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China Thoughts and the Circle of Competence

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.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on our website. John can be reached at john@sabercapitalmgt.com. 

 

23 thoughts on “China Thoughts and the Circle of Competence

  1. Hi John,
    Nice update and welcome home.

    What are your views about JD? Do you think is that one of the inevitables?

    Regards,
    Wilbert

  2. Hi John,

    Interesting update. One question on owning Chinese equities: how do you get comfort with the legal status of your ownership stake? My fear is you could well be right on the prospects for the company, but your stake could be expropriated in whole or part?
    Is such a fear misguided?

  3. Great post, thanks. I can say that diving deep in a few areas, and pretty much eliminating the rest from consideration have improved my results over the years. You can get to something like compound growth in understanding if you focus on a few areas. You can’t get that if you’re spread all over the place. Same exact thing that happens with the tomato plants in my back yard — if you keep them pruned back to a few leaders, you get fantastic fruit because all the plant’s energy is directed into them. If you let them sprawl all over the place, you get boxes of duds.

  4. John-
    I was wondering if you had seen the recent documentary, “The China Hustle”, which details the massive fraud that has been going on with listed Chinese companies. Audited companies were found to not have anywhere close to the assets and sales that were listed in their financials and quickly evaporated. The conclusion of the film is that China is basically non-investible and cites even Allibaba as a company that could be fraudulent.

    Your thoughts?

    1. Hi Roger,

      There is a lot of misinformation and false narratives out there on China. I do think some of the research that the shorts have put out is legitimate, but also much of it is biased, and a few things I’ve read are just false. But that said, there are certainly some risks that they highlight (accounting and other) that are worth considering. But my overarching view is that China is becoming more open, and much more of a market driven economy. I think the incentives of both the Party and the citizens are aligned. Both groups want China to be successful long-term, and the government knows that to be successful long-term, they need to be part of the global economy, and the global economy is a market economy. They also know that inhibiting the transition to a market economy means a step backward, and so I think it’s extremely likely that this transition continues. I think China’s economy will continue to grow, its people will continue to see their incomes rise, and businesses will thrive over the long run. There will be lots of bumps in the road, but I think there is no doubt in my mind that there will be a number of companies in China that will create enormous wealth for shareholders over the long run.

      To your more specific question regarding the accounting issues that we see at some companies, this will get sorted out and fixed over time as well. If you read about the 1920’s in the US (or anytime during the pre-Depression era, which ushered in, among other things, some sweeping regulatory changes such as the SEC), there was a lot of accounting fraud, self-dealing, and all kinds of other conflicts that illegally extracted value from minority shareholders. But betting against the US was a big mistake, and I think the same will ultimately be true for China. Also, on that point, I think there are plenty of companies that are completely legitimate (no, Alibaba is not a fraud, and is a completely legitimate company that is one of the best businesses in the world). There are plenty of sour cases of fraud and shareholder theft in China, but these tend to be smaller companies with poor governance. I think most of the large firms (such as Tencent or JD) have good corporate governance practices that would be acceptable to Western investors. The VIE structure is another issue that gets misinterpreted by many, and while I won’t discuss it in this already too long comment, I think the key again is to look to incentives. I think the incentives are clearly aligned between the government, the citizens, and foreign investors. As Charlie Munger says: look to the incentives!

      I think China has a very bright future. Lots of companies will rise, and lots will fail, but in aggregate, I think there is no doubt that China is one of the “inevitables” over the long run.

  5. Hi John. Excellent post and insight. Wish I could share your enthusiasm. How do you fight through the complexity of the numerous and myriad cross-ownerships that are happening with these Chinese companies? How do you deal with the overwhelming number of opaque subsidiaries that exist? And, what of the ingrained culture of dishonesty throughout the Chinese Corporate World? The sheer number of frauds that have been unearthed there in public companies is dispiriting. No matter how much time I spend studying investment opportunities in China, I can’t come away feeling that I’m not going to get ripped off. And finally, what of the fact that the Chinese government still will not allow oversight of their companies by US based accounting expertise? Isn’t that enough to keep your investors away from this snakepit of fraud?

  6. Hi John,
    One of my positions which I’m heavily invested in is JD. Just want to share few of my concerns. During the last earnings call, they mentioned about the development business of logistic parks and potential upside of it as well as an opportunity of managing it. More over, tons of more new initiatives, that keeps popping up each new earnings call. I understand that, JD is huge and still kind of in the start up phase of acquiring market share. What really concern me is that JD is defocusing. They sort of try to put all the five fingers in one mouth)))). Especially, the thing with building and selling infrastructure which is absolutely non core thing for JD, in my view. I am starting to feel as if I bought a bag with double bottom, which I keep discovering.
    Whats your view on that?

    1. Hi Murat,

      I have this view of capital allocation for a number of companies I follow. I think it’s uncertain whether some of these investments end up paying off, and I scratch my head as well at a number of them (Tencent investing in TSLA is another), but I think the overall value of these business will continue to be driven by how well they execute in their home market, which will be multiples of its current size over time. I do think JD will continue to do well there. I don’t think they’ll beat Alibaba, but I think the market is big enough for them to be much larger and more profitable over time. Richard Liu is extremely ambitious, and sometimes I wonder if he is biting off more than he can chew, but he also built JD into what it is now starting from a small stall in the Beijing market selling CD’s, so I think if the horse you’re betting on is the future of China’s ecommerce market, he’s not a bad jockey.

