London Value Investor Conference 2015 - Part 3 - The Chinese Stock Market...

"The Chinese Stock Market: from Ugly Duckling to Beautiful Princess"

(A talk by Dato' Cheah Cheng Hye - of Value Partners Group)

Introduction

This is the final part of my three part series of articles on the London Value Investor Conference 2015, held at the QE Centre, opposite Westminster Cathedral, organised by Metropolis Capital.

I was particularly keen to attend this session on the Chinese stock market, as the recent history of smaller Chinese stocks listing on AIM has been, let's be honest, disastrous. Not just AIM either - numerous Chinese companies listing overseas have turned out to be outright frauds. Hundreds of them. For this reason, my opinion in my morning reports here on Stockopedia has, for a couple of years, been that Chinese stocks on AIM should be treated as uninvestable. All of them. People who took heed of my warnings have avoided numerous banana skins, as one by one they are collapsing.

This got me thinking. China is the world's second-largest economy, and has underdone an utterly astonishing period of growth, which has transformed it from, just a handful of decades ago, a desperately impoverished, agricultural sleeping giant, into now the world's manufacturing powerhouse.

So, whilst they might list their junk (geddit?!) on AIM, there's clearly a lot more to China than has so far met the eye of a UK-based small caps investor such as myself. So I very much went into this session with an open mind, and hoping to learn more about China.

The Speaker

Called Dato' Cheah Cheng Hye, of Value Partner Group, the speaker began by telling us who he is, and his background. His firm is listed in Hong Kong, and has built up an impressive $17bn FuM. Their performance has been strong - which he stated has been 17.2% p.a. compound since 1993, compared with 8.6% p.a. compound on their benchmark, the Hang Seng.

Before fund management, he spent 17 years as a journalist, and witnessed at first hand the economic miracle going on in China.

To give a little idea of the style of this talk, Dato' spoke fluent English, but with a heavy oriental accent, so at first I found him quite difficult to understand, but I quickly adapted, and soon found his delivery both modest and quirky, as well as good-humoured. So within minutes he had the audience eating out of his hand, in what was a charming, and often very amusing talk.

As an aside, this chimes with something I read on Twitter about Chinese culture - where I was told that apparently arrogant or bombastic Westerners don't do well in China, whereas more modest and good-natured people fit in well. So I made a mental note this seemed to be confirmed by Dato' in the way he delivered this talk.

His investing style is very much value orientated, as you would expect at a value conference!

What he looks for

In terms of investments, he summed up his approach very simply, as the Three R's;

• Right business
• Right people
• Right price

That's investing in a nutshell really, isn't it?!

He likes to visit companies and kick the tires. This is vital in China, to "avoid the pirates" (more on this key point later!). In a similar vein, he likes to diversify, as "due diligence in Asia is so difficult" - which I took to mean that there are lots of fraudulent companies & people to avoid, so it's vital to diversify the risk.

Think of yourself as stupid!

What?! I had to concentrate to understand this point, but it then clicked. His view is that, if you think you're clever, you will do dumb things without realising it. But if you think of yourself as stupid, then you'll double-check everything, and end up probably making smart decisions.

So, as with a lot of this talk, perhaps a cultural point that we can learn from - in Western culture we all like to appear to be experts, and pride ourselves on this. Maybe that leads to us making stupid mistakes, as we over-rate our own skills? That certainly gave me food for thought, as I've definitely been over-confident in the past (hopefully not any more, but who knows?)

I liked another point, where he emphasised that research and decision-making on investments are two separate skills. That certainly struck a chord with me - where I feel my strength is in analysis, and sometimes less so in pulling the trigger at the right time.

The Chinese Stock Market

I have zero knowledge of the Chinese stock market, so will apologise now for being unable to add any colour to this at all. Hence this is entirely what the speaker said.

Chinese people have very short memories, and until Jul 2014 the stock market had been in a savage bear market, having dropped by two thirds from the peak (presumably pre-2008?). He said that people don't trust stockbrokers, or the financial system generally. So this led to the perfect conditions for a bull market - as valuations became unrealistically low.

Since Jul 2014 the Chinese stock market has shot up! It's doubled!!!

Are they in a bubble? He wasn't sure, but thinks this run has longer to go, maybe they are in the middle of a bull market. I was really shocked by this. Bull markets in our markets tend to be multi-year things. I can't imagine the FTSE 100 doubling in one year, can you? I can imagine it halving in one year, as falls tend to be more rapid. But bull markets have to climb a wall of worry, so take longer.

It sounds to me as if there is a massive speculative bull market going on in China. Also, as anyone who frequents UK casinos will know, the Chinese absolutely love to gamble! So I reckon they are culturally predisposed to create extreme boom & bust stock markets now that they have the freedom to do so.

China is now the best performing stock market in the world, this year anyway. Who knows where or when it will end?! In tears, would be my guess - I just don't know when!

