Decoupling From China?
“News of my early retirement is much exaggerated. It's simply a pandemic"
- Clay Baker
The portfolio is UP +14.00% YTD.
Our benchmark index, the S&P 500 is down -8.00% YTD.
Are we Decoupling from China?
I remember a time, not long ago, when I refused to write about China and the Trade War. Remember the trade war? I simply prefer not to jump into the cesspool of political rhetoric that neither informs or leads people to a brighter future, but rather sounds more like howling at the moon. A short trip in the way back machine helps us reflect on the fact that China was seen by all as a major consumer market to break into. Every major U.S. company wanted to carve out their space in China; some have, others failed.
I'll lead with the important information, this portfolio has very little exposure to China. Only Enphase (ENPH) and Fox Factory have small exposure to China through their manufacturing supply chains and both have been diversifying away from China.
Way too much commentary focuses on China’s supply-side role as an exporter of manufactured products, under-estimating its importance on the demand side.
Chinese consumption has become critical as its fast-growing middle class drives demand for everything from cars, consumer electronics and food to international services such as tourism. China has shifted from a small open economy into a very large continent-sized and much more closed economy in the 2020s. It has become more like the United States, and quite different from trade-dependent economies such as Japan, Germany or the United Kingdom, or large emerging markets like Brazil. China, like the United States is now a generator of shocks to the international economy, while becoming more resilient to shocks originating elsewhere.
Today the U.S Senate passed the Holding Foreign Companies Accountable Act. This bill requires that foreign companies that want to trade and raise money on U.S. stock exchanges must verify, through an audit, that the company is not owned or controlled by a foreign government. Obviously this is aimed at China, though the law will apply to all foreign companies. One of the great concerns from investors has been the accounting and reporting from Chinese companies does not even begin to compare to that of U.S. companies. In fact there has been an ongoing parade of fraud uncovered in Chinese publicly traded companies.
To be fair, not every Chinese company is a fraud, but even a company the size of Alibaba raises eyebrows because when you buy shares of BABA, you're actually buying shares of a holding company that owns Alibaba. Let's investigate BABA as an example of what better reporting might uncover and make more accessible to the average investor. Alibaba is hard to analyze on a fundamental basis because the company has a complex web of hundreds of subsidiaries, variable interest entities (VIEs), and separate operating entities, and a little more than half are in China and the others in the Cayman Islands, British Virgin Islands, Luxembourg, Singapore, and other tax havens. And they all do business with each other. Yet they exclude most of the related party disclosures among “investees” from its filings. Where are those, why do they exclude them, and how can investors feel comfortable taking a bottom-up approach to a company like that when they can’t verify what’s actually going on in the accounting?
Is there fraud here? One common check for fraud is to look at how much Gross Merchandise Value (GMV) a company generates per employee. Another measure is revenue per employee. Alibaba comes out looking rather peculiar.
GMV per employee:
Is it realistic for Alibaba’s employees to be 20 times more efficient than Amazon’s? If you own BABA stock, you better hope so.
Recently we learned that GSX Techedu, Inc (GSX) is most likely a complete fraud. GSX Techedu Inc., claims to be a technology-driven education company, provides online K-12 after-school tutoring services in the People's Republic of China. Its K-12 after-school tutoring courses cover various K-12 academic subjects, including mathematics, English, Chinese, physics, chemistry, biology, history, geography, and political science. The company also provides English courses for children in kindergarten; and courses that help children in grade one through grade seven. In addition, it offers foreign language courses comprising English, Japanese, and Korean, as well as English test preparation courses for students taking post-graduate entrance exams; and professional courses primarily for working adults preparing for professional qualification exams, such as teacher's qualification, the Chartered Financial Analyst designation, securities qualification exams, and other exams. Further, the company provides personal interest courses, such as yoga, fashion, guitar, and Chinese calligraphy. Additionally, it offers other courses, including offline business consulting courses to enhance management skills for principals and other officers of private education institutions; and operate Weishi, an interactive learning platform on Wechat. The company was formerly known as BaiJiaHuLian Group Holdings Limited and changed its name to GSX Techedu Inc. in January 2019. GSX Techedu Inc. was founded in 2014 and is headquartered in Beijing, the People's Republic of China.
