I had a great week in China with Jake Rosser and Connor Leonard, two good friends and fellow investors. We spent our time visiting a few companies, talking with employees and business owners, and just observing some day to day life in Beijing and Shanghai. I have spent a significant amount of time over the past few years reading and learning about China, and it was very helpful to apply the learnings with some real world on-the-ground observations.
I have a lot of thoughts on China in general, and I’ll probably discuss some of my company-specific thoughts at some point in a letter to my investors, but my broad takeaway is that China’s economy and its people have a very bright future. The energy in Shanghai and Beijing was palpable, and I think the entrepreneurial spirit, the work ethic, and the technological and engineering know-how of the Chinese people are significantly underestimated by the Western media and by many of us who live outside of the country. I think there will be lots of opportunities for investors who put in the effort to understand China and the companies that do business there.
There are also a lot of false narratives about the Chinese companies, the government, and the nature of their economy. There will be growing pains, as there are with all economies, but China is becoming more and more of a market-driven economy, and they are much more entrenched into the global economy, which is good for China, the US, and the rest of the world. Much of the narrative is focused on the wrong variables. A trade war is not good for either party, but even if that comes to fruition, it will be just a blip on the radar. Not only will it fail to correct the trade deficit, as trade imbalances are a byproduct of regional spending and savings rates (and those won’t change overnight), but more broadly, global trade in general is a good thing, and it is certain to be higher over time. The world’s economy is too interconnected and consumption habits are too ingrained for that to change. So a trade war could hurt China in the near-term, but it won’t change the future in the long-term. Other than economists, most people don’t know about the devastating Smoot-Hawley tariffs of the 1930’s. Strong economies will sometimes face headwinds, but they’ll keep moving forward.
Another somewhat misplaced narrative involves China’s large debt load (which is always compared to GDP but never to the other side of the balance sheet: e.g. the vast amount of assets that the Chinese government owns or controls. It would normally be reasonable to compare Apple’s $110 billion of debt to its annual income, but that datapoint would portray a very inaccurate picture of Apple’s credit risk if you ignore the $240 billion of cash that the company has in the bank).
But high total debt-to-GDP ratios has caused China bears to anticipate a debt crisis and an economic debacle. I have no idea if or when this occurs (and it certainly could), but like the politicians and the trade spats, I think the bears are missing the forest for the trees. Both groups are focused on the wrong time frame. I think the much more certain bet is on China’s long-term future and the inevitable rise in standards of living, consumption, and earning power of the Chinese people and their companies.
It’s important to remember that great businesses will continue to do well, regardless of temporary setbacks caused by economic downturns. Also, the timing is always tough when you’re betting on a downturn in the macroeconomic cycle. Tencent has seen its earning power grow 20-fold since I first started reading about China’s debt nearly a decade ago. This doesn’t mean the debt problems aren’t real or should be ignored, but great businesses that are providing valuable services to Chinese consumers will continue to do well on balance, over the long run. The future growth in buying power of the burgeoning Chinese middle class is significant.
Rapid Pace of Change
From a broader perspective, one thing the trip to China got me thinking a lot about was the concept of the circle of competence. There are hundreds, if not thousands of companies in China that will create fortunes for investors over the coming decades, but at this moment I am aware of only a few that I would be confident enough to say that their competitive position will be stronger in five years than it is today.
The problem for investors in China is that the pace of change is fast and the competition is so fierce that it will be very difficult to determine which companies will succeed and which companies will fold. New companies are cropping up everywhere and can quickly gain scale in a way that threatens seemingly entrenched incumbents, and this process can happen in exceedingly short periods of time. CATL didn’t exist eight years ago. Today, it is the largest electric-vehicle battery producer in the world, surpassing BYD, Samsung, LG, and Tesla-supplier Panasonic. An ecommerce company that currently serves primarily lower-tier cities called Pinduoduo didn’t exist four years ago, but today it has a burgeoning platform with over 300 million users and a $25 billion valuation. A year ago, Starbucks was the unchallenged leader in China’s premium coffee industry. Today, an upstart named Luckin Coffee has established a foothold with over 800 stores and plans to grow to an astounding 2,000 by the end of this year. The business life cycle seems to be getting more and more compressed.
