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Reflections on China and Its Markets
July 18, 2015
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In February of 2014 – at the Las Vegas Investment Club two day annual conference (the Econosummit) I discussed in detail why I felt investing in China may be worth consideration.

 

At that time my position was based on a stock market with stronger fundaments and stocks trading at under 13 times earnings.

Attendees were shocked as I advanced the idea that 50% + of members’ portfolios, allocated to stocks, be placed in Chinese stocks.  What followed was a lively and informative focus on the ‘interface’

One item that emerged from this discussion was the fact that Chinese stocks are difficult to acquire, however; my research then and since has shown that the ASHR (description below) was an excellent way to ‘play’ the Shanghai Composite.

 

It has been almost 17 months since the conference and with the advantage of retrospect it would seem that my position was a good one!

Up until the recent sell off – the Shanghai Composite was up well over 100% with the ASHR performing even better.

Even after the market pressure downward the market is still up over 60%.

I continue with my position that Chinese stocks represented strong value based on valuation.

 

The ASHR is 300 of China A share largest companies.   It has a high expense ratio of .82 basis points – but the offset is significant in that it is the best for liquidity.

For those who have a higher risk tolerance – a strong play is YINN.

 

The YINN provides 3x leveraged exposure to a cap weighted index of Chinese depositary receipts trading on the NYSE and Nasdaq. 

(3x leverage the expense ratio – is the average). 

 It represents an aggressive daily bet on US listed Chinese equities delivering 3x leveraged exposure to the BNY Mellon China Select Index.  

Its target is only US listed Chinese securities.  

The resulting pool of securities produces significantly different returns than most China ETFs.  

The YINN has a big stake in Chinese internet companies and little to no exposure to financials. 

The YINN represents a very aggressive platform and extreme risk, however; it did outperform the ASHR

I see it as a platform for very short term trades – at any time.

 

Things have now changed and at this point I consider that in many respects Chinese stocks are now overvalued, however; that does not mean that I are bearish.   In fact, although I advocate a lowered exposure to Chinese stocks I still view favorably – involvement outside the USA markets and in China securities.

 

Again things have changed.

Let us have a look at some of the risks.

The Chinese economy is definitely slowing and has a lot of debt.

The $4 trillion in local municipality debts and the slowest GDP growth since 2008 are key reasons for concern.

Price Earning ratios are currently above 20x (historically they average at about 13x). This is exceedingly high and rivals the USA stock markets which has much more transparency – and reporting on which investors can rely.

Also any investment in the Chinese stock market must be seen as high risk and profits MUST be taken ‘along the way’.

 

All this said, the Chinese stock market has something the US stock market does not have.

It has a government that considers a collapse of market prices a national security issue that can cause social instability – and the ability to take action

After all – it is estimated over 80% of buying in the Shanghai Composite is Chinese ‘retail investors’ and the government definitely wants to keep it citizens’ calm.

 

I am not betting on the Chinese stock market based on strong fundamentals and even consider it to be overpriced.  (Warren Buffet would be nowhere to be seen in this universe of stocks)

In fact, if a company is listed on both the Hong Kong stock exchange and the Shanghai Composite, on average the same company will trade at an 80% premium on the Shanghai composite (relative to the Hong Kong stock exchange) as there is no arbitrage.  It truly is the “wild west” – comparable to the circus of the OTC (Over the Counter) bulletin board stocks of the early years in the United States.

However, this time the backers are not pump and dump scammers with offshore accounts pumping up stocks but rather – the Chinese Communist Party.

 

In an effort to force prices upward the Chinese government undertook extraordinary interventions that included, banning some people from selling shares, providing cash for others to buy shares, ordering some companies to buy back their own shares, suspending IPOs so that more money would be available to buy companies already listed, arresting short sellers, and much more.

 

This is a completely rigged market – one which the esteemed pioneer of ‘political economy’ Adam Smith – would certainly ‘take issue’

That said I am still betting on the Chinese stock market albeit in a much smaller capacity than a year ago.  I am betting on the nervousness of the Communist Party to do what it has to do to keep its people happy and raise more money in the capital markets on behalf of its government companies that tend to ‘bleed losses’.

 

The Chinese government has made it clear that its political goals take a higher priority than allowing the stock market to function as it does in other developed nations.

