Emerging Dragon. The Road Ahead, Part IV

November 4, 2013

In The Road Ahead, Investment Perspectives Parts I, II and III, we explained how the United States, as well as much of the developed economic world, will contend with far-reaching systemic issues in the years ahead.
Economic and financial headwinds in the form of demographic trends and unsustainable policies will force a reckoning throughout the global economic system.
There are, however, areas within the global market place that will provide dynamic opportunities for intelligent, forward-looking investors.
Thus far, we've focused on the massive opportunities revealing themselves within the liquid natural gas and shale revolution. We have also described the huge opportunities present in small cap U.S. equities. This week we, we depart the American mainland in order to focus on the next opportunity.
This is the fourth installment in a five-part series.
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Ultimate excellence lies
Not in winning
Every battle
But in defeating the enemy
Without ever fighting.
-Master Sun, The Art of War
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"China is a civilization pretending to be a nation." -Michael Ledeen

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Dragons are oft depicted as nature's foremost symbol of fury and vengeance. They're depicted attacking the innocent. And as adversaries against evil. Bringing massive size, strength and speed to bear against all opponents, dragons are usually portrayed as majestic, fire breathing monsters who rise up to smite those before them. Nobody could withstand their vengeful brute force.
Aptly, the Chinese, who imbue powerful meaning and symbolism to nature and animals, hold the dragon as the highest form of animal in that spiritual bureaucracy. In fact, the dragon has come to represent China itself. Its promise, power, and opportunity.
With over 1.3 billion citizens, China stands to inherit the earth. It will not be the first time. The world's second largest economy has a rich tapestry of political, mercantile and diplomatic history. Under the Ming Dynasty, China dominated the world. Under Mao's Great Transformation, China struggled to integrate its massive population and changing culture.
China is the juxtaposition of a proud and ancient culture evolving within the paradigm of a western, modernizing world.
One thing is certain, China is among the oldest civilizations on the earth. She has learned from her vast experience.
Today, she stands upon the world stage like an agile empress, part tiger, part merchant, ready to transact business and achieve victories more than one hundred years in the planning.
In his book, On China, Henry Kissinger aptly describes the Chinese character and its distinctive means of progress. The Chinese ideal, Kissinger explains, stresses subtlety, indirection, and the patient accumulation of relative advantage. Conversely, the Western tradition prizes the decisive clash of forces, and overwhelming victory.
Nowhere is that distinction more apparent than in the subtle differences between the cultural choices in board games.
Western culture, and the U.S. in particular, have adopted chess as the game of choice. Chess is a class of opposing forces. White versus black. The goal? Total victory.
Long ago, the Chinese adopted a game that perfectly represents their subtle yet complicated approach to their philosophical, military and mercantilist traditions. Named "Weigi" (called Go, in Japan and the West), it stands in perfect contrast to chess. As China does the West.
Weiqi is a game of relative gain. Of patient, long term, strategic encirclement. Its underlying principles are echoed in Master Sun's haunting treatise, The Art of War, written at the time of Confucius.
Like China, Weiqi is about indirect attack. Psychological combat. Perseverance. Winning without fighting.
So, it is interesting to see how China waited for centuries only to end up where it began. On the precipice of world domination.
Economically speaking, that is.
As western civilization ages, and contends with an increasing array of societal difficulties, China has reemerged as the predominate economic story.
Since 2008, China has contributed the lion's share of growth to the global economy, as the developed world tried to rise, bruised and battered, from the 2008 debt crisis.
Today, growth has slowed. The Chinese government is attempting to reign in a $1.6 trillion lending boom that sent home prices skyrocketing and local governments with record liabilities.
Yet, China has positioned itself as the private banker to the United States.
According to World Bank figures, Foreign creditors currently own $25 trillion in U.S. assets. China is the largest owner. Recently, they've been dumping Treasurys and buying real American assets. Like IBM's personal computer division. The AMC movie-theater chain. Pork producer Smithfield. Not to mention some of our most valuable energy resources through equity deals with Devon Energy and Chesapeake Energy, among others.
Thus far in 2013, China has spent $10 billion on U.S. assets. That compares with $1 billion in 2008. At some point, China will stop buying debt obligations in likes of Fannie Mae and Freddie Mac and simply start buying the underlying assets - U.S. residential real estate.
In fact, they already have.
In 2012, the Chinese bought $3 billion of California commercial real estate. Soon, they'll likely begin buying residential. Before long, as we continue in our attempts to solve our systemic economic issues regarding entitlements and debt, American citizens will be paying rent to the Chinese. Literally and figuratively.
China is not only buying U.S. assets. Between 2005 and 2011, China made more than 350 direct foreign investments valued at $400 billion all over the world. The primary focus? Raw materials. Russian potash producers. African minerals companies. Canadian mining concerns.
