Is China's seemingly unstoppable GDP growth a mirage when it comes to stock returns? Join us as we dissect the perplexing performance of Chinese investments with Clem, and why betting on the MCHI ETF might not have mirrored the S&P 500's success. We peel back the layers of skepticism shrouding China's economic statistics and confront the elephant in the room – the outsized role of the Chinese Communist Party in the financial realm. With the backdrop of mounting US-China tensions, from trade spats to tech tussles, we scrutinize the influence these feuds have had on the Chinese market and deliberate the evolving landscape of capital acquisition by Chinese firms.
The journey gets personal when we dive into the world of Chinese ADRs, where the stakes are high and the legal complexities, even higher. Our discussion with Clem unveils the precarious nature of variable interest entities, a legal labyrinth that leaves investors balancing precariously on a tightrope of risk. We contemplate alternative strategies for capitalizing on China's economic engine without directly engaging with its volatile stocks. And as we traverse the terrain of global enterprises with deep roots in China, such as Taiwan Semi and Starbucks, we tackle the drama unfolding around transparency and accounting standards. This is a candid exploration of the US-China financial dance, laden with legislative maneuvers aimed at keeping foreign companies in line, equipping you with insights to navigate this challenging investment landscape.
Is China's seemingly unstoppable GDP growth a mirage when it comes to stock returns? Join us as we dissect the perplexing performance of Chinese investments with Clem, and why betting on the MCHI ETF might not have mirrored the S&P 500's success. We peel back the layers of skepticism shrouding China's economic statistics and confront the elephant in the room – the outsized role of the Chinese Communist Party in the financial realm. With the backdrop of mounting US-China tensions, from trade spats to tech tussles, we scrutinize the influence these feuds have had on the Chinese market and deliberate the evolving landscape of capital acquisition by Chinese firms.
The journey gets personal when we dive into the world of Chinese ADRs, where the stakes are high and the legal complexities, even higher. Our discussion with Clem unveils the precarious nature of variable interest entities, a legal labyrinth that leaves investors balancing precariously on a tightrope of risk. We contemplate alternative strategies for capitalizing on China's economic engine without directly engaging with its volatile stocks. And as we traverse the terrain of global enterprises with deep roots in China, such as Taiwan Semi and Starbucks, we tackle the drama unfolding around transparency and accounting standards. This is a candid exploration of the US-China financial dance, laden with legislative maneuvers aimed at keeping foreign companies in line, equipping you with insights to navigate this challenging investment landscape.
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Steve Davenport:
Hello, this is Steve Davenport. Welcome to Skeptics Guide to Investing. Today, Clem and I are going to talk about investing in Chinese stocks. If you hold an emerging markets ETF, about 30% of that ETF is going to be based in China. So whether to invest in China is a relevant decision, even if you're a passive emerging markets or a global investor. Let's discuss China. Clem, you've made the point that Western investors haven't made any money investing in China, even over relatively long periods of time. Can you put some figures on that compared to the S&P 500?
Clem Miller:
Sure, Steve. If you look at MCHI, which is the main China ETF, the iShares tracking the MSCI China index, you see that over the last five years the total return has been minus 16.54%, which compares to positive 101.95% for the S&P 500. So it's a circumstance, obviously, where you've got the magnificent seven in the US that's pulling the stock market up. But still to see China returning a negative 16.54% over the last five years is really an astounding number. I think many people investing in China probably thought they would earn a lot of money rather than lose a lot of money.
Steve Davenport:
What do you think is responsible for China's poor stock market track record? After all, the country has demonstrated pretty good GDP growth. Why hasn't it translated equally good stock market returns?
Clem Miller:
Well, I think there's several reasons, steve. One is that the statistics that China puts out on GDP growth are to some degree suspect. They come out right after the end of every quarter and are never revised, which is quite different than the situation you see with the US and many other countries. It almost seems like a politically determined number. I know for many years the number always had to be 10% or around 10%, more or less. Then it was more or less around 8%, and then it was more or less around 6%. So the numbers seemed awfully massaged.
Steve Davenport:
Sounds like election results.
