Welcome to the latest battle between longs and shorts, a brand new frontier where evidence is tough to come by and rumor is the currency of debate: China small caps. I’ve never encountered such vociferous and passionate discussion with so little actual evidence. Shorts attack companies based on assumptions, deductions and lies. Longs exaggerate growth, divinate business relationships and say they’ve been on the ground when they haven’t. All in all, the fight is far from fair and both sides have significant skin in the game. So, who should you, as an individual investor, choose to believe?
It isn’t an easy decision to make. After all, there isn’t the security blanket of apparent regulation by the SEC to keep you warm at night. If you go out on a limb here, there is a chance it will break. However, keep in mind that you are investing in a country with four times as many people as the United States, 10% annual GDP growth and in many ways a purer form of capitalism. Also consider that China does not like foreign entrants, so these smaller Chinese firms are primed for growth with interest free loans (just ask Baidu) and sovereign protection. Here are my reasons for going long China.
1. Sheer Volume
Many analysts are talking about growth expectations for companies based in China being too high because they don’t have any idea of the sheer volume and population that actually lives there. In my coverage of Baidu (NASDAQ:BIDU) I point out the huge opportunities present in the internet industry; China’s internet user population already is almost double that of the United States, and in a few short years could be nearly triple that of the US. Now, in terms of pure customer count, that is pretty impressive but you say the income per capita is still so low! China has already passed Japan in consumption and is closing in on Europe. In a few short years, that consumption will be tops in the world despite any income disparities or rural versus urban riff.
So, when a small Chinese firm that seems poorly run reports some exponential growth figures, the shorts cry foul. How could these idiots run a business? Well, the problem with that statement is that although these people may be new to audited financial statements and being traded on an American exchange, they are not idiots. The Chinese are as much a diligent and hardworking people as the rest of us, no more no less. To imply otherwise is at best ignorant and at worst racist. If you have enough entrepreneurs plying their craft, there will be some amazing investment opportunities.
Rino International made us all aware of the potential for fraud and deceit in the Chinese markets. Now, every success story you hear is inundated with doubt. Unfortunately, these things will happen, but it doesn’t mean you should avoid the market altogether. I remember a few American firms hiding in plain sight around the turn of the millennium that managed to pull the wool over our eyes, but that didn’t stop anyone from investing in American companies.
The key is going to be diversification, in this market as in any other. I don’t mean laying out your money across fifty different ETFs. I simply mean not putting all your eggs into one rickety wicker basket. Some people have been rolling all their dice on China Media Express (OTCPK:CCME), and I think that is a mistake. There are definitely some uncertainties about the firm. The responsible thing to do to alleviate those risks and uncertainties is to diversify by industry and geography across China. There will be pump and dump schemes and some losses from those, but for the most part I believe the returns are worth the risk. Just remember to research, invest carefully and make sure you have lots of irons in the fire.
3. Chinese Communism Is the New Capitalism
In many ways, Chinese communism is becoming the new capitalism. There is a huge population to potentially cater to, there is a strong national pride in Chinese companies and a government that will go to extremes to make sure their domestic companies succeed. If you throw in some loosening of the historical reigns by the Chinese government, you have a veritable explosion of growth in the mainland. Karl Gerth writes in a recently released book, that:
Although China remains a nominally socialist country, consumerism is now deeply entrenched in all areas of Chinese life.
Their citizens are learning how to consume, and their contribution to global growth in the form of consumption will only increase as the yuan appreciates. I think that China will be the bastion of global growth over the next thirty years. They are years ahead of the next most populous country in the world, India, in both economic and infrastructure terms. Investments in China could pay dividends in one year, or five, instead of ten or fifteen in India.
4. Sovereign Protection
As China attempts to teach their citizens how to consume slightly more and their companies learn how to grow, there is a sense that no foreign entrant will be playing on even ground. Google (NASDAQ:GOOG) had their pride bruised by a swift kick in the rear when they tried to tango with the Chinese government over censorship. Although their self imposed exodus was noble, it proved to be brief; the market in China is important enough that foreign companies will play by whatever rules are provided. These rules are very generally skewed in favor of Chinese companies.
Take, for example, a study released by the EU claiming ZTE and Huawei receive aid from the Chinese government in the form of interest free loans and credit lines. The investigative commission claims that this relationship represents:
Significant state interference—in that they benefit from published government policies financed by the state-owned banking system.
Baidu already admits that they receive interest free loans in return for doing government research. These relationships can be legitimate or they can be a violation of international trade policy in the form of an implicit subsidy. Either way, China has definitely learned how to best position their home grown companies to succeed. Why not position yourself?
5. Yuan Appreciation
The yuan is supposed to start appreciating at a faster clip than over the last few years as soon as the global economy starts regulating itself. With China facing a supposed inflationary cycle, the increase in value in dollar terms could serve to benefit China in some way. I’ve written previously about the struggle between the yuan inflating and appreciating, but from an investment perspective the impact is simple. If the yuan appreciates in dollar terms, dollar investors stand to gain.
The relationship is straightforward. If you are investing in a yuan denominated asset that is priced in USD, then the appreciative direction of the yuan would result in an increase in price, ceteris paribus. The speed and timing of the appreciation, however, is still very much in doubt.
These are the five reasons I would be long China if I were an individual investor looking outside US borders. There is a currency upside, sovereign protection for Chinese companies and a huge market to tap into when growth at home just isn’t enough. The market isn’t for everyone, so make sure you consult with an investment professional before you buy every piece of the mainland you can; if you risk profile matches, however, then you may be in for a heck of a ride.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.