Over the past couple of weeks, we have been concerned with our investments in Chinese companies. It was devastating to see one of our ex-holdings, TAL Education Group, drop over 95% from its 52 week high, reached in February 2021. We were fortunate to sell out of Tal close to that peak after expressing concerns about the increasingly challenging regulatory and competitive environments. Had we not exited this position, our investors and we would have suffered tremendous loss in our portfolio.
The damage did not impact TAL alone, as other high quality Chinese companies were also caught in the crosshairs of Chinese regulators. Even though our portfolio sizing in China eas appropriate, which helps us do well in many market environments, I cannot help but wonder whether China still deserves a place in our portfolio.
I remember between 2001 and 2008 how eager and excited I was with the promise of China’s explosive economic growth. As a Chinese descendant, I was proud of watching the opening ceremony of the 2008 Beijing Olympics (Photo is from Wikipedia).
China had expressed its prowess and power through a well drilled army, delivering a highly organized performance: the synchronicity of thousands and thousands of people. Who could do that, if not the Chinese? It was almost like looking at a robot performance in the flesh. As a woman of Chinese descent, who used to get called out on the street in Canada, I felt that this may force the western world to show some respect to oriental people. And hopefully, people would not be making fun of me in the middle of the street. Sure enough, people and businesses started to increasingly seek out and welcome Chinese customers and tourists. Most luxury shops I have been to would now have Chinese signs.
I traveled to France often enough to observe that most French customers do not always go for super luxury brands. In most luxury shops, I mostly saw Asian customers. I also used to work as a business developer in the energy field. A few of our clients were from Norway. When I went to Norway, I noticed that most houses were very small, even though the owners were wealthy. The Norwegians also tried to conserve their energy and water. They do not really have mega electricity projects in their country, even though they did create many mega projects. I then realized that they love to live in a simple way but with a lot of freedom to do what they love. So they create and invest in technologies, which they then sell in Asia. Asia is the place where the bigger, the better. We like to look good and look like we are up to the latest technology and trend. We are a target market for every vendor.
Thus I started to wonder about the real reason for businesses to target Asian or Chinese customers. Is it because they know that Asian customers love extravagant goods & services? I guess it is not that hard to observe. We, as Asians, try to express our status, to show that we are high achievers by driving luxurious cars, using brand name outfits, buying expensive arts, and drinking Châteaux Lafite Rothschild wine. Are businesses solely seeing us as money bags who have uniform mindsets with no interest in individualism?
As an investor, I have to try to anticipate where the opportunity may develop, especially when it comes to China, however challenging. I believe that the root of economic growth lies with people. And this belief was reinforced when I researched megatrends. People who try to solve their problems; people who try to make their own lives easier as well as the lives of their loved ones; people who are passionate about something they love to do. In other words, growth comes from the very people who try to innovate to solve their struggles or to express their passions. And many times, innovation happens by accident, too.
China seems to have manpower and also the ability to keep this manpower under the control of one leader. It seems to be a great recipe to conquer the world by force. Would that be a recipe to conquer the world by innovation and technology? What kind of environment does it take to nurture innovation? My instinctive guess is freedom to think!
Then in 2012, the Olympics in London came along. I thought how could the UK top China’s opening ceremony? Interestingly enough, the UK did not try to match China’s control of manpower. The UK played on individualism, pop culture! It was not about a rigidly organized performance. The UK showed what they could do with little manpower and great passion: free spirit that is topped with creativity. It was an eye opener. China had never lost its power because it has less population or less control over its people. Or is it true that most countries lost to the West because they missed out on industrial revolution? So why did the West not miss that? What environment did they have to foster their creativity, innovation and organization; and to use this innovation to its maximum potential. I think it is a balance between a few things:
- Limited resources and harsh living conditions: I need better living conditions for myself and my folks.
- The ability to think as an individual: what can I do to get what I want?
- The lack of government welfare: I cannot rely on someone else.
- A basic level of equality: I do not have to wait for my gurus to approve my ideas. Or I am not afraid that someone will not allow me to execute my idea.
- Freedom to see what is possible beyond the horizon: everything is possible. I am free to explore.
- The ability to get organized and to follow the agreed upon rules: I need an organization to manifest my big idea. I am willing to be inconvenienced and have less freedom for the project to be successful.
On all these 6 points, the author of Sapiens, Yuval Harari, said that the Western culture’s ability to get organized is the one thing that gave them power. However, I would add that this has to be balanced with the sense of individualism. Super uniformed and organized societies did not go very far in Nazi Germany or in North Korea.
A land of abundance is always full of people who want more without necessarily putting in the required effort.
By contrast, a land where people always do whatever they want, with the unfettered freedom to break the rules, often ends up in a mess.
I think China has a lot of point 1 and point 3 above.
I then went further into my research to check out when China was most prosperous in its 4,000 years’ history. I found out that it was during the Song dynasty, which was China’s age of innovation!
“Printing, paper money, porcelain, tea, restaurants, gunpowder, the compass — the number of things that the Chinese of the Song dynasty (A.D. 960-1280) gave to the world is mind-boggling. This vibrant period in Chinese history was marked by economic prosperity and remarkable technological innovation. China expert Robin D. S. Yates, Professor of History and East Asian Studies at McGill University, described this exceptional era and how it influenced the course of world history.”
