The Outsized Risk of Investing in China

May 7, 2020

In the face of a pandemic that has brought the world to its knees, Chinese markets have been outperforming the rest of the world. It may seem strange that the source of COVID-19 is leading the way for 2020. It may seem especially inappropriate given the international backlash towards the country. It becomes egregious when you layer on the large debt pile and often misleading numbers coming from the Chinese government.

MAP has long avoided investing in Chinese companies – for good reasons. China’s corporate governance is weak, and the legal system does not do nearly enough to weed out frauds and regulate businesses. Even Chinese firms listed on U.S. exchanges aren’t subject to the same accounting oversight as publicly traded U.S. based companies. [1]Short-sellers, who make their money when the price of a company goes down, have found an abundance of U.S. and foreign listed Chinese companies to bet against. While there will always be diamonds in the rough, there are also landmines. We strive to avoid those landmines:

Luckin Coffee

Founded in 2017, Luckin Coffee claimed to be a Starbucks killer in China. Just two years later, the now publicly traded chain reported to have 4,500 stores in China and $413 million in sales for the first nine months of 2019. After debuting on US exchanges in May 2019, the company’s share price rose to over $50/share. In April, the company announced its reported figures were inflated and the share price collapsed from $26/share to just over $4/share within a week. The company had been public for less than a year and had already proven to be a fraud. [2]

ArtGo Holdings

ArtGo Holdings, a Chinese company trading in Hong Kong, is another suspicious case of rapid ascent and implosion. It appears that the company’s share price was manipulated in order to be included on the MSCI China index. The stock increased more than 40-fold before crashing 98% in one day after further scrutiny from the index provider. [3]

These firms are just two examples of rapid implosion that has happened in some Chinese firms when exposed to foreign scrutiny. There are likely many more to come.

Widespread Manipulation

Certainly, China is not alone in fraud. Fraud happens everywhere in the world. However, evidence indicates that there is widespread earnings manipulation in China:

Notice in the above chart that U.S. companies’ return on equity closely follows a bell curve, while China’s numbers have a sharp (and unnatural) jump at the 0% mark. Perhaps Chinese companies are simply more profitable, but it is much more likely that they are manipulating financial reports in order to show that they break even. This should scare investors from believing the numbers reported, especially those reported to the U.S.. It is more likely that these companies would lie to foreigners, as there is little consequence. It is nearly impossible for U.S. authorities to pursue or even investigate China-based companies.

COVID-19’s Effect on China’s International Relations

At the beginning of 2020, the biggest concern for China’s international relations was the U.S. trade war. A “Phase 1” deal was quickly signed and it looked like the long-simmering trade tensions were cooling off. We believed it was likely that the Trump administration would look to continue the fuzzy feelings due to the upcoming U.S. election. A good economy means an easier election for incumbents.

COVID-19 has drastically changed the outlook for the U.S.-China relationship. The virus originated in China, and it is widely believed that China did not do enough in the early days to prevent its spread to other countries. The Chinese government has been accused of a massive coverup of the true death toll. U.S. Intelligence is investigating whether the virus originated in a lab located in Wuhan, the epicenter of the virus. Sentiment has shifted further against the Chinese Communist Party as evidenced by renewed talks of a trade war with China. [4]

The United States is not alone in its concerns. Countries will need to act in their own interest, regardless of their feelings toward the United States’ current leadership. Japan is paying their companies to move production out of China.[5] According to Angela Stanzel, a China expert with the German Institute for International and Security Affairs, in European countries like Germany, “the mistrust of China has accelerated so quickly with the virus that no ministry knows how to deal with it.” [6]

Companies had already shown a desire to shift manufacturing outside of China. [7] The pandemic and its effects will further accelerate this trend. A clean break with China is unlikely, as supply chains and global consumers remain reliant on Chinese labor. However, as foreign supply chains gradually move out of China, the country will face increased economic stress. While nobody truly knows how the Chinese economy is doing, we think the economic damage caused by this drop in demand for Chinese labor will be extensive.

Consequences of China’s Deteriorating Relations

While some jobs will likely shift to other foreign countries with low cost of labor, the U.S. and the world will continue to review supply chains that run through China. President Trump signed an executive order on May 1st that will assess the supply chain of the electricity infrastructure. The move will weed out parts manufactured in foreign countries, especially China, which are viewed as vulnerable to foreign sabotage or espionage.

The pharmaceutical supply chain will also be viewed with heavy scrutiny. Although it appears major issues have yet to surface, as much as 80% of the critical drug manufacturing facilities lie outside of the US, according to the FDA. [8] Certainly, medical supplies will be viewed as critical to national security and the health of the American people.

There is a reason why many things are manufactured in China: labor is cheap. As companies are forced to shift supply chains, costs will rise. Combined with the massive stimulus bill and ultra-low interest rates, we think this is a recipe for higher inflation. Perhaps even the return of the stagflation not seen since the 1970s.

Ultimately, no one will go unscathed as the world continues to deal with the worst pandemic in at least 100 years. However, we will continue to seek transparency and look for undervalued securities in companies whom we believe are well equipped to handle the coming volatility. Because of its lack of transparency, we think China is a bad bet. For this reason, you will not see Chinese securities in your portfolio at MAP.

Managed Asset Portfolios Investment Team

Michael Dzialo, Karen Culver, Peter Swan, John Dalton, Zack Fellows

Research and analysis by Dustin Dieckmann

May 7, 2020

Certain statements may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. Past performance is no guarantee of future results.

Citations
  1. https://www.bloomberg.com/opinion/articles/2019-10-07/u-s-listed-china-companies-should-follow-rules-or-exit?sref=IM5xUP6v
  2. https://www.wsj.com/articles/luckin-coffee-accuses-operating-chief-of-financial-misconduct-11585840274
  3. https://www.wsj.com/articles/investors-lose-their-marbles-as-msci-u-turn-spurs-98-stock-plunge-11574329092
  4. https://foreignpolicy.com/2020/05/04/trump-china-trade-war-restoring-tariffs-2020-election/
  5. https://www.bloomberg.com/news/articles/2020-04-08/japan-to-fund-firms-to-shift-production-out-of-china
  6. https://www.nytimes.com/2020/05/03/world/europe/backlash-china-coronavirus.html
  7. https://www.kearney.com/operations-performance-transformation/us-reshoring-index/full-report
  8. FDA;Safeguarding Pharmaceutical Supply Chains in a Global Economy, October 2019