Clem Miller:
Yeah, like election results, they seem less massaged lately, but you never know, given that particular history. That's one reason why. Second reason is that the GDP growth, not just in China but also around the world, is not necessarily a driver of of financial market returns, and that's something that we can address in a future podcast. But just keep in mind that GDP does not drive financial market returns.
Steve Davenport:
No, I think there's been some interesting research and what I thought one of the things that I've seen is that it depends on what you pay for that growth right.
Clem Miller:
Yeah, exactly, it's how much you pay. There's dividend yield that fits into that. There's share price, there's share buybacks, for example, that drive that. There are a lot of different factors, interest rates, for example. There are a lot of different factors that feed into stock market returns.
Clem Miller:
But I'd say, even more importantly than issues around GDP and its lack of efficacy is the fact that you've got an economy that is largely controlled by the Communist Party and the state, which basically operates as an agent of the Communist Party, and so the Communist Party has certain social policies, certain economic policies, and it sees all operations within the Chinese economy, including private businesses, as potential instruments for implementing the government's policies.
Clem Miller:
And we've certainly seen that over the last few years, and sort of the turning point on that was back when Xi Jinping ordered the arrest of Jack Ma, who was the head of Alibaba.
Clem Miller:
Now Alibaba at one time was considered one of the best managed stocks in the world. Some people actually came out and declared Alibaba that Alibaba, for those of you who don't know, is the Amazon of China and what happened was is Jack Ma got too big for the Chinese government, for the party, and he went out and gave a speech where he complained about economic policy and so that doesn't seem like a good idea, and so the party cut him down to size and actually made him disappear for a while, and it took, I think, almost a year for him to reappear, but he didn't have anywhere near the same stature that he had before this. And actually not too long after he disappeared, the Chinese government started implementing a crackdown on the internet platforms in China and the businesses that use internet platforms, and all of this was run out of an office that was attached to Xi Jinping's office, and so it was very closely run by the leadership of the party.
Steve Davenport:
These operations with respect to trying to control these individual businesses, especially the internet platforms- In addition to being concerned about party interventions and business, are you also concerned about the geopolitical situation between China and the US? How is the situation impacting Chinese stocks?
Clem Miller:
One of the questions about geopolitics and China is obviously trade relations. Trade relations came about, but it's always been an issue. It came to the fore during the Trump administration. The poor trade relations between the US and China, while they've been limited to certain categories of exports and imports, have a dampening effect on Chinese stock performance. I think that has an impact. Also, the heightened war or I should say, technology war between the US and China, with those being the protagonist, antagonist or antagonist protagonist, whichever way you want to create the direction is also dampening the environment for investing in Chinese stocks. You've had a reversal, so to speak, of the trend that you had in the past.
Clem Miller:
It used to be that Chinese companies, technology companies would really forgo trying to raise money in China and instead go right to the NASDAQ and put together ADRs, which is a way of accessing the US market. They would go in and raise money on the NASDAQ. That was perfectly acceptable to the US government, no problem at all. But lately that has been a problem. There's talk about delisting existing Chinese stocks that are listed in the US. There's talk about slowing up on new approvals. This isn't just an issue on the US side. It's also an issue on the Chinese side, because China would love to have their companies raise money at home and remain independent of foreign capital. That evil foreign influence.
Steve Davenport:
One of the things that I found interesting is that China keeps talking about growth and then spends money on their military. It feels to me if they were focused on growth, they would be working on putting more resources away from the military. Something doesn't add up in terms of their strategy for overall Chinese businesses. It concerns me especially around Taiwan.
Clem Miller:
We read a lot about financing problems. Steve, if I might add to that, if you look at, there's a thing called China Civil Military Fusion. It's a buzzword in US geopolitical geo-economic circles. The idea behind that is that pretty much a lot of the stuff that Chinese policymakers do with the economy is really aimed at trying to help the Chinese military. It might help the Chinese economy beyond the military, but that's a parallel benefit, not the primary thing that they're looking for. I'd also say that the Chinese government, in terms of their perspective on entrepreneurship, now they've been clamping down on the internet platforms, which are primarily consumer-focused. They have been quite aggressive in providing subsidies and other kinds of support to the advanced technology companies, such as the semiconductor companies, the solar companies and also the electric vehicle manufacturers Anything that's a hard technology, advanced technology, they favor, whereas the other softer stuff, like the Alibaba and Tencent and some of the others, are of lesser priority.
