Tigers And Flies: China's Remarkable Continued Success Provide 2 Possible Winners And A Potential Disaster

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Includes: AMZN, DE, ECL
by: Stephen Leeb

Summary

China had at least three major structural problems, an urban housing bubble, over-leveraged shadow banking and rampant corruption nationwide that could destroy a generation of record economic growth.

Two recommendations that should benefit mightily from China are Deere and Ecolab.

Amazon has been good to my subscribers and I still love its long-term perspective, but it looks more like a victim than potential beneficiary of a growing world.

China's growth this year, which could be around 7 percent, looks a bit lower than I expected. On the other hand, the country's 2013 and 2014 achievements paved a road toward rapid future growth that far exceeded my very high expectations. Given these facts, I think China's growth for the rest of this decade will likely exceed 7 percent, be much more balanced, give it complete hegemony in the Far East and bolster a currency increasingly able to rival or surpass the U.S. dollar as a worldwide reserve currency. For investors, the implications are enormous. I'll focus here on two potential stock winners, a potential stock loser and some major macro plays.

At the end of 2012, analysts widely recognized that China had at least three major structural problems: a housing bubble in parts of urban China; over-leveraged shadow banking that was "an accident of potential epic proportions waiting to happen"; and rampant corruption nationwide. These problems threatened to destroy China's remarkable feats-including a generation's economic growth that had proven faster than any in the history of capitalism, plus the migration of hundreds of millions of citizens from rural to urban areas, a feat unmatched in human history.

China has had almost as remarkable a success in addressing its problems as it has producing economic growth. Indeed, China made dramatic strides in all three major problem areas with only a small sacrifice to growth and little or no sacrifice in worker employment or in living standards. While protests in Hong Kong could temporarily muddy the water, I think China's progress will have little effect on its long-term trajectory.

Most of the recent accomplishments occurred during the tenure of Xi Jinping, widely recognized as China's most powerful leader since Deng and perhaps Mao. That Xi immediately received control of the military upon elevation to Party Secretary was a sign of things to come. In the past, party leaders had to wait a year or so before obtaining the role of commander and chief of the powerful military.

Following Xi in the power hierarchy is Li Kequang, an economics Ph.D. with a remarkably successful career in guiding the economic life of various regions in China. Li, who is married to an economics professor, is self-made. While the exceptionally talented Xi was the son of a former Chinese hero, Li's ascension stemmed entirely from his exceptional skills and merit. Also noteworthy: Li, who is charge of the country's economic policy-a more powerful version of our Secretary of Treasury-ranks higher in the political hierarchy than his predecessor, Wen Jiabao.

Credit for relatively steady growth in spite of a sharp housing decline and dramatically reduced loan availability from China's shadow banking sector, goes to its massive spending on infrastructure, especially in the energy arena. This multi-trillion dollar endeavor not only compensates for growth lost to reduced real estate demand and less speculative money available but also prepares the Middle Kingdom for the 21st century, in which a developed country will need a smart grid anchored by ultra-fast cabling. (As I've previously mentioned on this score, the U.S. trails China by perhaps a decade or more.)

Perhaps Xi's biggest accomplishment: the anti-corruption campaign that almost overnight turned a marred meritocracy into something close to a true meritocracy. China has always prided itself on its meritocratic government in which the best rise to the top. But when bribes, graft, and outright criminal acts become an everyday part of business, it taints the meritocracy. When Xi says his anti-corruption campaign is aimed at "flies and tigers," he means he will root out corruption in all social strata. As a result of this crusade, those currently serving long prison sentences range from former contenders to Xi's own position to past Politburo members to small bureaucrats.

China's housing bubble is more or less under control, although shadow banking and corruption remain problems-but problems under much more vigorous, proactive (and therefore successful) scrutiny than the most optimistic observers could have imagined even a year ago. Most important in tackling corruption: a less-corrupt Chinese society provides increased meritocracy and also a friendlier climate for business. If global businesses hear assurances that they will henceforward compete on an even playing field, they will come to play-especially in an economy that's as large and vigorous as China's.

China no doubt will stumble from time to time. But the past-and, indeed, the recent past-suggest its litany of successes will overwhelm the failures. By the end of 2015, I expect growth to approach, and possibly even exceed, 8 percent.

Who wins and who loses? Two recommendations that I think should benefit mightily from China are Deere (NYSE: DE) and Ecolab (NYSE: ECL).

Thanks to nearly perfect conditions in the U.S. Midwest, the world's largest area of corn production, prices for corn and other agriculture products have been under a lot of pressure in 2014. As a result, farm income has declined and so has demand for Deere products, by a wide margin the world's most widely used farm products. A perfect trajectory will not last, but China's growth and that of other developing countries assures a very long-term uptrend in demand for food, of which Deere is a leveraged beneficiary. Wall Street is woefully near-sighted when it values this stock at 10 times earnings in the face of very long-term growth that could easily be in the mid-teens. Few, if any, big cap blue chips have comparable long-term credentials. Deere, therefore, is a stock that belongs in your retirement fund, your kid's education trust, and, indeed, in the account of virtually any long-term investor.