  7. John,

    Could you give us an updated about view on JD? What do you think about Hillhouse Capital having trimmed their stake in JD and bought BABA instead?

    1. Hi Lukas,

      Regarding Hillhouse selling JD to buy BABA, I have no idea what their reasoning was. My hunch is that they were selling their stake in JD to position themselves to be able to invest in Ant Financial (Alipay), but this is just a hunch. Baba is rumored to be strong-arming potential Ant investors into cutting ties with Tencent and Tencent subsidiaries/affiliates (which is Alibaba’s main rival). This doesn’t necessarily mean that a Tencent or JD investor couldn’t participate in an Ant funding round, but Hillhouse may be positioning itself to be in Baba’s good graces just in case. Again, this is really just useless speculation on my part. I don’t know what Hillhouse is thinking, and it’s not really that important to me regardless. We did meet with a Hillhouse partner while in China, and she talked with us about the overall ecommerce landscape, which sort of reiterated two obvious facts: I think there is no doubt that there is a long runway for the major players in online retail, and that business in China is just brutally competitive. Who will win is of course the key question! (And there can be multiple winners).

      One thing that became clear to me (not just because of any particular meeting but more just a general observation) is that Tmall is really an entrenched business in China. I think Alibaba is a great business and will continue to do very well as the Chinese consumer continues to gain more and more buying power. In general, I think China’s retail and ecommerce market is certain to be much larger over time, and I think Alibaba and JD are both very likely to be beneficiaries of that trend. In my view, Alibaba has the better business, and JD has the tougher business (from an execution and operational standpoint) but both I think will do well over time.

  8. Hi John,

    I think you’ve hit the nail on the head when you’ve mentioned: intellectual honesty, circle of competence and VIEs.

    I regularly read your writing, and I consider you among a handful of people whose wisdom I value and I’ve never disagreed with anything you wrote until now (in fact we share several positions purchased at similar times). It must have been several years since I’ve last commented publicly, but I value your writing so much and this is such contentious topic that I feel compelled to write this in the hope of:

    a. Raising awareness amongst your readers
    b. Making you change your mind about your investment in Tencent

    I’m talking about the risk associated with the ownership of Chinese stocks, via the VIE structure in particular, and ownership rights not being protected in general.

    If you’re an avid follower of Berkshire, as I know you are, you will of course know that even Warren and Charlie don’t agree on this point. That alone is enough to demonstrate how contentious and controversial this topic is.

    Look to motives you say. The VIE structure was created to allow some Chinese companies and eager U.S investors to overcome the legal restrictions on investing in certain industries. Both sides were so eager that they were willing to make use of an illegal workaround, which to this day is formally illegal, explicitly threatened by a potential ongoing legislation and has been abused multiple times previously, including when the shareholders were considered very sophisticated (Yahoo management).

    When such eagerness arises, a helper will always be found to structure and stamp it for handsome fee. No need to go far to recall instances when such eagerness yielded sub prime mortgages repackaged and stamped triple A to meet investor demand with the help of eager helpers.

    I fully agree with you that the future for China and Chinese people and economy is bright. I also fully agree that picking winners is hard and I even agree with your Tencent thesis. But to my mind all this is dwarfed by the ownership rights risk. The questions you have to ask yourself are:

    Do I really own the assets that provide the cash flow? No.
    Do I have ownership rights? No.
    Do I operate within a system that can protect this ownership? Courts, legal and moral framework and a long history and tradition of property rights? No.
    Is it possible that my ownership would be compromised? Yes.
    Has it happened before? Yes. (‘I believe it because I’ve seen it’)
    What is the probability that my ownership will be compromised? I humbly admit that I can’t quantify it, but it’s significantly larger than 0.
    In the event it does happen what will the value of my holding be? I humbly admit that I don’t know, it could be anything.
    Is there an incentive for the other side to act this way? Yes, worst case greed, but even simply to protect the value of his holding when our interests collide (e.g. government requirement).
    Does china have a long tradition of honouring property rights like the U.S? No.
    Is it possible that the political situation will change in such a way that the winds will blow against me? Yes. No need to go far, consider the wealth redistribution in the soviet union and Russia which is still happening regularly to this day.
    In which jurisdiction would disputes have to be resolved? Chinese courts.
    Can I trust that such a dispute resolution system will be unbiased? No.

    I can go on and on, but I think I’ve made the point. I will finish with just one more thought, would you invest in a large, stable, profitable S&P 500 company with a durable competitive advantage that is attractively valued and has a clause in it’s articles of incorporation that the CEO can stay the CEO for as long as he wants (I’m sure you know which company this is). In this case ownership rights are only slightly restricted.

    My view is that if one is intellectually honest, the ownership risk immediately puts it in the ‘too hard’ pile and squarely outside the circle of competence of ANYONE. It doesn’t matter how much time one spends thinking about it, it simply cannot be known. It doesn’t mean I’m right, but one of us is and time will tell.

