China was once considered to be one of the most attractive regions for investment in the emerging world. At the turn of the 21st century, the country offered the perfect combination of economic growth, developed infrastructure and easy access to financing. Along with a young and growing population, it had increasing wealth and was likely to spend an ever-growing amount of money in the years ahead.
Events over the past few years have strained the relationship between China and the U.S., so at this point, it is not really possible to say whether U.S. investors will be able to achieve high returns by investing in Chinese companies over the next decade. The future is uncertain.
However, looking back over the past decade, one of the main challenges U.S. foreign investors have faced over the past decade is finding attractive investment opportunities in China using a Western business mindset. I believe the historical lessons regarding this topic can be useful to investors today.
Every economy offers opportunities for investment, but finding those opportunities is the hard part. Warren Buffett (Trades, Portfolio) issued some advice on this topic in the past. Responding to a shareholder who asked him for his views on buying Chinese companies at the 1999 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, Buffett said the following:
"Well, I don't know that much about them. But if I could buy companies that were earning 20% on equity and had the promise of being able to continue to do that while reemploying most of the capital, and they were selling at five times earnings, and I felt good about the quality of the earnings, you know, I would say that would have to be an interesting field."
While Buffett went on to explain that it was unlikely Berkshire would find enough big companies trading at attractive valuations in China to invest adequately in the region, he reiterated his point about how important it is to buy cheap no matter what:
"But I would say, any time you can buy good businesses — really good businesses — which we define as businesses who earn high returns on capital at five times earnings — and you believe in the quality of the earnings, and they can reemploy a significant portion of those earnings, additionally, at the 20% rate, you know, you will make a lot of money if you're right in your assessment on that."
Buffett repeated his usual caution that it is probably best to avoid any businesses that you do not understand. He also said that it's probably best to avoid the region if you do not understand its economy.
This could be interpreted as a mixed message. On the one hand, he is saying you should do well as long as you buy cheap companies. On the other, the Oracle of Omaha makes it clear that he does not want to be investing in anything he doesn't understand, most likely leaving China out of the equation for him. While buying cheap companies that generate high returns on capital is one of the best ways to ensure an attractive investment return over the long run, there is too much risk involved if you do not have adequate information on the business.
However, it is easier to find cheap stocks in emerging and developing markets because these countries generally have a lot of untapped potential, and their markets are less efficient. Companies can also extract better profit margins because there's less competition.
The drawback is these markets have much less transparency and regulation, so the chances of legal and accounting issues arising are much higher. It's a trade-off investors need to be willing to make when investing in these regions. If you understand the risks and rewards, it might be a trade-off worth taking.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Warren Buffett: Why Investors Should Avoid Declining Businesses
- A Look at the Deep Value Stocks of Kahn Brothers
- Charlie Munger: The Best Defense Against Inflation
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