Given China's recent growing pains, it now appears that China will again spark the allure of wealth and grandeur for investors around the world. Only, instead of doing so along the Silk Road, it will occur along Route 66.
China's conquests have transpired in the same fashion one might play Weiqi. Patiently. Strategically. Attacking indirectly. Encircling valuable assets. Always moving.
Ten years ago, China was largely viewed as an emerging backwater. A place to be avoided. Soon thereafter, China evolved into a "can't miss" regional investment to which every portfolio needed exposure. Today, she has lapsed back into the "house of cards" role she held a decade ago. Too big, too unstable, too uncertain.
According to the principles of Weigi, that is precisely how the Chinese prefer it.
Chinese investments are not risk free. We see certain risks based upon political corruption and massive demographic trends. We also believe that China is worth the risk. Investors unwilling to bet on this rising dragon will miss out.
In stark contrast to her Western counterparts, it is China's "communist" government that has been willing to directly confront the nation's challenges. Why? Because China doesn't have a 24/7/365 news and election cycle. Its leaders can tackle difficult issues head on, without fear of reelection, bad publicity, or future voter reprisal.
China's Shanghai Composite index has incurred its difficulties over the last few years. It remains at half is November 2007 value.
But, the time to buy is not when things are up. But when they're down. And before long, the Chinese stock market will respond to the nation's systemic reforms, not to mention the current economic recovery.
While Western equity markets have risen steadily since March 2009, the Dragon has slept. She will not sleep forever.
China's Shanghai Composite has fallen 29 percent over the last three years. 50 percent since 2008. While the MSCI Emerging Market Index slipped 8.8 percent since 2010, and the S&P 500 jumped 48 percent.
U.S. stocks have a P/E ratio of 16.7, near three-year highs. This, even as U.S. GDP is forecast to slip to half of its 2012 growth rate.
In contrast, Chinese stocks are cheap.
The MSCI Chinese Index is trading at a rock-bottom P/E ratio of seven times earnings. It has a price-to-book ratio of less than one. Historical valuations are as much as 20 percent below their norms.
As the S&P 500 index approaches a level of being "fairly to fully valued," having rise over 25 percent on the year, the Shanghai Composite Index has dropped 5.3 percent and offers a 44 percent discount to the S&P 500. That compares to an average premium of six percent for the Chinese index over the last five years.
The world has lost confidence in China. Investors were overly optimistic until 2008. They're now overly pessimistic. Most importantly, they are usually wrong.
Because now is the time to buy.
The Shanghai composite's price-to-book ratio is half of its November 2010 level. It's price-to-earnings multiple? 42 percent lower.
And while Chinese GDP growth has slowed from the dramatic double digit gains of a few year before, the nation's growth trajectory remains dramatically higher than all western counterparts.
Chinese stocks have rallied the last four months. Up 8 percent since July. Even as U.S. stocks sold off on tapering concerns, Chinese equities remained aloft.
Short term, the Shanghai Composite will likely sell off a bit as the Chinese government prepares to set the nation's economic agenda for the next year. Yet, as China emerges from its recent tumult, the Shanghai Composite will provide incredible opportunities to discerning investors. Opportunities to buy now, and sell years, if not decades into the future.
Investors can choose from a number of indices.
The iShares FTSE China 25 (FXI), SPDR S&P China (GXC) and Market Vectors China (PEK) can provide a simple, diversified means of investing into China's emergence.
More specialized indices like the Guggenheim China Small Cap (HAO) and the Guggenheim China Real Estate ETF (TAO) can potentially provide higher upside, but will likely be accompanied by increased volatility.
We prefer the best and brightest individual names within those indices.
Companies that are just ascending to China's grand stage. Companies that will play similar roles to that which P&G, Microsoft, Google, Amazon and Wal-Mart have in the U.S.
Companies like ATA, Inc. (ATAI), which provides computer-based testing services used for professional licensure and certification tests.
As waves of Chinese continue migrating into the cities, they will increasingly seek jobs that require specific licensing and certification requirements. ATAI will be the beneficiary. Trading at a P/E ratio of 17.9, with long-term earnings expectations of 15 percent, this company is poised to evolve with the rest of the nation's burgeoning workforce.
Consider Semiconductor Manufacturing Corp. (SMI), which specializes in computer-aided design, manufacturing, testing, packaging and trading integrated circuits, among other semiconductor services. Trading at a forward P/E of only 12.9 with earnings expectations of 15 percent, SMI will grow to meet China's exploding thirst for commercial technology and consumer gadgetry.
Finally, don't forget about WuXi PharmaTech (WX), a pharmaceutical, biotechnology and medical device R&D outsourcing company (another trend of which we're big fans). Headquartered in Shanghai, WX sells its products to U.S. and Chinese pharma, biotech and medical device concerns.
WX shares are already us a whopping 86 percent on the year, yet we think this $2 billion medical outsourcing concern will breathe fire into portfolios for years to come.
Treat your Chinese investments as you would plan a trip to the Middle Kingdom. Careful analysis, planning and foresight are critical.
Yet, for those willing to put in the time and effort, the results may be as stunning, exotic and rewarding as a trip through The Forbidden City.

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