Letters

September 2nd, 2021

The China Opportunity

Good Afternoon,

We recently completed our tenth month of investing. The portfolio has returned +24% since inception and +18% year to date. We hold approximately 50% cash and have done so over the period. We will deploy this as opportunities present.

In recent months, more than $1 trillion has been wiped off the value of US listed Chinese technology firms, with a much larger impact across assets. In response to regulatory developments, many western commentators have called China “uninvestable” and the exposure professional fund managers have, has never been lower over the past decade, than it is now.

We have increased exposure to selective Chinese assets and proxies in recent weeks. Detailed below is the context and our logic.

The document is separated into the following:

  • Personal experience approaching China
  • What is happening in China and Portfolio Implications: Government, Economy & Regulation
  • Team Addition – Michael Willis

Personal experience approaching China:

As a proud Australian, it is impossible to ignore the impact China’s domestic policy agenda has had on the country. Demand for natural resources has created a raft of intended and unintended consequences. Whilst at university, I spent significant time attending Annual General Meetings, reading company presentations, and investing in shares. Resources was the hot sector underpinned by the almost irrefutable line – “China has 1.1 billion people who need to live somewhere”. This all changed with the financial crisis, where correlations sky rocketed and asset prices plummeted. Yet in the space of six months, China unleashed enormous infrastructure investment and helped Australia (plus others) recover much more rapidly than western counterparts.

I moved to London in 2009 and was surprised by how few investors spent time analysing China in the Northern Hemisphere, let alone travelling on the ground, experiencing tier 1 to tier 4 cities. After all, this was a country that had brought 700 million people out of poverty, boasted the fastest growing region (of scale), had the largest savings as a share of household wealth and accounted for approximately 15% of S&P 500 earnings. Despite the increasing influence and scale, it still appears that the number of people analysing specific words from the US Federal Reserve completely dwarfs those looking at the Chinese ecosystem.

Over the past 15 years, I have worked hard to better understand the plumbing in China, as the economic, political and strategic ramifications are real. I have had skin in the game (and the battle wounds!) on the mainland and abroad, have seen Chinese mining operations in remote parts of Africa, engaged with corporates, consumers and government in Pakistan (the hub of China’s Belt & Road program), am an early investor in a Bangladeshi business (another Belt & Road beneficiary), have been fortunate to experience countless trips to the mainland over the past 12 years, taking me to about 20 provinces and learning from others. Yet as a pale, red headed, freckly kid who was brought up on BBQ’s and bananas, I didn’t have the stomach tolerance and food poising was common on the road.

I detail this background to illustrate that the conclusions below are (hopefully) thoughtful and considered. China like any country, is far from perfect. I do not pretend to know all the answers and there are always things we will not be aware of. However, at Conduit we aim to assess the facts, consider scenarios, and identify compelling risk adjusted investment opportunities, through an objective lens.

As Tiesto says, “Let’s get down to business”.

Policy – “Our way, not your way”

China continues to adopt a different policy approach to western counterparts (I wrote about this on 20/4/20 and can share) and the research should reflect this. For example:

  • Stimulus: Whilst the US prints money, China withdraws it. The PBOC’s has expanded its balance sheet 6% since pre-Covid. The US Federal Reserve has increased 96%. Most G10 countries have blown out their debt ratios – China is the outlier.
  • Security of supply: China’s domestic supply chain continues to move up the value chain, particularly in industries of the future. Spending on high-tech is growing at 15% (3x fixed asset investment over the past two years), in contrast to other Governments who have given out cheques during Covid. See details of how Conduit acted during the volatility at a portfolio level.
  • Reduce poverty: Xi wants to lift 100-200m people out of poverty. Reducing inequality has been a common policy of many countries, but if executed in China, the implications would be meaningful. In recent weeks, Beijing has referred to this as “social equality”, or common prosperity phrase.
  • RMB Internationalisation: Launch a digital RMB on a blockchain and expand the sphere of influence. The RMB accounts for 5% of global trade, what better way to increase its circulation through large tech firms and compete with the USD.

Rare earths are an example of the security of supply in action:

  • China accounts for 80% of the global rare earth (RE) supply chain.
  • RE’s are key enablers of the Green Revolution, a core Conduit investment thesis, which we estimate to be a $50trn opportunity in the next 15 years.
  • REs are necessary components of electrical vehicles and wind turbines.
  • The market is entering a supply/demand imbalance after eight years of underinvestment and depressed commodity prices, analogous to iron ore in the mid-2000s.
  • Expect demand to grow at approximately 10% CAGR until 2030.
  • Chinese entities have bought (blocking) minority stakes in many western businesses, to secure offtake and enhance control. The dominant US producer currently sells 100% of their offtake to a Chinese company.

