China Internet: Too Big to Ignore
A Lucrative Longterm Investment
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I am a fan of the Coffee Can Portfolio, an “Active Passive” approach to investing.
The idea of a Coffee Can is simple: Buy a basket of the best stocks you can and let them sit for years. You incur no costs with such a portfolio, and it is simple to manage.
You can follow and track my stock baskets here, on my Performance Scorecard.
Investing in China is personal. For some it’s too unpredictable. For others, it looks like a great risk-reward right now. Which camp are you in? I fall into the latter.
A couple years ago, I was listening to the Invest Like the Best Podcast, where Gavin Baker said something that really resonated with me: “Simple Is Beautiful.”
He spoke about a time several years ago, around 2007-2008, when he was debating with colleagues about Apple’s upcoming quarterly results. He recalled arguing about whether Apple would sell 850,000 iPods or 900,000 iPods that quarter. Everyone had very nuanced views… based on Asian supply chain data points, the product cycle, market trends and other factors. But then, one of his colleagues said, “none of that matters”. He said that Sony sold 400 million Walkmen in the past, and he believed that Apple would sell significantly more iPods in aggregate.
This was a light bulb moment. It no longer mattered whether 850,000 or 900,000 iPods had been sold that quarter.
By looking at Apple in this way, by focusing on the big picture, Gavin was able to simplify his investment thesis (and process), and significantly increase his chances of success. Apple went on to increase 7-10 fold from there...
Similarly...
By zooming out, can we come up with a simple case for investing in China?
That is, can we think of 1 or 2 relatively straightforward drivers that, if correct, virtually guarantees a successful investment? Let’s see.
Investing in China Feels Scary Today
A cascading set of CCP crackdowns has created much uncertainty in the markets:
First, Jack Ma disappeared for a while.
On the brighter side, they did find his doppelgänger :)
Alibaba was fined $2.8 Billion for anti competitive practices.
Meituan was forced to raise delivery staff wages
Public education companies have been turned into what are now essentially non-profits.
The market has clearly had a hard time quantifying the magnitude and future implications of CCP crackdowns, and as a result, stocks have sold off.
I agree there is lots of uncertainty today, but the good news is, there is a big distinction between uncertainty and risk. I am not convinced that investing in China today, is risky.
Let me explain.
In 2018, Warren Buffet, arguably the world’s most successful investor, wrote:
“In 25 years–a single generation–1.2% annual growth boosts our current $59,000 of [US] GDP per capita to $79,000. This $20,000 increase guarantees a far better life for our children.”
“Most American children are going to live far better than their parents did. Second, large gains in the living standards of Americans will continue for many generations to come.”
“Two words explain this miracle: innovation and productivity.”
Source: [Link]
Although he was referring to the US, why should China be any different?
If history is any guide, as long as China’s per-capita GDP growth continues, China will generate significant wealth. As a proxy, we should see an appreciating market over time.
Will China’s Per-Capita GDP Growth Continue?
First, let’s do a little math. China’s GDP growth rate is about 6% today. China’s birth and death rates are as follows:
Birth rate = 8.54 births per 1,000
Death rate = 7.09 deaths per 1,000
We can safely ignore immigration for the time being.
Therefore, the per-capita growth rate is huge.
Will this continue?
Here’s what I see.
China wants to become the world's largest economy. As Buffett states above, this will require innovation and productivity. Although Chinese tech companies have been called "copy cats" in the past, today they are rapid innovators, and one can even argue that many developed market companies are barely able to keep pace. China recognizes this, and therefore I would be very surprised if China doesn’t champion their own companies, who now compete on a global scale.
By cracking down, China isn’t trying to restrain future growth. They are simply changing the rules of engagement. What we have to remember is that China is a state capitalist system, meaning that investment capital is viewed as a tool to enhance society’s goals (i.e higher birth rates, affordable housing, protection of consumer data, educating the masses etc). If capital is instead being used to fuel the wrong societal goals, for example, high educational costs which discourage births or high housing prices which discourage family formation, then that use of capital isn’t productive.
As a result, with regulations, China is simply saying “Capital will only be rewarded if it fuels economic advancement in line with their long term goals.”
So, How do we determine China’s Long Term Goals?
This isn’t a secret - they regularly tell us. China releases the 5-Year Plan, a “blueprint” showcasing the government’s policies and priorities. The last 5-Year Plan specifically discussed how China aims to become a moderately developed country by 2035. Considering where other moderately developed countries stand, this implies a GDP per capita target of at least $20,000 to $25,000. They’re at ~$10,000 today.
Think about that for a second. China plans to increase per-capita GDP by $10,000-$15,000, that’s 100-150% growth in just 15 years! By contrast, Buffett was screaming with excitement for a mere 34% US growth in 25 years.
China is clearly growing extremely fast, and importantly, has a long growth runway ahead. China’s per-capita GDP will continue to grow far into the future.
Regulation and Damage Control
Yes, regulation in China is increasing. But that’s also true everywhere else in the world. The good news is the pace of regulation in China seems to be fast and swift. China realizes that Capital goes where it is treated well. China is therefore creating rules and specificity around its regulations. Over time, probably faster than we think, the details will get ironed out. This will help the market better quantify the risks and implications of these rules.
