Is the Chinese Market Good for a Value Investor?
Article Summary;
- The Chinese Market
- Government Crackdowns
- ADRs and US/China Relations
Some of the strongest companies in the world call China home. With the government’s recent 180 shift on regulation and monetary policy, many investors are looking to take advantage of some well-established and successful companies now trading at very low prices. Even notable value investors like Charlie Munger and Li Lu have taken notice, purchasing stakes in Asian securities. But is this really a good idea?
Value investors know that the key to intelligent investing is simply buying a healthy company at a great price, within a margin of safety. We at DYF Investing feel it’s important to understand there are differences between the U.S. and Chinese Markets that may skew how these are determined.
The Chinese Market
One fundamental difference is the type of investors. The Chinese stock market is dominated by retail investors, at over 80%. These investors are focused on short-term emotional trading, and tend to follow trends that are hugely influenced by what the Communist Party favors. This creates the boom-and-bust cycles in their market.
An example of this is the MSCI China ETF. Historically it has seen huge momentum-driven gains that last several years, followed by huge extended moves down. The chaos of the market can be seen in the graph above. Yet over time, it is slowly drifting with the value of the underlying stocks and demonstrating some consistency.
It’s important to consider that the U.S. Stock Markets provide some of the best investor protections in the world, protections not afforded in China. Chinese companies are famous for fudging numbers for the sake of keeping up appearances. There is a running joke that Chinese companies keep three sets of books: one for the regulators, one for investors, and one for the managers. When looking at company reporting’s or historical documents, investors need to keep in mind they are potentially sifting through inaccurate or inflated numbers.
Government Crackdowns
Another important difference is that the Chinese Financial System is still in its early stages. As technology is adopted and people move toward the cities, financial technology has become much more important. As a result, China has taken steps to make sure it’s being built “correctly”.
The Chinese Government acts like a strict parent who feels innovation is key, but must be retulated to proceed in the right direction.
The 2021 crackdown on Ant Group is a case study in the Chinese Government’s attempts to control “platform economy” and force competition. Foreign investors look at this strict government oversight and control as stifling innovation, but the Chinese take a different view. As Ray Dalio has mentioned, the Chinese Government acts like a strict parent who feels innovation is key, but must be regulated and proceed in the “right” direction.
This type of policy may be difficult for outside investors to navigate when trying to make intelligent decisions. It’s difficult to assess the moat a company is building if the government is likely to undermine it to avoid monopolies.
ADRs and U.S./China Relations
Another risk investors face relates to China’s prohibition of foreign share ownership. Because of this, outside investors must use American Depositary Receipts or ADRs. Owning an ADR is essentially like owning a share of a company (a depositary bank) that owns shares in another company (a custodian bank) that owns shares in the company you’re trying to hold.
The use of ADRs creates a complicated relationship that leads many to fear that China could simply cut their half of the cord at any point, and block all foreign investors. It’s these and other difficulties navigating the Chinese market that creates doubt about people like Charlie Munger and his ability to assess the U.S.-China relationship and geopolitics.
Value Prop or Value Trap?
However flawed the system seems to those outside it, China has demonstrated substantial growth over the past decades. Their own adoption of capitalism has shown incredible promise, and while its workings seem off to foreign investors, fundamentally it works.
But the Chinese market is also an emotional, chaotic one, with the government itself creating (or suppressing) trends that are not always based on free-market rationale. Despite this, many companies in the Chinese market have a familiar history; good companies with good products and defendable moats have survived hardships and market fluctuations to remain solvent and profitable.
On paper this type of chaos creates amazing value opportunities, ones that are likely to come along more often than in the U.S. But the lack of the standardizations and regulations seen in the West require far keener company research and a bit more speculation when considering these companies. Some of the metrics and markers American investors may take for granted will not always yield the same results or produce the same gauge of health as in the U.S. DYF Investing believes investors should enter this market only if armed with a great deal of experience and research ability, fully understanding the risks.