During the market sell off, we invested in a rare earth company, Vital Metals (VML AU). VML is fully funded (20% of market cap in cash at investment date) and recently entered production – the first in Canada. It is led by industry heavyweights who took advantage of a cyclical downturn several years ago to acquire assets at attractive prices. Its approach differs to peers and resonated with us – lower establishment costs and higher returns on invested capital. VML is on track to be the first North American producer of both light and heavy rare earths. It has no blocking, or sovereign shareholders on the register. Only 20% of offtake has been (tactically) forward sold, which differs from most (fully committed). If the US want to develop an EV supply chain, it needs rare earths.  Chinese EV production is running ahead of schedule (underappreciated). We expect rare earth feedstock to be incredibly tight for the next decade and trade wars aside, China to transition from a net exporter, to net importer. If correct, VML is well positioned to supply the rest of the world.

Regulation – Data, competition and influence:

As the EU and US attempt to regulate large US technology companies (through ongoing debate), China acted, as it has been doing for several years. The market attention has been on three areas: Anti-trust / competition; Data security and sector specific regulation. The large technology companies and private education firms have been the focus and much has been written (from west and east). I will not add to the specifics but recount views we have received from our contacts on the ground, companies, and political correspondence. Similar comments and proposals are debated in other geographies regularly and critically, many Chinese view these regulatory developments favourably:

  • “Is E-Commerce the technology the CCP values for the next decade and beyond?” Or does it represent the most (market) valued segment of technology?
  • Do we need some of our smartest people building more food delivery apps?”
  • Millennials spend 7 hours on their smart phone per day (average screen time), whilst youth unemployment is rising? With demographic and healthcare challenges, wellness must be a focus
  • The influence and power of large private companies was threatening SMEs and incumbent state owned enterprises
  • Tax – “Why do the most profitable and largest companies get significant tax breaks?” Selective big tech pays about half the rate of tax compared to others.

The fines and punishment have been modest in most cases (<$500k), given the size of companies, yet Beijing underestimated the market response (and perhaps didn’t care). Xi Jinping has argued that regulation and more will “advance the modernisation of the national governance system and governance capabilities” and help drive “shared equality”. The political jargon aside (ie – power and control), “donations” from large companies post the regulatory crackdown, should eliminate ambiguity (eg – Tencent pledged $15bln for “sustainable & social values”). We would not be surprised if more regulatory surprises emerge, analogous to some of the big names taken down by the corruption campaign.

Whilst the regulatory crackdown is the longest in his tenure, Xi has been increasing regulation of private companies since 2012. For example:

  • In 2019 the CCP required all Chinese companies to amend Articles of Association and place the CCP doctrine ahead of company law
  • In 2020, the CCP have started voting in the nomination of key executives

The list is much longer.

Investors who are now questioning shareholder rights, ownership structures, governance and more, have seemingly ignored, or been unaware of the creeping regulation in recent (rising share price) years. There are challenges, but it didn’t blossom in the past few months.

Portfolio implications: We carried little Chinese exposure into the rout and cut our holdings of select companies some time ago. As the facts changed, so did we – we bought several large technology companies in recent weeks and increased exposure, in line with one of our four themes, Technological Architecture.

  • On our calculations, these companies have never been valued at a larger discount to US peers.
  • US investors have been selling at any price, according to regulatory filings. Foreign ownership is at its lowest in a decade.
  • This is occurring whilst global equity inflows, according to Goldman are annualising $1trn – coincidentally equal to the value of the Chinese sell off. Such flows exceed all inflows between 1996-2020, in aggregate. The overwhelming majority of recent flows have ended up in large US technology companies, whilst China has been dumped.

Valuation and mean reversion shouldn’t be and is not the only comfort we look for. Things can become cheaper and get more expensive. At the very least, we would expect some tech firms to act as quasi-Government utilities. They are enablers of the CCP’s strategy and huge innovators (such as high tech automation, EVs and AI). The CCP is aware that despite a zero cost of capital (state owned banks lending to state owned entities), innovation amongst SOEs has been underwhelming. It is the private sector which has advanced so much. The return on equity of private companies is 65% higher than SOEs. Clients of Conduit Capital can see the portfolio in real time and have full transparency. In respect of their support for us, I will not detail specific stocks.

