Why Chinese Consumer Spending Growth is Underrated and How U.S. Investors Can Take Advantage
Alpha is the “holy grail” of portfolio managers and can only be achieved through outsmarting other investors. A U.S.-based PM with decent access to financial information in the 1950s[1] and a sound value-oriented investment process could have achieved consistent alpha over any running 24- or 36-month periods. Today, in contrast, a PM tied to the Russell 1000 benchmark isn’t expected to achieve any alpha, especially in the long-run. The reasons are two-fold: 1) The goal of achieving alpha is, on average, a zero-sum game. After fees, transaction costs, and free stock grants to company insiders are deducted, the performance of active managers in aggregate are by definition worse off than those of low-cost passive funds, 2) the proliferation of much smarter investors along with a leveling of access to financial information down to the retail investor level. Since neither stock prices nor the investment world are in equilibrium (i.e. market efficiency breaks down at various points, due to liquidity-related or institutional constraint reasons), finding and capturing alpha is possible, although it is not consistently available as alpha opportunities are rare, especially from the perspective of a U.S. large cap manager.
As an aside, some U.S. large cap managers have historically outperformed their benchmarks by either adopting a “value” tilt or consistently moving down the market cap ladder by purchasing smaller cap stocks. This is no longer a viable business model as: 1) both consultants and clients have gotten increasingly strict about PMs sticking to both its market cap and value/growth “boxes”, and 2) while both the “value” and “size” are known to be historical anomalies, the continued outperformance of these two factors in the long-run is a questionable assumption.
In my March 12, 2017 newsletter, I stated that my experience with generating “true alpha”[2] comes in three flavors: 1) Alpha generation by taking advantage of institutional constraints, 2) Alpha generation by providing liquidity to distressed, leveraged sellers, and 3) Alpha generation by taking advantage of less informed investors. In an optimal scenario, I always try to utilize scenario (2) for my short-term trades on the long side or as entry points for longer-term positions. For longer-term or buy-and-hold stock investors, I urge you to incorporate (1) and (3) into your investment framework as you select stocks/industries as part of an overall asset allocation plan (see my March 12, 2017 newsletter for more detailed descriptions of the three flavors of alpha generation).
Why the rise of the Chinese consumer represents an alpha-generation opportunity: There is no question that buying companies that would benefit from the rise of the Chinese consumer represents a sound, levered beta strategy, as: 1) for the most part, Chinese middle-class wealth generation is still a couple of decades behind that of the U.S. and Japan, 2) Chinese retail spending is still growing at double-digits, 3) the balance sheets of the Chinese middle class are still relatively unlevered, and 4) unlike the competitive dynamics in the U.S., there is “no race to the bottom” in terms of the massive number of retailers competing for U.S. consumer spending while Amazon/Wal-Mart both continue to act as a major deflationary force on U.S. retail profit margins. E.g. according to IBISWorld, the top five restaurant chains in China represent only 6% of China’s 5 million restaurants, while McDonald’s, the largest U.S. restaurant chain, represents nearly 5% of all U.S. restaurant sales alone.
<hr>[1] E.g. Warren Buffett specifically stated a process of studying the S&P manuals at your local library in the 1950s could’ve unearthed a list of NYSE-listed decent-quality stocks that were trading below net cash.
[2] In retrospect, many PMs who seemingly achieved alpha proved to be not alpha generators at all “once the tide went out,” as Warren Buffett would put it. E.g. Investors of major U.S. casino operators throughout the 1980s up to 2007 were generally employing a “levered beta” strategy – i.e. buying securities with significant underlying leverage or those that would benefit disproportionately from a general rise in U.S. or global economic leverage. This came to a screeching halt in 2008. There was no special genius involved other than recognizing that: 1) households were leveraging from the 1970s all the way to 2007, 2) U.S. households were increasingly traveling and paying for “experiences” in destination cities such as Las Vegas, 3) Las Vegas transformed itself to appeal to high-income families, and 4) Las Vegas was able to extend its appeal to overseas gamblers such as Asian VIP gamers. Much of the gains in Las Vegas-based casino stocks from the 1970s to 2007 were driven by levered beta factors. The only true alpha generators within Las Vegas or the U.S. casino industry over the last 40 years were entrepreneurs like Kirk Kerkorian and Steve Wynn.
In addition to being a sound, levered beta strategy, the rise of the Chinese consumer also represents an alpha-generation strategy, which fits the mold of flavors (1), (3), and even (2).