The central bank continues its program to provide cash to the China securities Finance Corp – which is a state run company that lends people money to buy stocks.

Last week half the companies on China’s two major exchanges were suspended from trading in large part to curb the sell off and to facilitate more money chasing fewer companies.

Initial public offerings were suspended so that newly issued shares would not compete for capital with those companies already on the market.

Company’s major shareholders with 5% of a companies’ shares, as well as executives and board members were banned from selling their shares for six months – and if they did they were arrested.

Also companies were forced to buy back their own shares.

 

As indicated earlier – this truly is a rigged ‘circus’.

This kind of market manipulation has no place in a modern economy but those involved continue happy to make money.

A curious perspective is to juxtapose the fact that investors are riding a wave of market manipulation which – in China it is part of normal business – against the same circumstances for which, in the USA, you would go to prison! 

 

If things become extreme and the Community party feared a challenge to their power it is a pretty safe bet that they would print an unlimited amount of cash to buy as many shares as it took to reach a target price.

That is why I am betting on the Chinese stock market. There is a tangible ‘bottom’. It is reflected in the Central Government driving motivation to ensure investors don’t lose money.

 

As all members are aware the Las Vegas Investment Club does not shy away from issues we regard as important. We have been and continue ‘proactive’ in this regard. Since we are on the subject of China….

 

A Chinese citizen in China would go to prison for criticizing the government in a public form like this.

There is much to favor with China as a completely ‘emerged’ economy – now.

However; in managing its economy the Central Government has left many Chinese ‘caught in the middle’

Of these – the very rich are especially vulnerable / and able to do things about it!

 

In fact, over 90% of EB5 applications for US immigration visas that are successful have come from China.

(The EB5 visa process represents a method of obtaining a green card for foreign nationals who invest money in the United States.  To obtain the visa, individuals must invest $1 million – creating or preserving at least 10 jobs for US workers excluding the investor and their immediate family)

Yet – as part of the process the US government does not ask for any source of funds!

(When Canada forced Chinese immigration Visas (similar to the EB5) to show proof of funds – applications from China dropped 90%). 

 

We are all well aware of the well publicized graft, corruption and bribery that made many government bureaucrats extremely wealthy in China.

We understand that they have stored their money offshore in countries which China has no extradition treaty with.

In America we talk about the concerns of money laundering but when funds flow to America the same rules don’t seem to apply.

Go to places like Vancouver and San Francisco and you can easily see the flow of these funds and the demographic changes that have resulted

We wrote a detailed letter to Harry Reid (US Senator – Nevada) about our concerns.

Unfortunately, the response was a form letter that had nothing to do with what was articulated in the letter to him.

 

The impact on Las Vegas for instance has been in the finance and build of the newest magacasino SLS Casino.

While on the surface this may seem a distinct positive – let us look deeper?

With well over 1 billion people in China even a small flow from that country could create a huge demographic change in America.

Our point is not the source or even the numbers – but the diversity of which we are so proud of – in this Country

 

If no more than 10% of any EB5 applications that are approved are accepted from any one country – this would prove to be a fair solution, however; ‘focus’ seems elsewhere

We reiterate

Over 90% of EB5 applications for US immigration visas that are successful come from China.

In synopsis

A huge challenge now for the Chinese government is that market fluctuations are becoming tied to the governing body.  Chinese investors who have been tangibly supported to become involved in the markets will certainly be angry with the government if there is a huge market selloff.

I believe that such dependence on the central government will have executives focus less on having their companies be more productive and innovative and more on continuing to find ways to win favor with the central government of China.

In my opinion China will need to develop an independent private sector and not one dominated by political influence.

 

At this point I recommend a lessened stock position in China equities but believe the risk / reward (with the intervention of the Chinese central government) benefits the investor.

I believe the Chinese stock market is overvalued but given the strong arm and risks for the government I hold that involvement may not be unreasonable – albeit at lower percentage than what was discussed in Feb of 2014.

 

The next Member meeting is on July 22nd at 6:59pm (yes we always start on time) in Salon A at the Orleans

See you there!

 

For more detail on the subject of China and its markets please go to:

http://www.mikelathigee.com/

And see his article:

Don’t Let America Become a Dumping Ground for Chinese Laundered Money

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Mike Lathingee

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