Investing in China…outside China

3 November 2014


 

As at Monday,03 November 2014

china-better-infographic

Idea in Brief

  • China’s rise has many opportunities which we can only explore in brief below
  • It also has risks:
    • Lack of accounting standards
    • Need for local partner
    • Risk of IP theft
    • Political support
    • Change in political winds
  • There are ways to reap some of the benefits from the opportunities while avoiding some of the country specific risks
    • Invest in countries that are riding China’s rise: Australia, Germany
    • Invest in industries that feed China’s rise: energy, raw materials, capital products, construction, luxury goods
    • Skip China altogether and invest in the next China

Why China?

The rise of China is a well-known story. As an investment firm, Firstline has been keenly interested in China. Firstline is always on the lookout for opportunities and we need to remain abreast to provide our clients with solid advice about opportunities and pitfalls.No investment is risk-free – everyone knows that. However, China presents some unique risks that investors need to be aware of. The duty of the investor is to determine if these risks are worth the many possible benefits of investing in China.

In an examination of the macro trends occurring in China, they all point to significant upside. What are these macro trends: 1) urbanization, 2) huge investments (FDI and government), and 3) growing middle class. All of these factors align to ensure that many companies within China have a large and growing domestic market to sell their products to. This is in addition to China’s legacy of export-led growth. The China government’s investment in infrastructure and education coupled with private sector investment in capacity means that firms are expanding to take advantage of the growing market and have the talent they need to do so. This is expected to continue for some time.

The Risks

While there is reason to believe in the upside of China, there are risks. Unlike the regular risks associated with any investment, some of these risks are China-specific. They have to do with the unique nature of the Chinese polity and concerns about China’s possible eventual transition to a more democratic society.

Most firms in China have three sets of books: one for the tax man, one for investors, and the actual set of books. Proud Chinese will tell you that China invented a form of the celebrated double entry bookkeeping centuries before traders in Italy came upon the same idea. However, much of this was lost in the Cultural Revolution and is thus being built anew. China is also concerned about having foreign-based accounting firms scrutinize their books and on foreign standards and laws apply to some of their firms. This means that instead of being able to import trust along with a big-four accounting firm, a potential investor has to do much of the ground work themselves. This is simply not feasible for many small investors.

In most instances, to set up a firm in China, the company needs a Chinese partner. In most instances this partner is a nominal, legal requirement. But in many instances, this partner provides some local expertise: marketing, distribution, or political connections. When there is a substantial partnership, it is not uncommon for the Chinese partner to steal wholesale the IP (intellectual property) of the foreign firm and create a locally-owned firm. This means that an investor in a new Chinese partnership can lose all of their investment and be shut out of the new locally owned Chinese firm. And if they wanted to invest in the new Chinese firm, they would be at a loss when trying to value the firm for the reasons above.

One of the benefits of local partners is political contacts. Doing business in China requires that the ‘big boss’ (laoban) has guanxi (pronounced gwan-she). Guanxi is essentially political favor. This is important to expedite the sometimes slow bureaucracy but also to ensure that rival firms are not able to shut down your business for any number of frivolous reasons. Guanxi does not show up on any balance sheet and the lack of it poses a risk to an otherwise sound business.

And sometimes even when firms have the necessary guanxi, a new President and a new 5-year plan could designate the industry as a strategic industry or national pillar. This can be a polite invitation for foreign firms to surrender their IP and exit.

 apple-china

Avoiding the risks

For all these reasons, one may want the exposure to what is readily acknowledged to be one of the greatest success stories of modern capitalism but avoid the risks mentioned above. There are several ways to approximate the performance of China without having specific exposure to China.
  • Invest in countries that are riding China’s rise
  • Invest in industries that feed China’s rise
  • Skip China altogether and invest in the next China
What is the only advanced economy to have avoided a downturn in the Great Recession (2008-2009)? Australia. Australia is a mineral-rich economy that has been exporting many of its raw materials to China. However, Australia has English common law, a respected legal tradition, and good accounting standards. Thus, general investments in Australia are more likely to mirror China’s rise while avoiding the China-specific risks. And the more tailored these investments are, the more close the correlation is likely to be.Germany provides China with many of the capital infrastructure it needs. The products of the Mittelstand are widely respected in China. These range from trains for China’s extensive train network, including subways in most tier 1 and T2 cities to machines in many factories. This author has a friend whose job it is to go from Chinese city to Chinese city designing, building, and commissioning new beer breweries. As such, Chinese firms go to Germany to find a trained ‘brewmaster’ (my friend’s actual high school and university diploma); and they do this for many of the engineering fields they need. Germany essentially trained all of the train engineers for China’s rail network. Thus, General investment in Germany would be a good way to be aligned with China’s rise. And again, the more targeted the investment, the more aligned the return.

During the author’s time in China, it was noted that the most numerous outsiders in China are Germans and French. Why are the French there? China’s nouveaux riche are being schooled on how to spend lavishly by European luxury brands. These range from…

  • French firms: cosmetics, textiles, art
  • Italian firms: cars, watches
  • Swiss firms: watches, textiles, jewelry/gems, hiding illicit capital
  • Apple: a luxury brand unto itself
An investor who buys these countries segments would be well poised to benefit from China’s rise. With this last segment, investing in the country as a whole would be unwise and a targeted approach would be desirable.
There are other sectors that are worth noting that are not as country-specific:
  • Energy: coal, gas, oil
  • Raw materials: iron, coal
  • Capital products
  • Construction material
  • Luxury: cars, cosmetics, jewelry
Any country or company that is a big player in any of sectors would be worth looking at. Firstline Securities Limited has the knowledge to make these links and deliver superior returns with a lower risk profile to our clients.

Skip China altogether

The last alternative is to skip China altogether. China’s formula for economic growth is not a secret. In fact, it is widely studied by academics who are looking to understand what lessons can be gleaned. Other countries are also trying to mimic China’s success. If one is concerned about China for some of the reasons mentioned here or some other personal reason, you can simply go onto the ‘new Chinas’. Two prominent examples are Vietnam and Myanmar. Vietnam is further along than Myanmar and its communist government is explicitly looking to use China’s model to produce success for its population. Many factories in China who depend on a lowest cost model have already relocated to Vietnam. Myanmar is exploring its options for opening up. It is not yet certain how much they will open up or how fast. One of the rules of investing is to know more than the other guy and to know it sooner. Thus, a shrewd investor may want to explore opportunities in Myanmar now to be well poised to jump in when the country finally does open up.

Conclusion

There are many things to consider when investing beyond the risk versus reward dynamic. You need to make sure you’re being shrewd about finding ways to get the reward you want without taking on any unnecessary risk. What you just read was just one way to accomplish this. This is one reason to choose your financial services partner wisely. Naturally at Firstline Securities Limited, we believe that we have the knowledge to give your investments this edge. As China continues to rise, we are expanding our capabilities in this area and building the linkages necessary to serve our clients. Come talk to us about diversifying into this new and exciting region and give your portfolio the potential boost it needs. Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@firstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.

 

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