Ecolab leads the corporate pack in cleaning everything from water to kitchens to industrial labs. Axiomatically, as the world's population expands and economies grow, people will increasingly need greater amounts of fresh water, energy, and health care. Ecolab's strong position in water treatment and the chemicals management assures it a critical position, not only in providing the world with potable water but also supplying and treating the ever-growing amounts of fracking fluids. As for health care, a leading cause of recalcitrant bacterial infections is unclean hospitals, a prevalent problem in the developing world but unfortunately a characteristic of hospitals around the globe.

I can't resist: water and energy are two commodities with finite supplies against a growing world that will need ever more of both. But you cannot have one without the other and the dependencies, at least in America, seem to be increasing. Recently the Wall Street Journal pointed out how much more productive fracked wells are today than a decade ago. Missing from that report: the fact that today's productivity, three times that of yesteryear, also requires roughly 60 times more water. Water is not weightless and its delivery requires energy. The more water that can be cleaned and recycled, the less mess created by fracking chemicals, of which quantities used increase right alongside increases in water. That makes more water available for crops and every other water-based need.

Unlike Deere, Ecolab is not a cheap stock, with a current P/E of about 30. However, I estimate that long-term, the company can grow quite a bit faster than the presumed consensus figure of 15 percent; growth approaching 20 percent a year over the next five years would not surprise me. That would give the stock a PEG of 1.5, hardly overvalued for a company that is generating growing free cash flow with a current free cash flow yield of over 3 percent. In an aggressive growth portfolio what's not to like?

Losers? Here I ruefully single out: Amazon (NASDAQ: AMZN). Ruefully, since the stock has been very good to my subscribers and I still love many things about the management-especially its long-term perspective. Still, Amazon looks to me like a more likely victim than beneficiary of a growing world.

Of course, Amazon remains the best-in-class online retailer and plows back almost every cent of available capital into developing new opportunities for the future. Jeff Bezos, Amazon's captain since its start, doesn't focus on the next quarter, the next year or it seems even the next decade. He wants to do whatever it takes to make Amazon the world's online retail franchise. And in America, he has come very close-close enough that future growth for the company must be weighted to international markets. In that area, I think even Amazon lacks sufficient funds to carry the day.

The kind of distribution Amazon established in America is much harder to do even in Europe. In China, where the biggest developing middle class lives-his low hanging fruit-easy access to wide ranging distribution looks unlikely. Moreover, another emblem of China's success, Alibaba (NYSE: BABA), just made the scene as the largest IPO in history and competes in many ways with Amazon. The numbers tell the truth. Increasingly, Amazon has derived growth from the U.S. market place. The company's international business has been shrinking. Amazon's valuation, now at a nose hemorrhaging level, will have to drop. Alas, I consider this one-time favorite a short sale, or at best, a stock you want to avoid for the foreseeable future.

I can hear you asking, what about Google (NASDAQ: GOOG) and other high tech high-fliers? It is a different story. Google remains a recommendation of mine. In contrast to Amazon, growth for this company is tilted toward foreign markets. In 2007, the United States represented about 52 percent of Google's revenues; today that number is less than 45 percent. The big conceptual difference between Amazon and Google is that Amazon is delivering the same product that anyone else can deliver. They want to do it faster and more reliably, which in many countries they may not be able to. Google, on the other hand, has a proprietary search engine that's arguably the best in the world. If, say, you are buying The Brothers Karamazov, you want the best translation and if that were only sold by Amazon, it would have a big edge. But, in fact, any bookseller will have the same book. On the other hand, if you want to find out, which is the best translation of the book, Google arguably is the best place to start. Of course, there's a lot more to Google, which I'll tackle at another time.

I have a few brief words on macro plays. Buy gold and gold-correlated assets. Gold is down and may fall further, but China (not because it wants to punish the U.S. but because it wants to wholly protect its sovereignty), seeks to accumulate as much gold as it can get its hands on.

The years 1946 to 1971 were a golden age for the American economy: the U.S. controlled the one currency exchangeable for gold, against all other currencies convertible into U.S. dollars, and within fixed bands. China now wants that kind of top billing for the yuan.

Already hundreds of billions of dollars in trade deals have been signed between China and Russia, with most of it very likely to be denominated in yuan. Moreover, China, already a rapacious accumulator of gold is setting up international trading zones that will feature gold futures. In a year or two or three, China will be the world's biggest gold hub and probably will have more gold than the rest of the world combined. That first critical step should help China establish a new reserve currency, convertible into gold, in what will be the world's largest economy. No promises about tomorrow or even the day after, but for the sake of your families and their progeny, accumulate gold and gold-correlated assets.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.