Opportunity and danger in China investments, part 2

Applying insight and nuance

In October 2019 we joined an immersive tour of Chinese technology companies and gained valuable insights from investors, industry experts, government officials, and entrepreneurs on the nuances of business in China. In part one of our report, we set the framework with an analysis of the opportunity and danger in investing in China. We conclude with a look at the whole concept of “capitalism with Chinese characteristics,” and what that means in practice for investors.

“It doesn’t matter whether a cat is black or white, as long as it catches mice.” – Deng Xiaoping

While there have some been bumps along the way, capitalism with Chinese characteristics has been nearly miraculous in transforming the country over the last few decades. The path has been very different relative to the Western experience, which has been an ongoing source of consternation. As always in China, political considerations are an important factor, playing a “visible hand” in potential outcomes. While this involvement is viewed negatively by many in the West, often for sound reasons, firms that successfully navigate this dynamic enjoy a significant unfair advantage (i.e., a moat).

The State Council has targeted China with being the global leader in the development of artificial intelligence (AI) theory and technology by 2030. It provides funding and support to its “national champions” in AI to reach its goals, much like the U.S. government did with its Apollo mission to moon in the 1960s. A number of U.S. companies leveraged the technologies developed for Apollo as a springboard for business opportunities afterward. One might speculate that will probably be the case in China as well.

Observers have noted the impressive leaps in the quality of China’s AI research in recent years. While not yet at par with the U.S., China is quickly catching up. Many pundits also predict a shift in the nation’s ability to retain homegrown talent. That is partly because the government has implemented some successful retention programs and partly because worsening diplomatic and trade relations mean that the United States, its key rival when it comes to most things including AI, has become a less attractive destination for talent. China is fast adapting to a new world where it no longer trusts America as it did before. This will have important long-term implications.

Global firms in China – the dangers of Western bias, misunderstanding and misinterpretation

“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.” – Mark Twain

Our trip was focused on China tech, where there is not much competition within the country from Western firms due to the “Great Firewall of China” – a combination of legislative actions and technologies enforced by the state to regulate the internet domestically. Its role in internet censorship in China is to block access to selected foreign websites and to slow down cross-border internet traffic. This is unlikely to change in our opinion. However, plenty of other Western non-tech firms operate in China. We heard a number of interesting anecdotes about how a Western perspective and media bias can lead you astray.

For example, when Costco opened up its first store in China in August, Western business media enthusiastically reported that the store was so popular that it had caused traffic chaos and had to close early because of huge opening-day crowds. This “news” sent the stock soaring. However, the reality on the ground and reports from Chinese media told a very different story. There were a lot of local voices suggesting that the Costco opening frenzy was not indicative of future success and probably not sustainable.

First of all, there were a lot of extremely low one-time discounts on high-profile items that attracted hordes of bargain hunters, a real community in China who turn up in force only during times of extreme bargains. When the deals disappear, so do the crowds.

Furthermore, Costco’s lax policies for memberships and returns, which were optimized for Western shoppers, may have been abused by some Chinese customers. Before you can shop at Costco, you need to be a member, so many bought memberships simply out of curiosity, knowing they could easily cancel soon thereafter. In the following days and weeks, there were stories in the local media of line ups, not for sales, but for membership cancellations and returning unwanted items.

From a long-term perspective, world class ecommerce and extremely robust logistics in China make it difficult to compete against purchasing online. Add on all the new innovations in “smart retail” and there are significant practical advantages to staying with existing offerings, developed specifically for the Chinese consumer, instead of driving out to the edge of the city to buy a large quantity of items that are too bulky for most Chinese apartments.

These kinds of important nuances are often missing from the North American perspective. On the other hand, it was clear that some global firms like Starbucks, with fast-growing, profitable operations in China, have durable competitive advantages and plenty of runway, despite fears of new emerging local competitors, like Luckin Coffee.

Why we care (and so should you)

“Learning is a treasure that will follow its owner everywhere.” – Chinese proverb

While we continue to be focused primarily on Canadian and U.S.-listed ideas, decades of globalization have increasingly blurred geographic boundaries when it comes to investing. Even if you have no interest investing directly in China, the country cannot be ignored, given its fast-growing consumer market and position as the hub of global manufacturing.

We think it is definitely worthwhile to visit China and to see for yourself how people there live. There are lots of things that are interconnected, but not necessarily intuitive, particularly from a Western viewpoint. There are multiple “China’s” inside of China – the people living in urban and rural areas have a huge divide in consumption habits, but both populations are massive, so you can build very large companies by catering to either one or the other.

While the business mood in China was cautious and more inward looking than in times past, and there will be inevitable bumps along the way as we see today, we believe it is a mistake to be gloomy about China over the long-term. We plan to keep building our knowledge base on China because of our belief that the country will continue to gain in importance in the coming decades.

Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management. He works alongside David Barr, Pender’s President, in setting the direction of Pender’s overall investment strategy. This article first appeared in the Pender blog. Used with permission.

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