2 October 2021

On today’s show, Stig Brodersen has invited back David Stein. David is a former chief investment strategist for Fund Evaluation Group, a $70 billion investment advisory firm. In this episode, David will break down what is going on in China and whether we as investors should be concerned about a stock market collapse.

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  • How are Chinese stocks valued historically?
  • How to think about stock market valuations in the US vs. China.
  • Why are some investors like Charlie Munger, bull on Chinese equities?.
  • Why are some investors bear on Chinese equities?
  • What is the true debt situation in China?
  • Can Evergrande lead to a stock market collapse?
  • What happens to investors’ ADRs if they get delisted in the US?
  • What is happening in the tech sector from an investing and regulatory perspective?
  • What is the intention behind common prosperity?
  • What are the known knowns and known unknowns when investing in China?
  • What are the implications of the new Chinese currency?
  • How to position yourself when investing in China.


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Stig Brodersen (00:03):
For today’s show, I invited back, David Stein. David is a former Chief Investment Strategist for Fund Evaluation Group, a $70 billion investment advisory firm. In this episode, Dave will break down what is going on with Evergrande and Alibaba, and whether we as investors should be concerned about a stock market collapse. I hope you’re going to enjoy this episode as much as I did, so sit back and enjoy the always thoughtful David Stein.

Intro (00:32):
You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Stig Brodersen (00:52):
Welcome to The Investor’s Podcast. I’m your host, Stig Brodersen, and today I’m really happy to have invited you David back on the show to educate us on what is going on in China right now.

David Stein (01:04):
Well, it is great to be here. Thanks for having me, Stig.

Stig Brodersen (01:07):
David, let’s set the scene for this conversation. The Chinese equity market this year, especially tech stocks have just tanked and it might start to look cheap for a lot of investors, especially whenever we compare it to the S&P 500. That already looked somewhat expensive and so far here in 2021, it’s up another 20%. Let’s try and sum up for 2021 and say, is the Chinese stock market cheap historically?

David Stein (01:37):
Well, first before we do that let’s think about how Chinese stocks have performed. And when you talk about Chinese stocks there’s many different markets. There are the big tech stocks that make up or some of the top 10 companies in the world like Tencent or Alibaba, but we also have stocks like the A shares, which are just local companies that trade in China itself. Those are actually positive year-to-date of about 2.7%. The China 50, the biggest names are down 17% year-to-date so they’ve had the biggest fall. And then the overall China MSCI China Index, which includes a little bit of everything is down around 12% here today.

David Stein (02:16):
Long term, though, China has been a profitable place to invest. If we look at the tenure annualized returns for the Chinese stock market overall, the MSCI China Index has been about 8% annualized, so less than the U.S. over that timeframe but that’s certainly competitive. And I think most investors would be happy with an 8% annualized return if it was broadly diversified. If we think then about valuations, and the Chinese stock market is not that old. It reopened again back in the early ’50s, it was closed from really the ’50s to the early ’90s. And even when the Chinese stock market reopened, in those early years it was mostly state-owned enterprises getting raising capital.

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David Stein (03:03):
And so I have some valuation statistics from the mid-’90s but that’s about as far as we go back. And so when we compare to the U.S., oftentimes the valuations would go back to 1928 or earlier, but even more modern period it’s certainly longer than just going back to the mid-’90s. But if we look at, for example, the Shiller Price-Earnings ratio, which is the PE or price to earnings of stocks but using the average earnings over the past decade, right now China is at 13.6. Its average, going back to 2006 is about 16.3 so the Chinese stock market is around a half standard deviation, cheaper than its longer-term average.

David Stein (03:47):
But that’s looking at 10 years’ worth of earnings and to put that into comparison, the U.S. Shiller PE is at 37, 1.8 standard deviations above its average, so the U.S. is clearly an expensive market. China is less expensive, but if we look at some other valuation metrics, just looking at the dividend yield for Chinese stocks right now, it’s 1.7% going. Back in 1995, the average is 2.4% so the Chinese stocks are more expensive on a dividend basis. On a cash flow yield basis, Chinese stocks are at 7.4%. The longer-term average is 11 and a half percent by that measure. And with these yields, the higher the yield the more attractive the valuation.