Let me explain:
· Institutional constraints: As an asset class, EM equities were extremely popular during the 2-3 years surrounding the 2008-09 global financial crisis as it outperformed almost all other asset classes. In September 2012, for example, CalPERS announced an increase in its EM equity allocation, just as the asset class entered a relative bear market against U.S. equities and U.S. Treasuries. Similarly, both U.S. pension funds and endowments are still reeling from the EM equity relative bear market and the Chinese economic slowdown/anti-graft campaign of recent years. As such, U.S. institutions are currently underweight EM/Chinese equities; hence Jeff Gundlach’s call to overweight EM/Western European equities vs. U.S. equities at last week’s Sohn Conference—which matches precisely with our call to overweight EM/Western European equities vs. U.S. equities. Perhaps more importantly, many institutions are investing into EM equities through a passive strategy—which by definition, is highly inefficient. E.g. The Vanguard FTSE EM ETF (ticker VWO) has $54 billion in AUM, versus the actively-managed American Funds New World fund, which only has $29 billion in AUM. A passive EM portfolio is highly inefficient as it contains significant allocations in low-ROE, Chinese state-owned enterprises or corrupt enterprises such as Petrobras. Out of VWO’s top ten holdings, for example, four are Chinese SOEs (China Construction Bank, China Mobile, Industrial and Commercial Bank of China, and Bank of China). A glance at CalPERS’ 2013 annual investment report, for example, also shows significant holdings of China Construction Bank and China Mobile.
· Clear informational advantage: The U.S. has been the largest economy since the 1890s and certainly the largest consumer economy by far since mass-advertising began to emerge as a force in the 1920s. Most U.S. and Western European PMs came of age “picking stocks” during the 1980s/1990s secular bull market and do not appreciate or understand the rise of both the Chinese economy and consumer and how this will shift global consumer/mass-marketing patterns over the next several decades. In nearly every investment discussion on China, at least one PM invariably poses a question on the “Chinese housing bubble” or the “bad loans within the Chinese banking system” and how these will lead to a Chinese economic recession. This anti-Chinese bias is also evident in the U.S. financial media. E.g. Consider the biases in last week’s Bloomberg headline “China’s $246 billion foreign buying spree is unraveling” and Quartz’s “A German imperialist paved the way for China to revive the “Silk Road.”” In reality, China’s “One Belt One Road” and the Asian Infrastructure Investment Bank (AIIB) initiatives were a result of: 1) China’s relative exclusion from international finance and infrastructure institutions such as the IMF, World Bank, and the Asian Development Bank, which remain the exclusive domains of the U.S., Western Europe, and Japan, and 2) the lack of financing for EM Asian infrastructure from existing multilateral institutions such as the World Bank and the ADB. As Dr. Sok Siphana (advisor to the Cambodian government) recently commented on the Chinese entering the world of infrastructure lending, the influx of funds into ASEAN infrastructure today mostly come from China and Japan… “The rest – the UN, World Bank, ADB – are a joke.” Similarly, the vast majority of so-called Chinese “experts” in the U.S. have no Chinese heritage and certainly cannot relate to the last two centuries of “humiliation” and why this has acted as a major motivating force for all Chinese to work on the modernization of her economy – with innovation and the “Made in China 2025” initiative as their main goals. Simply put, most U.S. PMs are skeptical or downright scared about investing in Chinese companies; this includes U.S. companies with substantial Chinese presence, such as Yum! Brands or Las Vegas Sands and Wynn Resorts. The inability of U.S. PMs to form objective pros/cons regarding China means there is significant alpha potential in investing in selective, high-quality Chinese companies or U.S. companies with a significant Chinese presence.
We are certainly cognizant of the macro risks facing the Chinese economy in the long-run and this is a topic that we addressed in an April 27, 2017 Forbes article (“Three Known Risks That Could Derail The Chinese Economy”). In terms of financial risks, we are mostly cautious on the amount of unknown/leverage risks that have been building within various Chinese “wealth management” products that are by nature opaque and have been outside the control/reporting requirements of Chinese regulators. Uncontrolled leverage within an opaque lending/investment framework is what led directly to the Panic of 1907 and the 2008-09 global financial crisis. While the amount of Chinese NPLs is a cause for concern, its immediate result—similar to what has occurred within the Italian banking system—is simply a slow-down in bank lending, and consequently an economic slowdown. Bloated NPLs can only lead to a systemic banking melt-down if: 1) there is no credible backstop (i.e. central bank with the power to provide an unlimited amount of liquidity), and 2) if the country providing the backstop does not have a strong balance sheet (e.g. Brazil in 1998). China has proven it can and will recapitalize its banks with an unlimited amount of liquidity; moreover, China is the world’s third largest creditor, only behind Japan and Germany. Including the balance sheet of the Hong Kong Monetary Authority, China becomes the world’s second largest creditor. With Chinese regulators having recently instituted macroprudential policies to curb the proliferating in shadow-banking products, the Chinese financial sector remains on a firm footing, for now.
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