The stock market has continued to move higher to start 2018 as talking heads discuss how long the current bull market has been and how expensive stocks are on a historical basis. Not knowing what to invest in has resulted in flows into alternative investments such as Bitcoin and emerging markets stocks as investors are looking for any sort of “value”, which may only exist at the moment on a relative level.

A rising tide lifts all boats, and cryptocurrencies and EM stocks have accordingly joined the wave. Cryptos have captured most of the headline attention despite having a small relative market capitalization versus all other asset classes – which in turn is an argument made by crypto bulls that Bitcoin and peers have a long way to run still.

Chinese Stocks in the 9-Year Bull Market

Although late to the party, Chinese markets have also been running hot right now, with the most widely looked at benchmark, MSCI China, rising over 50% in 2017 and already off to a good start in 2018. Despite this, Chinese equities continue to trade at depressed multiples versus global stocks for a variety of reasons, while traditional China bears continue to bring up old fears of overcapacity, a growing debt pile and potential geopolitical flash points either organically between the US and China or indirectly via North Korea.

Whether or not there is an investable opportunity in China is not something that we are prepared to answer – however, we would like to share some of our thoughts pertaining to an increasingly important market.

A Personal Anecdote About the Chinese Stock Market

In corporate finance, professors explain underpricing for IPOs to students, with the idea that when a company lists on the stock market, investment bankers will help find the appropriate price point below perceived market value so that there will be a “pop” – where the price of the stock jumps from the IPO price sold to primary investors once trading commences.

The “pop” rewards investors who will fill the orders on the offering. Without underpricing, investors would not be compelled to participate in IPOs, and companies would have less certainty in raising capital.

They would then proceed to show a bar graph with national stock markets and the average underpricing for offerings. Developed markets such as the US and Australia would have mild underpricing – the “pop” was the least pronounced. Brazil and Mexico were much more pronounced. The average Chinese underpricing was an order of magnitude larger and was cut off on the graph. Suddenly, all the students were interested in investing in Chinese IPOs.

Suffice to say, the Chinese market was very inefficient at one point – but not necessarily because investors were not aware of what an appropriate value was. Rather, the stock was deliberately priced at a substantial discount to intrinsic value while the order book was filled by the politically connected, resulting in large transfers of wealth to crony capitalists. It was impossible for normal retail investors to get a piece, so the underpricing mechanism was pointless.

This has changed with Xi Jinping’s focus on reinforcing the legitimacy of the party by aggressively combating corruption. While not yet mature, the Chinese market has come a long way and is seen as an attractive area for investment – there is strong underlying growth in the economy and due to low understanding of the Chinese market by global investors, equities are relatively cheap on a multiple basis versus US stocks.

The Efficiency of Chinese Stock Markets

Looking at stock markets in terms of institutional ownership (large asset managers such as Blackrock with ample collective investing experience) versus retail ownership (the everyday, unsophisticated investor), China and Hong Kong still have significant retail influence. In contrast, English speaking developed markets are dominated by institutional investors, especially for large blue-chip stocks such as Procter & Gamble or Microsoft.

The Chinese market also has additional complexity because of the large number of state-controlled players that are listed companies. This may mean opaque communication with shareholders, very low debt and accordingly different cost of capital assumptions.

Not only is the market not yet mature, but experienced investors that have extensive track records for generating alpha in the US or UK do not have the same edge in China. Being able to understand Chinese equities is in no small part an extension of being able to understand Chinese behavior, which in turn is a function of understanding China’s culture, values and history.

However, as it follows, investors who do understand China and have feet on the ground will know about what restaurant chains are blowing up, what apps will have high penetration in the next six months and what millennials are spending money via what platform.

Bear Case on China

China “Bears” – investors and commentators who are betting on China’s decline – have repeatedly fallen flat on their face with their positions. The investing track records of the China bears vary as it pertains to their other bets. The commentators would have bankrupted investors.