David Stein (04:32):
Even on an earnings yield basis, the Chinese stock market is not… it’s not cheap. And I think we’ve seen periods where this Chinese stock market has been much, much cheaper, so earnings yield for Chinese stocks, which is the inverse of the PE ratio. And I like to look at valuations on a yield basis just because then we can compare it to interest rates and what those are doing. At a 6.9% earnings yield, Chinese stocks the longer-term average is about seven and a half percent going back to 1995. So it’s not cheap, it’s still more expensive than average.

David Stein (05:12):
If we look at a period like from 2012 to 2018, the Chinese stock market was much cheaper with earnings yields up double digits. And so putting in a longer-term perspective, even with the seller year-to-date in Chinese stocks, they’re not cheap. They’re not incredibly expensive like you see in the U.S. and some other countries, but they’re not a bargain by any means.

Stig Brodersen (05:37):
If we look at the U.S. stock market, you mentioned like the Shiller PE with U.S., 37, it looks really, really expensive. And then you have other people arguing that they’re supposed to be very expensive because the interest rate is just so low. How does that work with China? Whenever you say it’s not that cheap, you said it was half standard deviation cheaper, perhaps you can first talk about what do we really mean when we talk, oh, it’s 1.8 standard deviations or a half standard deviation, what does that mean? But also, how does that relate to the interest rate level in China?

David Stein (06:11):
Well, by standard deviation that is a statistical measure. And so you might’ve heard a three-sigma, a two-sigma. So three-sigma is really a shorthand for three standard deviations. So something that is far away from its expected or its average, the wider that standard deviation. And so in the case of the U.S. stock market, 1.8 standard deviations for the Shiller PE, that’s an extreme. Only a certain percentage, typically for two standard deviations, only about 5% of the observations would be more expensive than that.

David Stein (06:45):
If we look at earnings yield, the Chinese stock market relative to the bond yield, so the 10-year government bond yield in China is about 2.9% right now. That earnings yield for stocks is 6.9 and so that difference is 4%. If we look at a comparable for the U.S. stock market, its earnings yield is 3.8%, the 10-year treasury is at one and a half percent and so the difference is 2.3%. And so yes, the U.S. stock market can justify higher valuations, but not a PE of 25 to 35 based on the interest rate.

David Stein (07:27):
You can argue, okay, the U.S. has more tech companies, so maybe on a sector-adjusted basis it should have a higher valuation. But even when you do the sector analysis the U.S. stock market is just it’s expensive. And all that means as an investor is, it doesn’t mean don’t sell all U.S. stocks, it just means your expected return for your stock market is going to be lower. And maybe it’ll do better but one of the things that I’m always looking at is what are the drivers of those returns? It comes from the dividend yield, the income. It comes from the earnings growth, and it comes from the change in valuations over time.

David Stein (08:05):
And it’s hard to argue that with the extreme valuation in the U.S. stock market that we can suggest that they’re going to get even more expensive and that’s going to drive return because what has allowed the U.S. stock market to outperform the Chinese stock market over the past decade is the earnings or the valuations have gotten much more expensive for the U.S. stock market and that has allowed for greater price appreciation.

David Stein (08:31):
If we assume U.S. stock the market is going to get cheaper and let’s say fall PE by 10 points, then that brings the U.S. stock market down to low single-digit returns over the next decade. And so as an allocator, and we’re all allocators, we have to weigh these different markets, what are the risks and the rewards? And from a pure valuation standpoint, China is more attractively priced in the U.S, it’s just that there’s also a lot of other uncertainties with the Chinese market that I’m sure we’ll discuss in this episode.

Stig Brodersen (09:04):
You’re definitely right. There are so many red flags and it seems like all over the news all we hear are bad stuff that comes out of China. But before we get to that, David, I would like to take the contrarian you, if we can call it that. And let’s talk about the bull case because you have several prominent investors, including Charlie Munger who has been very vocal about the attractiveness of Chinese equities. Before we get to all the bad stuff, why are some people really bull on Chinese equities?

David Stein (09:34):
Well, one thing they look at is they see that the Chinese economy is huge. Billions of people live in China and they see that the Chinese stock market only makes up about 4% of the overall stock market globally based on market capitalization, but the Chinese economy is 17%. They just look at those numbers and say, “Well, this is utter luck.” We have the U.S. comprising 22% of the global economy but is 60% of the global stock market from a capitalization standpoint.

