Churchouse Letter
May 2015                   by Peter Churchouse

Fear and Loathing in Financials

There's still a huge amount of bearish doom and gloom in China... even more so since the market skyrocketed.
There are plenty of areas of worry for sure, but the policymakers know them better than we do.
There's one key sector of this skyrocketing market we think offers great value.

"Everyone's afraid of the big bad banks..."

Last week, I was invited by the Norwegian consulate in Hong Kong to attend a breakfast meeting. Around the table was a posse of about 20 of the most senior players in the Scandinavian investment-management scene. There was a great deal of financial and intellectual firepower gathered over coffee, bacon and eggs.

The Norwegian Government Pension Fund, with US$882 billion under management, ranks as the world’s largest sovereign wealth fund. Not bad for a nation of around 5 million people. And I counted another trillion dollars in assets under the management of the moneymen around the table.

The group had just spent a few days in China, mainly in Chongqing and Chengdu. I was intrigued that the Norwegian delegation had elected to visit these cities. They are major industrial cities in the west of China that, to be honest, few foreigners visit unless they have to. Most similar groups focus on the “superstar” cities of Shanghai, Guangzhou, Shenzhen and Beijing.

The truth is I believe Chongqing and Chengdu provide a clearer window into modern China. In terms of industry, they have the traditional smokestack stuff, for sure. But they are also home to some of the most-advanced technology companies in the world. Large numbers of European manufacturing leaders have slotted their China operations into these cities.

It is here that you come to terms with the Chinese revolution, Version 2015. Not the political or even industrial kind. This revolution works at cyberspeed, and is leading to the fastest generation of output, wealth and social change that the world has ever seen.

In this issue of The Churchouse Letter, I am going to explain how so many people, normally far from China, misunderstand what those changes mean. I will break down the risks that China faces at a decidedly dicey point in its economic evolution.

Many of our Scandinavian friends were clearly very knowledgeable about China. But they were wearing their China concerns like the red-and-white badges on the lapels of their suits. Won’t China collapse under all its debt? Isn’t its economic engine broken? Hasn’t the huge amount of foreign direct investment that flooded into the country left it awash with overcapacity?

Who can blame them? Prior to their visit, they had been reading the business press. And this is what they would have been reading:

“The Doomed Dragon: Is China’s economy headed for a crash?”

“Unexpected Collapse in Chinese Trade”

“Analysts Fear China Financial Crisis as Deflation Looms”

“Is the Chinese Economy About to Fall off a Cliff?”

“China Property Collapse Has Begun”

I shouldn’t be surprised. Journalists need big head-lines and bold stories. Those sell newspapers. Or generate clicks nowadays, I suppose.

A calm, rational analysis of facts, trends and events doesn’t set the pulse racing in quite the same way!

So you can’t fault the questions that the Norwegians raised. They are valid, even if you do hear them time and time again.

We could talk at length about the distortions that the media often presents to us. The T.V. screens right now for example would have me believe that Rome… or at least Baltimore… is burning to the ground. My friends in the publishing business who live and work there assure me it’s nowhere near as bad as presented in the media.

When the pro-democracy protests took hold in Hong Kong last year, friends from overseas asked if we feared for our safety and if we were contemplating leaving the city! Ahem. Not quite.

What you see on the news and read in the papers must be approached with an open mind and plenty of scepticism… and the financial media is no different whatsoever.

I travel frequently to China and read masses of material produced by people who spend a great deal of their professional lives digging into the weeds of China. I am constantly talking to people who work or have businesses in China. I sit on boards and advisory boards of companies doing business in China.

As a result I think get a more balanced picture of what is going on than I would get by simply reading newspapers or watching T.V.

There are many risks, but you won’t hear me ranting about an impending “Chinageddon” in this newsletter.

Back to the breakfast. Aside from me there were four senior leaders from Hong Kong based businesses at the meeting to help field those queries from the Norwegians.

These Hong Kong executives run multinational conglomerates spanning power generation, ports, media, real estate, retail and transport in Hong Kong, China and other parts of the world. These are top executives. They are very realistic about business and conditions in China. They have put in the hard yards over the years. It has not been easy, and success did not come on a plate.

They are not cheerleaders for China. They are realistic hard-nosed business people.

They did not downplay the difficulties that the Scandinavian entourage would encounter if they cemented their business interest in China.

They told them how hard it was going to be dealing with partners who don’t always have your best interest at heart. How tough it would be straddling the cultural gap not only between the West and the East but also within China itself, where some of the world’s tallest skyscrapers were built by former peasant farmers who don’t even have the right to live in the city they’ve built. How exasperating it would be to pump millions in capital into a country that then wouldn’t let you take your profits back out.

At the same time, they also reassured the Norwegians who were now choking on their breakfasts that China wasn’t about to explode and vanish in a mushroom cloud of economic smoke.

Yes, there are the China apologists, analysts and researchers who see China through rose-tinted glasses. “China is good, it does no wrong… it’s on a one-way path to global greatness.”

But most of the folks who have cut through those thick weeds in China have a healthy degree of scepticism about much of what happens there.

I am one of them.

I have watched and been involved in this transformation for parts of five decades. In that time, I have often approached China policy initiatives with a shaker full of salt.

Take for example, the initiative in 1980 to turn a vast area in the small community of Shenzhen into a Special Economic Zone, or SEZ. The aim was to attract the world's manufacturers to set up shop in the SEZ.

I rolled my eyes at the idea. It will never work, never happen. How wrong I was. Within a few years the sleepy town of a few hundred thousand souls had become a manufacturing metropolis with thousands of factories and a population of around 5 million. Today, that has grown to more like 11 million, and is now very much pushing into service industries and high tech.

I can cite lots of examples of this kind of thing where I was very wrong. In China, you have to expect to be disappointed. But you must also prepare to be amazed. In investment terms, position your portfolio to protect yourself, but also to allow for what, if you have planned wisely, may be surprising returns.

This is the message I was trying to deliver to our Scandinavian visitors.

Good Reasons for Doubt

And so looking at today’s problems in China there are certainly reasons for concern.

Debt is high and has grown rapidly. Defaults and nonperforming loans are going to grow. Excess capacity exists in many smokestack industries. Growth is slowing. The property market is oversupplied. Corruption increased during the previous leadership’s tenure. Pollution is terrible. Food safety is non-existent.

But you know what? There are three reasons why I think that this state of affairs is not going to lead China into a disastrous financial and economic meltdown.

I believe many investors are making the mistake of assuming that what has just happened in the United States and Europe is about to happen in China. And they are having flashbacks of the 1990’s Asian financial crisis and expecting it to happen again.

They are wrong. And they will miss out on money to be made.

First, the Chinese authorities and policymakers actually recognise their country’s problems, and understand them.

Second, they have the will and the political might to put policies in place to address the problems.

Third, and most importantly, they have the ability and firepower to do so.

So let’s look at these in turn...

  • In this edition, Peter lays out a play for China which runs contrary to popular opinion...
  • Plus you can discover how The Churchouse Letter's investment recommendations have been performing by clicking here.

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