Most of the commentators have carved out a niche in repeatedly painting a pessimistic portrait of China’s economic situation, such as Charlene Chu (who does not speak Chinese), previously of Fitch Ratings, Gordon Chang and The Economist. These China bears have been persistently incorrect but will continue to receive timeslots in major Western financial broadcasts as the media exists to sell itself. Much of the argument against growth appeals to emotions and may be xenophobic, so they should not be taken into consideration for the investment decision.

China bears such as Jim Chanos and Kyle Bass have more credibility due to the prominence and success of previous shorts. Most of the common arguments against the Chinese economy’s continued rise are debt levels, heavy industry overcapacity, accounting fraud and over/undervalued currency.

Whether or not they are wrong remains to be seen – although their bets are longstanding losses – however, their theses are usually anchored on framing China from a US market reference point. Leverage in China is not necessarily leverage in the states, and the levers that the government can pull cannot be understood without having a deep understanding of China – something which hedge funders with several, dispersed ideas cannot easily gain.

The combination of the market developing rapidly while the pool of astute investors is thin while traditional institutional investors stay away mean that there is substantial alpha to be generated by value investors that understand Chinese businesses (which means that they understand Chinese) while the market has much more torque than a developed index.

Over the last year, this has been supported by several mutual fund and hedge fund managers making up to 300% returns in China based on public equity security selection. Once the market becomes better understood, which we would imagine the knowledge gap being closed by the next generation of Chinese business graduates, we can expect saturation and thinner alpha opportunities.

China is Moving Very Fast

It is not as easy to implement conventional buy and hold strategies because China is developing at an incredible pace every year. Since the addressable market is 1.4 billion people, today’s leader for bikesharing with 50 million subscribers may be extinct tomorrow if a competitor manages to increase their penetration.

How quickly China is moving is best understood via a trip to any major city. Infrastructure is state of the art and constructed at breakneck speed. Entire metro lines that are of vital importance in areas with such high urban density can be constructed in one year. Construction happens at all hours of the day and the work ethic is culturally ingrained.

As a developing country, there is still a lot more of the “easy growth” that allows for high GDP growth rates until China’s per capita figures catch up with the United States (or at least comparables in South Korea and Japan). However, the efficiency stemming from centralized planning and natural recession hedges (the migrant workforce) give confidence to us that there may be a growth story that may exceed that of the US stock market.

Additionally, there is a new stage in technology coming, with China being a thought leader in two key spaces. Just as the majority of development in human civilization of over 7,000 years has come in the last century, as evidenced by life expectancy, productivity and quality of existence, there may be a further acceleration via quantum computing and artificial intelligence.

Quantum computing is poised to make supercomputers obsolete – allowing for the processing of very large quantities of data in a short period of time. This power will be fed into rapidly improving AI, which will in turn have applications for health care, energy, military and transportation.

We recently visited a growth capital fund in a Tier 2 city (Tier 2 cities have over 10 million people and GDP of over US$100 billion), where the principals mentioned that any technology company needs to ensure it is Top 3 in its market, otherwise it will either be priced out from economies of scale or acquired.

Taking all of this into account, and knowing that stocks bear the risks and rewards of ownership, potential windfalls are investing are large, but investments must be closely monitored.

Not All of the Best Opportunities in China Are Investable

Despite nothing being as egregious as the underpricing phenomenon detailed above, some of the best opportunities will only be accessible to sophisticated investors/investors with deep pockets – with a growing venture capital and growth capital presence in China. This is not unlike any developed market, however – the smart money gets in first and the dumb money gets a piece once it IPOs.

The average investor will have to settle for investing indirectly via the venture arms of publicly listed companies such as Tencent and Alibaba. Influential apps such as Didi Dache and Toutiao rarely fall off the radar of the incumbent leaders. Even old industries such as insurance will see ample investment in new technologies as management looks to keep ahead of a dynamic market – for instance, Ping An Insurance will have fingers on several fintech start-ups.

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