    Good Luck!

    1. Hi Eric,

      Thanks for the comments. You bring up relevant risks and relevant facts. I would just disagree with your conclusion. I’ve done a lot of work on this, and while I don’t have time to go into too much detail in these comments, I’m convinced that the key thing to understand is the incentive structure. Everything you say regarding property rights and ownership is true, but to believe that the contract you own would be unilaterally rendered null and void would mean that you believe that the government would act irrationally.

      From a very broad view, I think the government knows exactly what they are doing, and they understand that the VIE structure allows them two key things that they want: 1) domestic control over the companies in the industries they deem sensitive (internet, banking, energy, etc…) and 2) foreign investment. The government wants Alibaba, Tencent and their ilk to be controlled by Chinese nationals, but they also want the $25 billion to flow from New York to Hangzhou when Alibaba sold shares to the public. The government gets money flowing into China without running the risk of foreigners influencing their domestic firms. The government gets to have their cake and eat it too.

      The government understands that China needs foreign investment (they know what the Soviets tried didn’t work, and what they tried previously didn’t work, and they know an open market is essential for becoming a global superpower). So they know that they need foreign investors, and doing things to harm outside shareholders would cause foreign capital to flee. There is no doubt that such action would cause panic and chaos with devastating economic effects and political ramifications. It would weaken their own economy, it would crush their currency, and it would (most importantly) weaken the Party and their political control, which is absolutely something the Party avoids at all costs. It doesn’t mean it’s impossible, but it certainly means you’d have to believe that the Chinese leadership would have to act completely irrationally and against their own best interests. China’s leadership is very smart, and many in Xi’s circles have been educated in the West.

      Also, it’s very interesting to study what the State Council said earlier this year regarding their program to implement CDR’s (Chinese Depository Receipts), i.e. getting firms like Tencent, JD, Alibaba and others to list their shares (or receipts of their shares) in China. In a way, they are indirectly approving the legitimacy of the VIE structure by creating a path for these companies to list their shares at home. Again, this is a complicated subject, and if people are interested they can study it and come to their own conclusion, but I’m pretty convinced that the risk of foreign investors getting their property stolen or contracts voided is very low.

      In short, China knows that they need to be part of the global economy if they are to accomplish their goals, and they know that in this time in history, being part of the global economy means being part of a market economy, and they know that harming foreign investment would severely inhibit their progress (while negatively hurting their own citizens). I think the incentives are crucial to understand in order to be comfortable investing there. The risks you point out are definitely worth considering, and there are risks, but spending a lot of time thinking about the incentives and the likely outcomes have led me to believe that while nothing is a 0 risk, it is very unlikely.

      Thanks for the comments!

      1. Thank you for your reply John. I can certainly see your point of view as well and that you’ve spent a a long time thinking about it. Good luck and I hope you keep writing and enjoying it, as much as I enjoy reading it.

  9. I’ve been watching JD for a while from the sidelines. (fortunately) I am starting to get more interested now that the stock price is plummeting and sentiment towards the company and China are terrible right now. However, there are a couple of items that are giving me pause.

    The first is that the company may be struggling with profitability or maybe the lack of profit is attributable to investing for future growth. I still can’t quite figure this out as it looks like expenses are rising at a faster pace than management expected.

    The second and more troubling problem is the recent arrest of Richard Liu on possible rape charges. I realize this could be a complete hoax. Men in his position are huge targets in today’s society. However, even if he is not guilty, he should know this and not put himself in these positions. One of the primary factors for investing in JD is his reputation as a high integrity CEO. I think his reputation is going to/has already take(n) a serious hit for this. In my view, Richard Liu is absolutely essential to this company performing at a high level. If he is convicted or replaced, I’m not sure how JD will fare long term.

    Many longs are freaking out about the drop in stock price, but every great growth company I have ever seen (BRK, SBUX, HD, etc.) has had at least one drop of 50%+ in its history, usually more. Buying here could easily net a 10 bagger in a decade, or the company will continue to struggle with profitability due to the brutal industry it is in. I view the company as more of a speculation, but possibly a really good one at the current price ($27).

  10. Hey John,
    What do you think about companies like CXDC and SORL with management who owns a large chunk of the business (maybe too large) and because of the depressed share price wants to take the company private?

    What are your thoughts on this and how do you view these companies?

  11. Hi John, I have nothing really of value to add here, but just wanted to say hi and that I enjoyed reading your post from China. I am also a fan of Alibaba and Tencent. Tencent in particular is an amazing company.

  12. My main concern about China is actually just the environment and air quality, not the investment risk. Since those could more directly impact my health when I’m hanging out in these cities with “moderate” or “high” air pollution risk… (Currently I am in Jinan). Personally, I think they should decrease the number of roads so fewer people can drive, use computer vision to tax vehicles based on number of occupants in the vehicle, increase bike-only transportation lanes, and rapidly increase gas tax with all raised funds going towards corresponding subsidies for electric until internal combustion engines eventually become too costly for most people. But I think the U.S. should do the same.

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