So one of my main takeaways from the trip is that I am certain that China has a bright future, but I think it will also be very difficult to pick winners. It’s a massive land rush where everyone is in the process of trying to stake their claim.
The good news is that there are a few companies that I am very confident in, and a couple that I would consider to be “inevitables”, a term I borrowed from Buffett to describe Tencent in a presentation I did last year. Luckily for investors, a few great ideas might be all you need in order to benefit from the massive tailwinds in China. But resting on the laurels of those select few great companies is not my only plan, and I came home excited about the country’s future and eager to continue learning about the businesses that operate there in an effort to steadily build out the watchlist of potential future investments.
But this is where the concept of circle of competence is really important. It’s crucial to be intellectually honest about what you know and about what you don’t know, and there is a lot that I don’t know about China. But fortunately there are a few things I do know, and I’m working to build on that base and work to expand that small circle over the coming years.
Li Lu on the Circle of Competence
I’ll have more to say about China in future letters to Saber Capital investors, and over time, I’ll discuss investments that I’ve made, but for now, on the topic of circle of competence, I thought I’d share some quick notes that I took on a talk by Li Lu that I recently reviewed in preparation for my trip. I think he captures one of the most important things to remember when thinking about investing, whether it’s in China or anywhere else. This is a subtle, yet extremely important aspect of the circle of competence concept:
“The more honest you are intellectually, the more prosperous you tend to be. I have never met intellectually arrogant people who can successfully practice the game of investment.”
That was a portion of what Li Lu said in response to a question on what sectors he thinks are undervalued at the current time. I’m going to simplify and paraphrase the other portion of his reply. He basically said that he doesn’t know which sectors are cheap, but he also implies that this isn’t really the right question. You don’t need to know everything about everything. Anyone who says they have a view on so many different things is usually not being honest.
What he’s saying is that sticking to your circle of competence is key, and not straying outside that circle requires being honest with yourself about whether you truly understand the investment idea that you’re currently analyzing. If not, then it’s best to keep learning, and not invest. This is very difficult to do, and since many investors are smart people, they convince themselves that they know more than they actually do about a particular investment.
I love Li Lu’s reply to that question, and I think that being honest with yourself about your own knowledge-level is one of the absolute requirements for avoiding debilitating losses.
Gaining an Edge
A couple years ago I wrote a piece titled “What is Your Edge?”. Basically, my point was that gaining an edge in today’s market is no longer based on gathering information (which has become commoditized because of technology). Information gathering is obviously crucial to investing, but it usually won’t give you an edge. Each piece of information that you think is proprietary is – with very, very few exceptions – known by scores, hundreds, or usually thousands of other investors out there. So technology has leveled the playing field when it comes to gaining information. But what hasn’t become commoditized is the ability to gain an edge by understanding and acting in a way that gives you a behavioral advantage.
Investors can gain an edge through thinking differently than the crowd and also through thinking on a different time horizon than the crowd. These are potential advantages that have not only not gone away, but they’ve likely strengthened as attention spans, patience, and the time that investors are willing to wait for positive results have all gotten much shorter. This pervasive short-term thinking creates a gap between price and value as sometimes short-term investors are selling stock because they think the next few quarters will look bad (even when they know the next five years will look good).
I think the intellectual honesty that Li Lu is talking about in this talk is a key concept that is part of what it takes to capitalize on this potential behavioral edge in the stock market.
To Sum It Up
The circle of competence is talked about constantly, but one subtle truth that each investor should remember is that part of sticking to what you know is being honest with yourself about what it is that you know (and what it is that you don’t).
I think this is especially important when evaluating companies in China, because the incredibly attractive future has led to an incredibly competitive landscape. There will be fortunes to be made, but I think it will pay to be very selective, patient, and of course honest about your own level of understanding. As is the case with investing generally, it will only take a few great opportunities to make all the difference.
I’m excited to be back in the office, and I look forward to learning more about some of the companies we visited during our stay in China. For the Saber Capital investors who are reading this, I will be sending out my mid-year update in the next week or two, which will contain some other thoughts on the portfolio.
Thanks for reading!
Disclosure: John Huber and clients of Saber Capital Management own shares of Tencent Holdings.
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that employs a value investing strategy with a primary goal of patiently compounding capital for long-term oriented investors.