2015 Q1 Commentary

China remains a major topic of discussion, rightly so as the world’s second largest economy (and number one according to purchasing power parity rankings) and projected to take over the top spot within the decade. Although it is such a major economic force -the IMF estimates it will actually be the largest contributor to world GDP growth for 2015- it is still looked at with suspicion by some as if it does not belong on the world stage, let alone atop it. Many choose to simply ignore it. This we believe is a serious mistake, but this lack of understanding and relatively tiny following compared to other economies (and especially individual companies) is precisely why we find it attractive. This is where long-term opportunities reside.

Much has been made of China’s economic growth (GDP) slowing from its unsustainable annual rate of over 10% during the last decade, to what is expected this year to be around 7%. Left out is the fact that the rest of the world is growing at half that rate at best, and despite all the cheerful talk of recovery and joy on Wall Street, the US last year grew at just 2.4%. More important, because the base of GDP has grown so much over the last decade or so, a 7% increase now brings in more actual growth in total dollars than did 10% from a smaller base ten years ago.

China seems to be stuck in the same position as the kid who’s trying to make the team, but is competing against the coach’s son for the last spot on the roster. Nothing he does is ever going to be good enough in the coach’s eyes; every good play must be lucky, a one-off.

First China was growing too fast and was too reliant on exports. Real estate was in an obvious speculative bubble and the government had too much control; central planning doesn’t work (these last two said by the same people who missed the US bubble caused by loose monetary policy here and now call for more regulations and federal oversight of an ever larger piece of the economic pie). Inflation? Too high. Wages? Too low.

Fast-forward to the present. China has initiated deliberate efforts and enacted policies to stabilize the economy. It had indeed been growing at an unsustainable rate (mathematically; the highest single-year increase was a whopping 14%), but this was deliberately induced in order to pull as many people out of poverty as quickly as possible. Massive government spending on infrastructure and cheap manufacturing meant for mass export were the basis of that phase of economic development. This has transformed to a more service and consumption based economy (while still having a significant amount of real exports), with the government not only loosening its hand, but actually selling off majority portions of state owned enterprises (SOEs) to the private sector.

Private firms are now reported to be responsible for 80% of all employment, and virtually 100% of net new jobs. The government itself has stated that they could only help incubate and take things so far; afterwards, experienced business managers were needed to take over from government bureaucrats. Wages have risen at near double-digit rates for the last two years, yet inflation has remained tamed, so much so that if necessary a financial stimulus program could be initiated.

What we believe to be some of the most important news of late from any country, is the loosening of restraints on the trading of mainland A-shares and the allowance of a wider variety of traditional trading practices, such as short selling. The China Securities Regulatory Commission announced after the end of March that mutual funds will be able to trade between Shanghai and Hong Kong, foreigners will have access to Shanghai-listed shares, and Chinese citizens will be able to access stocks traded on Hong Kong’s Hang Seng Exchange for the first time in history. Mutual funds are now able to trade between Hong Kong and Shanghai.

The Hong Kong Exchange (where the H-share stocks owned by Pendo trade) currently trades at a discount to those of the same companies traded on the mainland. This should narrow considerably with the benefits mostly in favor of the H-shares, as Chinese are finally able to invest outside of their own country, and keen on taking advantage of the newly-available arbitrage situation. Shenzhen is expected to join the mix later in the year, and trading in commodities and fixed-income instruments should not be far behind.

Will there be missteps and corrections along the way? Of course, but that is natural for any dynamic economy, especially one growing and transforming at such high rates. One failed company or changing industry does not an economy ruin.

As far as that talented kid trying to show off his skills and being ignored by the coach? Perhaps it’s not the player but the coach who is wrong…