Steve Davenport:
I think they've got a problem and they don't know where, how quickly, to get out of that problem. I think it's interesting from a sharing of resources a lot of Chinese nationals are still attending US colleges and universities and doing research and then bringing that research back to China. In my mind, this is a battle going on at the chip companies and some of these technologies, but there's many other places that China is doing battle with the US and it's not always as open or as clear. We have had a lot of problems recently with financing in China's property developers. These problems are also hurting the Chinese stock market.
Clem Miller:
I would say so in a general sense, where anything that hurts the broader Chinese economy is going to hurt the Chinese stock market returns. So I would say that. I will say, however, that if you look at the composition of the Chinese stock market, if you look at, for example, the composition of MCHI, you'll see that there's very little in the way of property included in that index. So the direct effects on investors in China are pretty minimal, but the broad sort of diffuse effects of the property crisis are certainly broad in there. I want to emphasize, though, that there are a lot of folks who are China promoters who will say well, let's just wait for the property crisis to end and then we'll go back into China. Those same folks said, well, let's just wait for zero COVID policy to end and everything will be great and we'll go back into China. Well, those are statements that may not have any merit, given the fact that you've seen such negative performance over such a long period of time.
Steve Davenport:
Well, I also think that it's a multi-dimensional issue, and I think that's why we do these podcasts is to try to get into a little deeper discussion about is China good, is China bad, and try to really put some point on what are the points that we have that we think will be difficult for us to invest. And that brings me to the next question, which is corporate governments in China, right, what can you tell us about corporate governance and the policies there versus Europe and US policies?
Clem Miller:
Well, corporate governance is an item that is very important in the US and in Europe. There's a real emphasis in Western countries on companies being managed for the benefit and in the best interests of their shareholders, and that you don't really have in China. If anything, it's kind of secondary. I'll give you an example you may have boards of directors that include investment companies, even Westerners, on some of these boards of directors of Chinese companies, but you also have, either on the board or in an office that monitors what the board does, a local office within the company of the Chinese Communist Party. So there's a wing of the party that operates within at least the major companies in China and that has some degree of influence over what those companies do. So that's a corporate governance question. And also, steve, I don't know if you're going to ask about accounting, but there are also accounting questions with regard to China as well, and some accounting issues that I think are unresolved and that should be a problem for US investors.
Steve Davenport:
No, I think the accounting is definitely something that we all have to be aware of in terms of what is the global standard and how does China meet or not meet those global standards? I understand there are some legal issues surrounding some of the Chinese companies listed as ADRs in the United States. Can you explain those issues?
Clem Miller:
Yeah. So, without getting into a lot of detail which is sort of beyond the scope of this podcast, there are companies. So it's technically illegal for at least some Chinese companies to issue stocks on foreign exchanges. So they get around that issue by creating entities in places like the Cayman Islands, which they call variable interest entities. And these variable interest entities have they have rights to returns based on the performance of the stocks in China. So for those companies, us investors don't really own shares in those companies. What they do is they own a piece of these rights to the performance.
Clem Miller:
So the risk that raises is whether the Right the right is able to assure yeah, whether the legal contracts that underpin this may be defective or not. And every time anybody raises this with the Chinese government, they sort of hymn and ha and say, well, it's not in our interest to do something about these. But what happens if there's a serious, serious, serious geopolitical crisis? China might be incentivized or might be tempted. Let's call it tempted, not incentivized. I don't think they'd be incentivized, but tempted to do something to undermine those variable interest entities.
Steve Davenport:
No, I think it's a big concern. I'm especially concerned personally about Taiwan Semi. We held it for a while and we thought that China reopening was going to mean more stability and it hasn't happened. And I think there's still a cloud hanging over Taiwan Semi, which, as a technology company, as a producer of the best nanometer chips, it's a shame that I can't invest in it for my clients Right now. I feel like there's too big a cloud hanging over. Is there a way for us to benefit from Chinese economic opportunities without investing specifically in Chinese stocks? I know some people like the idea of well, we'll look at what the suppliers are, and I think about Australia supplying a lot of Chinese natural resources and if China continues to grow, it continues to need those resources. Is there other ways for us to invest in opportunities in China?
