Why Investors Have Got It Wrong On China

The vast majority of people who are bearish on China's economy and stock market now were cheerleaders just 18 months ago. It represents a remarkable 180 degree turn that's little talked about. Rather than focus on the mix of self-interest and self-delusion involved in this, I want to instead look at why so many got China wrong in the first place. The finance industry isn't known for introspection but it seems to me that there are valuable lessons to be learned from this episode.

Because the list of those who were positive on China from 2009 to 2011 and called it incorrectly is as high profile as it is lengthy. It includes the man known as Britain's Warren Buffett, Anthony Bolton, famed investor Jim Rogers, star economists such as Stephen Roach, almost every stockbroker, and thousands of companies who bet big on China and lost. All were wrong. Some disastrously so.

This newsletter isn't about rubbing their noses in it. For the record, I still have immense respect for the likes of Bolton, Rogers and Roach. But it's clear that they made significant errors, ranging from buying companies in industries with immense over-capacity issues, to having misplaced faith in Chinese leaders' ability to manage the economy and a belief that Chinese demand for goods, overinflated by extraordinary stimulus, would continue unabated for many years. The aim here is to examine these errors to help you to avoid making similar mistakes in future.

On the wrong side of the trade

When Anthony Bolton strode into Hong Kong to run Fidelity's China Special Situations Fund in early 2010, he had a reputation that few investors on the planet could match. He'd run the UK-focused Special Situations Fund which returned 19.5% per annum for the 28 years to 2007. An astonishing track record, and along the way, the UK press had dubbed him the "quiet assassin" and "Britain's Warren Buffett".

Bolton came to Hong Kong as he saw China as the big investment story of the next decade. And he wanted a part of it. I remember attending a speech by Bolton at a conference held by my old employer, CLSA, in late 2009. What struck me most was that he was cool, methodical and had an extraordinary breadth of knowledge.

Notably though, Bolton had limited emerging markets experience. He also came at a time when China's immense stimulus package was kicking in, providing a flood of liquidity into the economy.

And these two things proved part of his downfall. The first couple of years for his fund were a disaster. Only in the third year did it make up some ground. The fund ended up largely matching the 15% decline of the MSCI China index for the more than three years to June 2013. Recently, Bolton announced that he would be retiring early next year. No doubt with his reputation slightly tarnished.

While it's difficult to fully judge Bolton's performance without knowledge of the dynamics of his portfolio, it's clear he got caught out on several fronts. He invested in a number of U.S.-listed, China-based companies which proved to be frauds. For those that don't know, many Chinese companies chose to list in the U.S. rather than China for a variety of reasons, including to get money out of China and due to America's relatively lax listing standards for reverse mergers.

Bolton also got caught investing in companies involved in industries where there were significant over-capacity issues. No matter how good the company, these issues overwhelmed everyone in the industry. The problems proved a landmine for many so-called value investors, including Bolton, as many industries in China experienced over-capacity. Particularly as the initial economic stimulus wore off and the hangover began, starting in 2011.

It wasn't just the "bottom-up" investors - those focused on stocks rather than industries or countries - who got burned in China though. "Top-down" or macro investors were hurt too.

Investment guru, Jim Rogers, was one of them. Rogers is a U.S. raised, now Singapore-based investor who once partnered with Soros and made enough to retire at the age of 37.

Rogers has been bullish on China since the 1990s and he's been largely right on this call as well as a host of others. But he wrote a book called "A Bull in China" in 2007, close to the peak of the market. It's evident that he didn't pick the extent of the Chinese economic slowdown now underway or the impact that it would have on the stock market (down around 65% from the 2007 peak). And he put too much faith in the ability of Chinese leaders to manage the economy (he seems to have nothing positive to say about western leaders but nothing negative to say about their Chinese counterparts).

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To be fair, Rogers is a long-term investor who thinks in decades rather than years. And he's done well on other Chinese investments such as the yuan.

Star economists were wrong-footed on China too. Stephen Roach, the former chief economist at Morgan Stanley and new senior fellow at Yale University, was among the more prominent.

Roach is well known for having warned about problems in the developed world in the lead-up to the 2008 financial crisis. He's failed to issue similar warnings about China's prospects in recent years though. Like Rogers, Roach seems to have placed an enormous amount of faith in Chinese leaders' management of the economy. Even though they were largely responsible for the unfolding credit crisis.

Strangely, Roach hasn't admitted his errors. Instead, he's recently written an article [15] insisting that China doesn't have the serious issues that most people believe:

"Far from crashing, the Chinese economy is at a pivotal point. The wheels of rebalancing are turning. While that is not showing up in the composition of final demand (at least not yet), the shift from manufacturing and construction toward services is a far more meaningful indicator at this stage in the transformation.

So too are signs of newfound policy discipline - such as a central bank that seems determined to wean China off excessive credit creation...

Slowly, but surely, the new China is coming into focus. China doubters in the West have misread the Chinese economy's vital signs once again."

I happen to agree with Roach on positive signs for China on the reform front but any optimism shouldn't overshadow an economy that's clearly in trouble. Roach hasn't owned up to this.

Lastly, we can't leave out the thousand of companies who either entered China or were already there and subsequently beefed up their investments between 2009-2011. In fairness, the West was on its knees during this period and China seemed to offer one of the few opportunities for growth. What they didn't see, however, was that China's growth was anything but normal.

The mining companies were at the forefront of this. They saw Chinese demand in this period, extrapolated it out to the next decade and invested accordingly. Now, that demand is slowing and many commodities are dealing with excess supply issues.

