision in China.
Of course, there is more nuance in this, but the general takeaway as it pertains to markets is that the social good will prevail in China versus investor profits. We will revisit this several times below.
China is growing very quickly while market behaviour and business practices are still maturing. China and the propensity of its population to speculate from real estate to stocks has given rise to multiple bubbles. The government fears bubbles and associated crashes because it fosters instability. People who experience near-total losses of capital can contribute to instability. As such, officials are keen to avoid situations such as 2015 when the SSE Index rocketed above 5000 and subsequently collapsed.
The Old China Stock Thesis Does Not Work
Previously, the China thesis that Wall Street pushed to investors was very simple. China is adopting a capitalist model, so everyone simply has to find the Amazon (Alibaba), Google (Baidu), Facebook (Tencent/Sina), Expedia (Ctrip), Tesla (BYD) and Groupon (Meituan Dianping) of China where the total addressable market is far larger and make massive returns on capital.
Did it work? Sort of – but while Alibaba and Tencent ended up being excellent picks, Baidu has failed as a recent investment decision and other copycats have been left behind as well. A lot of companies have been exposed as frauds, while certain companies such as Kweichow Moutai have outperformed being in the consumer sector versus as an industrial name. China was not going to remain the world’s factory forever.
Alibaba and Tencent also have morphed into their own business models with several working ecosystems that look nothing like their U.S. peers that they are often compared to.
The reality is that China is not growing the same way as the western world and in many ways has leapfrogged certain technologies across payments, mass transit, high speed rail and the sharing economy.
Investors looking to pick securities have to be able to see where the wind is blowing and be a student of China’s development path.
The addressable market argument continues to stand, with the added bonus of China creating its own new markets by helping developing regions such as Africa and Southeast Asia become consumers.