Clem Miller:
Oh yeah, a lot of companies industrial companies, consumer staples companies have a lot of sales and derive a lot of earnings from within China. This is particularly true with European companies. So, for example, take the European luxury companies like LVMH, for example. They drive a lot of revenue from China. Industrial companies like Siemens in Germany derive a lot of revenues from China. So you can benefit from Chinese economic growth without running the various kinds of risks regarding accounting or party influence or corporate governance that you run into by actually investing in Chinese stocks.
Steve Davenport:
Okay, let's look at our mailbag Again. They ask do you own any Chinese stocks, directly or indirectly? And I'll just comment that what Clem just said, that we've tried to gain our exposure through companies who are dealing with China. So we own Siemens, we own Estee Lauder and we own Starbucks, and part of the reason was because we thought that their presence in China was going to make them have an unusual growth pattern coming out of COVID, and what we've found is that, while their accounting may be good, while their company is good, that association with China has put a pall over those stocks. And I think that when we look at growth, we look for that incremental value that a stock can give you, and for these three companies, that incremental value has been not there.
Steve Davenport:
So I would also say we were an owner of Taiwan Semi up until this year and early in the year we got out of it and it has been an under performer for us in the chip space and it feels like this situation. The market has already made its decision. What about you, Clem? Do you own any Chinese stocks?
Clem Miller:
So I don't own any Chinese stocks. I don't own this ETF. As you can tell, I'm pretty skeptical about China as an investment destination. I would say. If you asked, is China uninvestable? I would say I wouldn't go that far. I'm sure that some investors might find some opportunities worthwhile in China, but I don't, and maybe that's because I'm a little bit conservative, perhaps, but I will not invest in China as far as companies that sell in China.
Clem Miller:
A lot of companies sell in China US companies, european companies. So I don't hesitate to invest there. I also own some with those companies I invest in. I do invest in some of the semiconductor, western semiconductor stocks, us semiconductor stocks, and some of those still have some exports into China. But what happens is many of them have said that the rules that have come out from the Biden administration don't bite that hard as yet, because some of them as yet, because their exports are largely this larger nanometer type of chips which they can still export into China. So it depends on the company. But I do invest still in some semiconductor stocks that primarily stay out of this whole military aspect which requires the smaller nanometer stocks.
Steve Davenport:
So how would you sum up China? I think you did a pretty good job there, but is there anything else in submission that you want to say about China?
Clem Miller:
Yeah, I would say that I just want to touch a little bit more on that accounting issue.
Clem Miller:
So, in addition to the corporate governance issues, you do have the accounting issue, and a few years ago not too long ago, maybe less than a few years ago the Public Company Accounting Oversight Board, which is an arm of the SEC, found that they weren't getting good transparency in receiving financial accounting work papers from the Chinese affiliates of the major US accounting firms that operate there.
Clem Miller:
As you may know, the global accounting firms tend to work through local subsidiaries and affiliates, and that's the case in China, and the Chinese government prohibited these accountants in China from delivering work papers that were required by the US Public Company Accounting Oversight Board, saying that they were national security data. So that's obviously something that doesn't comport to Western accounting standards, and so there was actually a law passed by Congress something like the Holding Foreign Companies Accountable Act, something along those lines, where they told the Chinese that we're going to start delisting Chinese companies from US exchanges if you don't start providing this transparency into your financial statements. So you could look at that as yet another sore point in the US-China relationship, and you can also look at that as another reason to question what the level of commitment is to China to doing what's necessary to be an outstanding investment destination.
Steve Davenport:
So I think it's got a long way to go to be outstanding. I think today we might have gone over that skeptic line and to the cynic line. Yeah, exactly, I feel like we're both pretty clear that there's a lot of questions still unanswered, and I think it's been a great discussion. Thank you, Clem, for all you've given us today. I appreciate everything. Thank you, Steve. All right.