I remember going to several presentations by BHP Billiton's then CEO, Marius Kloppers, who talked continually of Chinese and emerging market demand driving bull markets in many commodities for several years to come. Amazingly, Kloppers tried to buy Rio Tinto at the top of the market in 2007, tried to buy Canada's Potash Corporation near the peak of the potash market in 2010 and spent ludicrous amounts of money on mining exploration and expansion, and he's still remembered fondly by many investors!

My mistakes

Just so that you don't get the impression that I'm just a guy who likes beating up on others, it's time for me to come clean on some of my own mistakes when it comes to investing in China. From 2011, my scepticism towards China's economic growth quickly turned to bearishness and that bearishness hardened by late 2011. That didn't stop me from making errors along the way though.

For those that don't know, I was a portfolio manager for a large institution that ran two funds, a China A-share fund and an Asia ex-Japan fund, between July 2010-July 2012. The China A-share fund invested solely in stocks on the mainland and it had a very good performance record during this period. However, that didn't stop us having several blow-ups in Chinese stocks which led to underperformance in the Asia-ex Japan fund. We were far from alone in making these mistakes but they probably hurt us more than most.

One of these blow-ups was in a Chinese retailer, which was included in the portfolio on my recommendation. The loss that ensued led to much introspection on my part. I found that like Bolton, I'd underestimated the extent of over-capacity in this company's niche and the potential impact that it might have.

But there was much more to it than that. And I discovered many of the answers in a book called Capital Account [16], a collection of reports from highly successful UK-based global fund manager, Marathon Asset Management.

The book details Marathon's capital cycle theory. The theory attempts to tie the stock market to business cycles. In short, when a company is valued at a premium to replacement cost, there is a strong incentive to increase investment. Or, as the book puts it, "when a hole in the ground costs $1 to dig but is priced in the stock market at $5, the temptation to reach for a shovel becomes irresistible."

Increased investment results in rising industry supply which is normally accompanied by optimistic demand projections. Investment banks encourage the increased investments via IPOs, financing and mergers and acquisitions activity. And, not to mention, glowing research reports to get clients to buy into these companies. Which leads to even more industry investment.

Fund managers are sucked into the game as share prices of these companies rise and they buy them not because they believe in their investment merits but because they don't want to underperform respective benchmark indices. To do so would cost them their jobs.

When an industry's supply-demand situation gets totally out of whack, a downturn eventually takes place and weaker companies get consolidated into stronger ones. And then the cycle starts to work in reverse.

Many investors in China, myself included, could have saved a lot of money had they applied the capital cycle theory.

Anyhow, I moved from portfolio manager to writer of the Asia Confidential newsletter in August last year. Since then, I've been relatively consistent in having a negative outlook on the Chinese economy.

The one exception is that I did expect a very short term pick up in the economy mid this year as stimulus from late last year started to filter through. That hasn't happened and the call has been wrong. It's now apparent that stimulus is having less and less impact in China.

So there you have it, warts and all.

The lessons

Here are some of the key takeaways from investor errors in China in recent years:

1. If you want to make money in emerging markets, you better know the nuances of these markets. Bolton didn't and paid the price. Emerging markets are very different from developed markets. They are far more volatile, less transparent, and more prone to investment fads, with less mature companies and management teams.
2. Never extrapolate the present into the future. Things change and today's heroes often become tomorrow's enemies. China is a perfect example of that.
3. Growth aided by stimulus isn't normal growth. China illustrated that and it should serve as a warning to those that believe developed markets such as the U.S. can recover without further QE.
4. Be very sceptical of any politician or central banker's ability to successfully manage an economy. You can't centrally manage an economy towards perpetual growth but it's amazing how many in the finance industry believe that you can. Roach and Rogers thought that China's leaders were superior to those in the West but events didn't bear that out.
5. If there's excess capacity in an industry, be very wary of investing in any company in that industry. Usually, everyone suffers, as I found out.
6. If you invest in a company, make a thorough study of the financials. Yes this is simple but you'd be amazed how many professional fund managers failed to do basic due diligence on the Chinese companies that they invested in. They deserved what came to them.
7. If it's too good to be true, walk away. There were many Chinese companies which were delivering +100% earnings growth in 2010-2011 and investors continued to chase them to their detriment.
8. Don't become so cynical that it blinds you to potential opportunities. Many investors got burned in China and will never return. That's the wrong attitude as there are bound to be opportunities in the wreckage. You just have to be open to them.

The minority who got it right

It would be remiss of me not to give a brief mention to those investors who either successfully side-stepped China's stock market woes or profited from them. First State, Aberdeen and Platinum Asset Management are among the Asia funds that did well to avoid much of the carnage and to a limited extent, make money from it. These funds recognised the macro-economic and company risks at an early stage.

There are several global fund managers who did likewise. The most well-known is U.S. short-seller Jim Chanos. He recognised the developing credit bubble in 2009 and likely made a lot of money from it. Others included U.S. hedge fund, Pivot Capital Management and highly regarded U.S. asset manager, GMO. See this excellent compilcation [17] on how these funds identified the impending China downturn.

This list is far from exhaustive but covers the more prominent investors. One thing to note is that almost all of the funds mentioned had managers who weren't based in China. It makes a nonsense of the asset consultants and others that push for China or Asia funds to have people on the ground in China. The theory being that by doing this, there's a better chance of outperformance. There's no evidence to support the theory and it should therefore be given zero credibility.

This post was originally published at Asia Confidential: http://asiaconf.com/2013/08/02/investors-wrong-on-china/ [18]