Considering the recent sell-off in equities, which has hurt not only outside investors, but also domestic ones, China is already in damage control mode. China’s Securities Regulatory Commission (CSRC) recently said this:
“Many promising companies are growing rapidly in China, which are potential high-quality issuers in capital markets. In an improving market ecosystem, listed companies that have solid operating performance and good corporate governance will naturally attract global investors. We see great certainty in the prospects of sustainable and healthy development of China’s capital markets.”
“Strengthening regulatory cooperation is the inevitable path.”
Here’s the full statement:
Ways To Invest
On my Investment Scorecard, we see that the best performing Coffee Can was purchased during the depths of the Covid crisis. This demonstrates that times of peak pessimism and high uncertainty can be great times to make long-term investments. Due to the recent selloff, investing in Chinese equities today may represent a similar opportunity.
Volatility likely won't decrease until there's an extended period of no regulatory announcements. But volatility is not risk. And if history is any guide, I believe this “regulation crisis”, like every other major crisis, will be forgotten soon enough.
Over the coming years, I believe many enduring businesses will be Internet enabled. Why? Because the most likely driver of GDP growth will be Consumption (C in the GDP equation below), and access to goods and services will continue to be democratized by technology.
Although CCP crackdowns have hurt Chinese businesses, when it comes to large Internet businesses, stricter regulations can actually cement their leadership positions, and be a competitive moat long term. We therefore have a chance to invest in some of the best large Chinese Internet businesses around, ones which are likely to still be around a decade from now.
Enter KWEB
I continue to ramp up on Chinese business but since I don’t know how long current low market prices will last, in order to invest now, I am taking a basket investment approach to start, and simply buy ETFs that invest in publicly traded Chinese Internet companies. KWEB is one such ETF.
There are three benefits to investing in KWEB:
Access to dominant Chinese Internet companies that provide similar services as Google, Facebook, Amazon, etc. (Important since we want to invest in large businesses with the capacity to endure)
Exposure to companies benefitting from increasing domestic consumption by China's growing middle class. (Important since this will likely be the biggest driver of Chinese GDP growth)
Exposure to companies listed in both the US and Hong Kong. (Important since not all businesses will be listed in the US)
KWEB’s Top 10 Holdings are as follows, and make up >60% of the ETF.
Over time, I will probably transition my investments into individual companies.
CWEB
CWEB provides a leveraged way to invest in the above. This ETF seeks daily investment results of 200% of the performance of KWEB. Note the keyword daily. This has risks, as seen in the graph below.
Blue Line = KWEB
Yellow Line = CWEB
In the above, we can see that when KWEB trends downwards, due to leverage, CWEB performs extremely badly:
For example, KWEB is currently down ~50% from its Feb 2021 peak. Meanwhile, CWEB during the same time is down almost 80%!
Similarly, between Jan 2018 to Jan 2019, KWEB fell about 45% while CWEB fell more than 70%.
On the other hand, we can see that when KWEB trends upwards, CWEB does exceptionally well.
For example, KWEB was up ~169% from its Dec 2018 lows to its Feb 2021 peak. During this time, CWEB was up over 440%!
So... investing in CWEB isn’t for the faint of heart. The big risk is the swift price declines that accompany a downward trending market. This is the downside of leverage.
The VIE
Lastly, we haven’t talked about the VIE Cayman Structure. VIE is a legal structure used to circumvent the fact that foreign ownership in certain Chinese industries is prohibited.
Of course, this is a risk. But one that’s been around for a while. If you believe the CSRC’s statement above, then that should give you some comfort that China won’t simply pull the rug out from under US investors. Plus why hasn’t China already done this? Now would be the perfect time, with all the other crackdowns going on.
If VIEs are too big a deterrent, that’s completely understandable. But, if you’re not a Chinese national or resident, and if you still want to participate in the China growth story by owning stocks, you don’t really have other choices...if you decide to invest, size your investment accordingly.
Wrapping Up
Let’s go back to the original question I posed:
“Can we think of 1 or 2 relatively straightforward drivers that, if correct, virtually guarantees a successful investment in China?”
To me, that one driver is per-capita GDP growth.
Barring something drastic, I simply do not see a future where China’s per-Capita GDP isn’t significantly bigger 5, 10, 15, 20 years from now.
This growth will be led by innovation and productivity. Recall that the dire circumstances induced by Covid led China to stand up hospitals in a matter of weeks last year. Meanwhile, the US struggled simply sending its citizens stimulus checks. Imagine how big the difference in capabilities will be 10, 20, or 30 years from now? By investing in China today, that’s what we are betting on. And near-term market uncertainty has given us great prices to buy-in at.
Since I believe GDP growth will be led by consumption, I believe Internet-enabled Chinese businesses will do very well over the long term. Because access to goods and services will continue to be democratized by technology.
Therefore China Internet ETFs represent a simple, yet lucrative investment opportunity.
In conclusion:
Will China inevitably be the world’s largest economy one day? Yes.
Will US & China Capital Markets eventually figure out how to get along? I believe so.
Do I think the road will be bumpy? Yes.
Will I still invest in China? Yes.
Per my Investment Scorecard, I invested in
CWEB on 7/28/2021at $24.62
KWEB on 8/27/2021 at $48.23
CWEB on 8/31/2021 at $22.52
Over time, I may transition my investments into individual Chinese companies as I become more familiar with them.
I’ll end with the following quote:
Reference Doc:
[Link]
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Thank you and Happy Investing!
Wondering how you're thinking about this with the current political and market climate?
Simply outstanding