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Grahamites
Grahamites
Articles (328) 

Fish Where the Fish Are: Chinese Equities

Why it makes sense to invest in Chinese equities for the long run

May 12, 2019

In my previous article where I shared my notes on this year’s Daily Journal (DJCO) meeting, I wrote the following:

“This year more than 50 questions were asked. Among them, five or six questions were specifically related to investing in China. Munger’s message was consistent with what he said in the previous meetings – what American investors are missing is that there are more opportunities in China than there are in the U.S. The great companies in China are cheaper than they are in the U.S. And the Chinese market is much less efficient. You gotta fish where the fish are.”

In today’s article I’ll share some observations on the attractiveness of the Chinese equity market.

China’s competitive advantages and what it means to Chinese companies

Last year, Warren Buffett reminded all the shareholders that for long-term American investors, the overriding question is, “How is American business going to do over your investing lifetime?” I think this applies to all of non-U.S investors too. In other words, we need to think about how the business in the country we invest in will do over our investing lifetime. This boils down to national competitive advantages of nations and the industries that will be globally competitive due to competitive advantages of the nations. A great book I recommend is Michael Porter’s, "The Competitive Advantages of Nations." There are a few important messages in this book:

First: "Many of a companies' competitive advantages lie outside the firm and are rooted in locations and industry clusters." In other words, if 3M was not founded in the U.S., Nestle not in Switzerland, BASF not in Germany, would they still be great companies?

Second: "Shift in economic power of nation impacts competitiveness of companies." Some companies were great in the past but because of the shift of economic power, they are no longer great.

And third:"Firms from one or two nations achieve disproportionate worldwide success in particular industries." This goes along with competitive advantages of nations.

A great mental model that I’ve find very useful is Professor Porter’s "diamond" model of determinants of national advantages – factor conditions, demand conditions, related and supporting industries and firm strategy, structure and rivalry. To use factor conditions as an example, in 1978, all factor conditions in China were bad. But during the past 40 years China’s factor conditions have improved dramatically. The labor force is much more skilled and advanced, and more educated. Capital is much more easily accessible. And the infrastructure has become world class. There’s a very powerful positive feedback loop of diamond conditions, which is also a lollapalooza effect. All of these make China as a nation, and hence, Chinese companies, more competitive globally.

Attractiveness of China’s equity market

Charlie Munger (Trades, Portfolio) has been talkings about the attractiveness of China’s equity market, and it’s been a great place to fish for the past couple of years. I moved back to China at the end of 2017 and have been focusing exclusively on China’s equity market. Before that I spent most of my time on the U.S. market. I’m starting to feel Munger is absolutely right. While competition has picked up in China, it’s still much more inefficient than the U.S. market. Here are a few important factors of the attractiveness of China’s market.

First and obviously, the best Chinese companies have been growing much faster than the great U.S. companies. In the U.S., high single-digit top-line growth is considered very good, but in China anything below 15% is considered mediocre.

Second, if we look across emerging markets, China has a relatively stable political environment and stable currency. The Chinese government plays an incredibly important role here, which may be vastly misunderstood by non-Chinese.

Third, as mentioned above, many industries and companies have benefited from the great industrial revolution of China and are now globally competitive.

And fourth, the Chinese market is much more volatile because there are many investors who can’t tolerate volatility and drawdowns, which is great for value investors who have the right temperament. IThere are a few structural factors that contributed to the inefficiency:

  • Gambler’s mindset.
  • Distorted institutional performance evaluation system.
  • Language and cultural barrier for foreign institutional investors.
  • Retail investors dominate trading volume.
  • Limited supply – small percentage of floating shares.
  • Frequent policy impact

For example, we can take a look at two important factors – demand and supply, which we can use trading volume breakdown and ownership structure as proxies.

Proportion of trading volumes by investor type – China A-share

On the trading or demand side, 80% of the trading is done by retail investors. And on the supply side, government and corporate ownership is high, and very often these are usually not tradable. The float can be a very small portion of total shares outstanding. On top of that, retail investors make up the largest portion of the shareholder base. You can see why the equity market is less efficient in China.

Conclusion

As a nation, China’s moat has continued to widen since the reform and open up, which makes many Chinese companies more competitively globally and bodes well for the best companies in China. The great companies in China are likely to grow faster than the great U.S. companies, and structural factors exist so that the equity market in China will likely remain inefficient for a while. It’s a great combination for value investors.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.6/5 (9 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

Thanks Grahamites. China is a country where I did much work i my previous life as a health care consultant, but little in the equities markets. I enjoy reading your insights and hearing your thoughts on where China is headed and what impact it can have on my investment thesis, processes, and opportunities. Thanks again. Best - Tom

Valuator
Valuator - 4 months ago    Report SPAM

Sorry boys, the People's Republic of Madoff is going down. Can't stop that now.

They need Dollars. Trump just cutoff their allowance. Without Dollars, their banking system just might finally collapse with the yuan. It's only 4x to 8x their GDP which doesn't report capital consumption allowance which I'm sure is just miniscule in a country like China, right? Ours was 1.3x GDP before the Great Recession.

Probably nothing.

Grahamites
Grahamites - 4 months ago    Report SPAM

Tom - You are welcome. Glad it was helpful to you and please let me know if there is anything I can address in the future.

ed_l_grey
Ed_l_grey - 3 months ago    Report SPAM

The USA is bad enough about having firms that monkey with their accounting numbers, but it's nothing compared with China. Add in reverse mergers and the chance of the Chinese government intervening in a way detrimental to foreign investors, and you have too much risk, too many black swans taking a dump on your windshield at just the wrong moment.

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