Moreover, I looked at who was the leader of the most Golden time in the Song dynasty: it was Emperor Taizu. He encouraged freedom of thought and stimulated growth in the fields of science, art and literature. His reign was peaceful. He expanded his economy and territory, turning the Song dynasty into a golden period. (Photo: Emperor Taizu)
Then I looked at what made Song fall. It seems to be the combination of an external invasion and the internal uprising of people. External invasion does not surprise me, as everyone wants a piece of the golden era. But what made people in the country revolt? I found that as the dynasty progressed, the belief system used by the ruling class went from Daoism and Buddism to Neo-Confucian. The Neo-Confucian philosophy served to ensure that bureaucrats were loyal to the dynasties. However, coming with this philosophy, innovative reforms and political debates were restricted by the imperial rulers. Innovation and personal freedom were stifled towards the end of the Song dynasty. No wonder there was a revolution at the end of Song. As William Wallace’s famous quote put it: “they may take away our lives, but they will never take our freedom”.
We do not have to look very far into China. Just look inside ourselves: do we not work hard in order to achieve more prosperity, as we want freedom to live life in our own terms? We innovate with passion in all areas of our life because we aspire to freedom. God gave us free will, but the Chinese emperor can take that away. Interesting…
If economic growth has a lot to do with the ability of people to innovate, I can guess that China may lose this ability sooner or later.
So many people have told me that China has scored several technological advances, reflecting its ability to innovate. I had been a nuclear engineer and a scientist. I even hold a couple of international scientific awards. Oh, and one of them I got in Beijing. From my small perspective, I do not think that China is more advanced because China’s current technology has been built on outside innovation for the past 20 years. The fact that Chinese people use more phone apps to pay or embrace digital payments or face recognition is not proof of technological advancement. Rather, it is proof that now they will be fully controlled by their government. I do not think that European or North American citizens would allow a store or a traffic light to recognize their faces. The reason they will not allow it is not because they cannot do it, but because they do not want to.
When it comes to the fields of energy, medicine, space and weapon, the technologies are also from outside China. Most technological advancements seem to originate outside China. Yet once the technology reaches China, the scientists there can refine and make it significantly more efficient than the original one. I guess you can call that innovation. In my book, I would call it either an incremental or a great improvement, however advanced. Clearly, China currently has a big basket of technologies upon which to improve and perfect. But when the basket eventually runs dry, China largely lacks the adventurism and innovative powess to create something new. Because even great Chinese innovators want to move out from China for access to freedom! And that is what America is offering. America sold people the dream for a better life and the freedom to live one’s life as they see fit.
Most great and famous innovators in America, old and new, came from somewhere else, from Einstein, to Tesla, to Musk. Why did they not go somewhere else, like China? Like the early Song dynasty, America promotes freedom of thought and even speech!
Recently, there was a regulatory crackdown on the tutoring industry in China, which resulted in a disastrous drop in the sector’s stock prices. China’s leaders justified this by saying that this was because it increased the cost of raising children. thereby discouraging people from procreating. It is true that education and schooling in China is can be very expensive, but why do Chinese parents want to pay that? Because they want a better life for their kids. And you know what is the better life for them? Ironically enough, it is America’s life. We do not have to look very far: where do the Chinese leaders, big and small, have their education? America and UK! Middle-class families see where their leaders send their kids to school, so they want the same for theirs. Parents would sacrifice everything to offer their kids’ a better future. The future to live better and not have to be told what to do.
Now, Chinese leaders are looking to extend their control to tech giant’s and their apps, and also the real estate sector. So what is the point of trying to do something in China, really? Because, let’s say that I spend 20 years of my life to innovate and work on something. Then, when it gets to be so successful and so big, my enterprise could get shut down. If that is a trend, I would be better off moving first before starting to pour my life into something that will be taken away.
I talked to a few wealthy Chinese people. Many think that their leader is smart and creating a growing China. I agree that Xi Jinping is very smart, as supported by plenty of evidence. However, ironically enough, these people do not want to move back to China. Instead, they want their kids to get a western education. Conventional leaders often like people to do what they say but not what they do. Yet, as humans we often learn through example, not because we are being told.
It is evident that China’s leaders demand a lot of respect from people and others while giving very little respect in return. If you respect a person, then you should allow them to think and decide for themselves. In China, national policy tries to dictate how many children to have. Families can’t even get a little respect in making a decision in one of the most fundamental area in families’life.
Finally, the investment environment in China has seemingly become less stable. One thing that seems to be certain is that the state will interfere in whatever public area they chose to in order to maintain absolute control. Therefore, investing in China requires to rigorously manage the risk that our companies may not be allowed to become too big and powerful. Success might attract increasing regulatory risk. It conversely becomes harder to find companies that can generate compounded growth at a superior clip over the long term. Compound growth of privately owned companies might deem to be threatening Chinese authorities at any point. Look at Google, Facebook and Amazon, they are already more powerful than states and therefore are subject to regulatory risk. However, I believe there is little rtisk of them getting delisted, like what could happen to Didi. (Photo is from muhabarishaji.com)
The risk is that investing in China becomes more about guessing the next regulatory moves of the Chinese leadership rather than finding high quality growth compounders. Having said that, China’s economy can outgrow many other large economies in the medium term because of their sheer population and economic dynamism. Furthermore, if a measure of economic decoupling is achieved from the US, China could provide some diversification benefit in a global portfolio.
For these reasons, we will continue to carefully seek out quality growth compounders in China while emphasizing tight risk control and rigorous portfolio construction. The risks highlighted above will tend to keep our China weight lower than it otherwise would be.
Sara Savalaxs (Wang Ai Ling)chinainvestmentrisk