Carson Block, Chief Analyst and forensic accountant at Muddy Waters Research recently put out a research report and took a short position in GSX, claiming that 70-80% of GSX average daily user numbers are likely a complete fraud. Block has been warning investors about Chinese companies for a decade or more and has publicly displayed his findings along with his short positions. For a complete list of all Muddy Waters short positions visit their research page; Muddy Waters Research. The list is a parade of publicly traded Chinese companies that have profited from U.S stock exchanges. Anyone with even a modest education in accounting or statistics would say, at first glance their appears to be a trend. Regardless of where these companies are headquartered, the U.S Securities and Exchange Commission (SEC) and several other agencies, have a responsibility to require these foreign companies to adhere to the same rules as U.S companies with respect to accounting standards and reporting.
What other evidence is there of Decoupling from China?
Last week the White House directed that federal retirement savings account halt investments in Chinese companies. Labor Secretary Eugene Scalia has warned that the Federal Retirement Thrift Investment Board plans to invest billions of dollars of federal employee and military retirement accounts into Chinese companies poses a threat to retirees and to U.S. National security. More important is that the board was planning to link their I Fund account to the MSCI ACWI ex USA index. There is both very real risks to investors in the fund, and political positioning, but it looks like another step in the decoupling to me. With $41 Billion dollars invested in the I Fund one has to assume that those dollars will find a new place to invest; presumably in U.S stocks or other emerging country stocks (ex China).
Phlow, a U.S.-based, public benefit drug manufacturing corporation, has received federal government funding of $354 million for advanced manufacturing of America's most essential medicines at risk of shortage, including medicines for the COVID-19 pandemic response. This project has been funded with federal funds from the Biomedical Advanced Research and Development Authority (BARDA), part of the office of Assistant Secretary for Preparedness and Response (ASPR) at the U.S. Department of Health and Human Services (DHHS). The total contract value awarded to Phlow is up to $812 million which includes a four-year base award of $354 million with an additional $458 million included as potential options for long-term sustainability.
If one thinks that globalization is still strong and that there's no real evidence or support for the decoupling from China, consider that exports as a percentage of global GDP have been in decline for the first time since World War II.
Survey firm McLaughlin & Associates released their poll of American attitudes towards China on April 22 and it showed that 75% felt that the U.S. should end its dependence on China for medical imports, including things like N95 respirators and even ibuprofen, two markets China dominates. Note that this opinion holds across party lines with 62% of Democrats saying we need to end some or all dependence on China for medical equipment; 80% of Independents and 85% of Republicans. The decoupling isn't just a grand idea on the wish list of right-wing Republican extremists; this is a generally held belief that spans age groups, party lines and even country borders.
The Trump administration has sought to decouple economically from China, by reducing U.S. imports through higher tariffs, by restrictive screening of Chinese investment in critical sectors and expanded controls over exports to China of potentially sensitive technologies. The decoupling, partially or fully, isn't a future phenomena, it's happening right now.
As investors we all have to reflect on what our own skill level is, how deep our patience runs, and what our individual threshold is for volatility and losses.
Keep in mind that the most liquid, skilled and patient investor
is no match for unseen fraud.
"Markets don't go to zero, Portfolio's do.
Buy quality, be patient...and look twice for motorcycles."
- Clay Baker
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Keep Me Honest 2020
Today is a good time to carefully leg into stocks again (3-20-2020).
Worst Case: S&P 500 decline further to around 2,100 - 2,150 (3-28-2020).
Middle Case: S&P 500 level out around 2,650 - 2,700 (3-28-2020).
Best Case: YE S&P 500 eventually rise to around 3,000 - 3,200 (3-28-2020).
Market bottomed March 23, 2020 at S&P 500 2,237.40 (4-17-2020).
Rule #1: Don't lose money
Rule #2: See Rule #1
Rule #3: Portfolios go to zero, markets don't, Stay Invested
Rule #4: When a good stock you own drops 10% below your cost basis, add shares
Rule #5: Bull markets aren't sustained without the Transports
Rule #6: When Forward P/E is lower than TTM P/E, expect earnings to increase
Rule #7: When an investment bank sells below book value, buy it
Rule #8: Tips are for waiters. Do your own homework.