Ironically, following the financial crisis it was bank regulation that enabled technology and digitisation to flourish. Mid-tier banks struggled and those with insufficient capital went under. Even those that survived didn’t see the prior lofty heights. Regulation is not the end but creates opportunities and this is where we have deployed capital. See here for more detail about the changing leadership in prior decades.

Economy: Show me the (absent) money

A convergence of weakening factors (liquidity, real estate and e-commerce) is/was placing strain on the economy. The background:

Liquidity (is tight):

  • The contribution of each RMB to GDP has been shrinking for most of the past decade. In other words, more money is needed to maintain the same level of economic activity.
  • The PBOC balance sheet has recently contracted and Ministry of Finance deposits, increased.
  • The gap between Government revenues and spending is almost 20% (the widest I’ve seen). The Government takes 100 in receipts and spends 80.
  • China’s approach is diametrically opposed to the US
  • The PBOC has criticised western central banks for incredibly accommodative (money printing) conditions as reckless.

Real Estate: Restrictive financial conditions are causing a slowdown in select industries. For example, the property sector, a substantial contributor to GDP, has been under pressure:

  • Growth rates for property development (land sales) have been falling since the peak in February. Government revenues from land sales represent approximately 50% of Chinese tax revenue.
  • Local Governments can’t afford to be sufficient without Beijing’s support.

The challenge for Beijing is that property is the cause of the wealth gap:

  • 25% of bank lending is for property and access to funding for property is the discriminating factor (like other countries, such as Australia), not the deflationary forces from large technology platforms.
  • Income from property, as a share of total income, has increased 3x in the past decade. All income gains from property, have been at the expense of wages.

If the (net) liquidity withdrawal was to continue impacting sectors like real estate, whilst regulation on the digital economy accelerates, which has grown 10x over the past 15 years and accounts for 40% of GDP, the consequences may be severe. There is a real risk of kneecapping growth.  Many assets inside and outside of China are not reflecting the intended and unintended consequences of such a strategy.

Whilst Beijing appears to have underestimated the impact of regulatory announcements on confidence and market sentiment, the indications in the last week, suggests they appear to understand the (kneecapping) risks to growth. This realisation is significant and positive.    

 The beneficiary of a more accommodative approach will likely be the consumer in lower tier cities. Beijing has advocated social equality and a narrowing of the wealth gap.  There are 500m people living in rural areas and the average income is 48% below the national average and the bottom 20% (100m), have incomes 80% below the average. Improved access to funding for 50m micro enterprises and home ownership in Tier 3 & 4 cities would gather even more support for Xi and the CCP. It would also catalyse economic activity as the marginal propensity to consume (ie the more you spend, of what you make) in lower tier cities (400m people) is 2-3x higher than Tier 1 & 2 cities. The correlation with house prices is meaningful.

At a portfolio level, if another 100-200m people entered the middle class, it would be hugely supportive for travel, leisure and consumer businesses. The Next Billion Asian Consumers is one of our four themes. We used market volatility to enter three new positions (two onshore, one offshore). These companies are segment leaders, with recognised brands and rapidly growing e-commerce strategies. We believe in the Chinese consumer.  The shares we purchased are valued at a noticeable discount to western companies who trade at a premium because of their Chinese exposure. We don’t think the persistent divergence is probable.

In summation, China is complex and difficult and why many have thrown the towel in. There are a lot of moving parts and the length of this note aims to detail that none of the above can be viewed in isolation. Despite this, our research suggests that certain assets may be misinterpreting Beijing’s medium-term objectives. We view this as an opportunity and increased our exposure and entered new positions. If the volatility continues, we will consider adding more, within our prudent risk management framework. Please contact me if you would like to consider making an investment, or apply directly online.

Team Development:

At a business level, we are fortunate to welcome Michael Willis as a Partner of Conduit Capital. Michael spent the past 21 years in the UK leading financial services businesses, focused on global equities. We have worked together directly and indirectly for more than a decade and have a strong relationship, yet are not afraid to hold each other to account. I’m delighted he has agreed to our offer and returned to Australia with his family. Michael is a highly valued member of the team, with extensive global relationships, and a (bit!) more grey hair than me. He can be contacted at Michael@conduitcapital.co .

Please contact me if you would like to consider making an investment, or apply directly online.

Thank you for your support.

What an exciting time to be alive!

Jack Dwyer

Founder

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