Valuation

The speaker believes some Chinese stocks are now getting expensive, and he sees signs of irrational exuberance in Chinese small caps. But brokers are raising margin requirement on about 650 smaller caps, so that should curb euphoria there.

As an aside, I heard that a UK-listed American company, making laser guided concrete screeding machines (NB. I hold shares in SOM) Somero Enterprises Inc (LON:SOM) recently said that orders from China had temporarily slowed, because Chinese customers were punting their cash on the stock market! This all sounds like real bubble stuff to me. So I think a crash is inevitable, once the euphoria has continued for some time & run its course.

The speaker said the valuations on the Hang Seng Index are still reasonable - a PER of only 9.8. Although that is the cheapest Chinese market, he indicated.

NB. There are several different Chinese markets, so you need to be sure you're comparing apples with apples. In particular, there is a pricing arbitrage between H-shares and A-shares, where H-shares can be 30% cheaper, for the same thing. So apparently, H-shares are the better value ones to look at, but being a smaller market, may not see such big speculative flows.

The Chinese Economy

The speaker explained how, despite the economy having roared ahead, GDP per capita is still low, at $7,500. There are many sectors for potential growth in China, e.g. healthcare (Mark Slater also remarked on this at UKIS, with a Chinese stock he likes very much, Hutchison China MediTech (LON:HCM) )

The speaker made many other bullish points about why he is much more bullish about the Chinese economy than many Western commentators, e.g.;

- ample scope for authorities to ease policy

- trust in Govt is very high (may sound surprising to us, but he says the people recognise that the Communist Party has a track record of finding solutions to peoples' problems)

- the Govt is stimulating the property market again

- there are 8 big reforms underway, which will be very bullish for the economy/equities (I didn't catch the detail on this, sorry)

- above all, the Government WANTS the stock market to go up.

- The Chinese Govt is paranoid about the collapse of the USSR, and will do everything in its power to prevent that happening in China (not likely though)

Risks & Opportunities

The Chinese Stock Market will be very turbulent - it sounds to me as if bubble conditions are building up, so extreme volatility sounds about right, and should be expected.

Chinese markets are inefficient - often people throw away great value stocks, as they're chasing go-go stocks - creates very good buying opportunities for patient value players. This reminds me of 1998-9, when value stocks got cheaper & cheaper as TMT stocks soared. That turned out to be a very good buying opp for value stocks, when the TMT stocks later collapsed, and sanity returned in 2000-2002. It sounds as if a similar dynamic is now occurring in China perhaps?

Pirates

The speaker then turned to talking about "pirates", in business. How does he spot them in China? Answer - they wear expensive suits & watches. They have top degrees from the best Universities. They know exactly what to tell you - i.e. what you want to hear.

There was a collective sharp intake of breath in the room, as he had basically described many of the British people in the audience here in London!

This was not at all what we were expecting! So as well as flagging up what to look for in crooked Chinese, I think the speaker cleverly reversed it to point out that some of the people in the UK financial sector are little more than crooks, in some cases - especially the highest status people with all the flash trappings of wealth.

Who should we back? He likes to back the real people, in their factories, working hard, and getting their hands dirty.

Final Points

A few other remarks that stuck in my mind, and are of general benefit when investing, not just in China.

The internet allows investors to check facts, figures, and trends, in many different ways. So use it creatively to check if what you're being told by companies is true! I really liked this point, as all too often I think we can just get our information about a company from that company itself. Yet often the truth is very different. It's out there on the internet, so get googling!

The speaker believes China has an air of confidence & optimism. This seems the opposite of Western fears of a China hard landing.

Culturally, he believes that China is increasingly rejecting Western values. The days of Western dominance are drawing to a close. I think he's right about Western dominance, but perhaps not so right about Western cultural influence - but we'll see!

Finally, he sees China morphing from a major exporter of physical goods, into a major exporter of capital. So he sees a flood of money leaving China, and creating opportunities for investors all over the world, if you correctly anticipate where that capital will be seeking a home.

Conclusion

An absolutely fascinating lecture, challenging many of our preconceptions about China, which I'm very glad I attended. Thank you to the speaker & the organisers.

Will I be buying any Chinese stocks on AIM? No. Mainly because AIM is completely discredited now as a place to buy overseas stocks, due to the broken NOMAD system, and effectively zero regulation. Therefore AIM will continue to act as a magnet for crooks from all over the world, not just China.

Would I buy Chinese stocks on the Chinese markets? No. I have no idea how to, for a start, and I'd rather leave the big markets to the experts. My view is that the best potential returns are to be found by finding a small, and inefficient market, and then becoming an expert in it. This is why I have chosen to focus on UK small & micro caps. Although it sounds as if the Hong Kong market might have opportunities there for people who want to take an interest in it.

This concludes my series of articles on LVIC, which I hope you have found interesting. People should try to get along to this event next year, if you can rustle up some readies, as it's well worth it in my honest opinion, having been to the last three.

Regards, Paul.