David Stein (10:11):
And I started as an institutional advisor back in the mid-’90s and this was right after Japan was a significant portion. 40% of the global stock market on a capitalization basis, which is the capitalization and being sized weighted basis, was Japan. Japan today is 6% of the global stock market, which means it isn’t inevitable that the U.S. stays at 60% of the global stock market. If the earnings fall off, if other countries do better you can see that waiting go down. And there is a disconnect right now between the size of the U.S. economy, 22% of the world GDP, and 60% of the global stock market, and that’s reflective of how expensive U.S. stocks are.

David Stein (11:03):
Now, if we look at economic growth on a per person basis, per capita, the U.S. is one of the largest in the world at $63,000 per person. But China’s per capita GDP is only $10,429, so much less. Even though there’s a lot of Chinese citizens, but the amount of wealth or income, or output they’re creating per person is much less. And so a bullish case for China is that as the companies, as individuals become more productive, are able to produce more wealth per person that will flow into higher corporate profits, a bigger market capitalization. Because that’s what happened when we look at, for example, Mexico versus the U.S.

David Stein (11:51):
I remember being in… we were vacationing in Mexico, I spend a couple of months there and I was talking to a security guard on the beach. And his question is, “Why is Mexico so much poorer than the U.S.?” And you look at the reason why, and he was seriously trying to understand, who’s making the money? Is the boss taking the money or what’s going on? You look at it, it’s productivity, it’s per capita GDP. When you look at how farmers in Mexico are, how mechanized are, it’s much less. And countries such as Denmark, the U.S., that have higher productivity, they’re able to produce more, which means an accountant in Denmark makes much more than an accountant in Mexico, even though the job function is probably very similar, but there’s a spillover effect.

David Stein (12:37):
If you have a very highly productive tech sector, they pay everybody more money. It’s that per capita GDP, that growth. The potential for China there is what makes it very bullish if it can increase productivity. One of the challenges that we’ll discuss is the government’s pushing back and doing things to actually potentially reduce the productivity of some very, very successful Chinese companies, such as Alibaba that you alluded to.

Stig Brodersen (13:03):
And I think that would be a nice segue into the other side of the coin. We will be talking specifically about Alibaba and Evergrande. But before we talk about that crackdown on everything that has happened, we also hear that there’s a general Chinese bear case, even before all the skeletons have been falling out of the closets here all… well, I guess it’s over a year now, if you count it from the very beginning. But, David, what is your bear case for China?

David Stein (13:32):
Well, we’ll certainly talk about the regulatory crackdown and the uncertainty of that. The other more bearish case, and I’m not a Chinese bear, I’m agnostic. I’m looking at the data, I see some uncertainty. I don’t see an inexpensive stock market in China that can mitigate some of the risks we’re seeing so I’m just waiting and seeing. But one of the things that you’re seeing in China is the population growth is slowing. For decades China had a one-child policy, now they’re encouraging more children, but as in many countries, Chinese parents aren’t overly excited. They worry about the expense of having more children.

David Stein (14:19):
And so one of the things that I look at a longer-term that can influence a stock market, certainly influence this economic growth, there are many other things that influence it, but certainly, the working-age population is what drives economic growth longterm, is the number of workers and how productive those workers are. And so if you have a country where the working-age population is increasing as a percent of the overall population then that’s a tailwind for economic growth.

David Stein (14:49):
What we see in China, if we just look at the working-age population, ages 15 to 64, right now it’s about 68% of the population. By 2050 it’ll be down to about 60%. The working-age population as a percent of the total is actually shrinking and it’s very similar to what you see in Europe, Germany, Poland, Switzerland, China, they all have stringing working populations as a percent of the whole. Whereas there are other areas where the population is growing. Even the U.S. should see about a five percentage point increase in the working-age population over the next 30 years. But then you start looking at a country like India, which I am significantly overweight, its working population will increase about 15 points over the next 40 years.

David Stein (15:42):
And then you have the frontier markets, Ethiopia, Bangladesh, where you have significant working-age population growth. But what remains uncertain is a lot of the framework for capitalism in those countries that can impede things. But just purely on a population basis, China’s population growth is shrinking for working-age individuals and that comes somewhat of a headwind. Now, they still have this opportunity to become way, way more productive and so you got both of those sides. You’ve got the population growth as a headwind, but you have potential productivity as a tailwind.

David Stein (16:20):
And then the other major bearish thing is just all the uncertainty, is, will China allow companies to innovate and be productive or will they try to clamp down on areas that they feel are negative to the populace? Because the Communist Party their biggest fear is social uprising. They do everything they can to try to just… and someway smooth out the volatility, the volatility of the citizenry. And what we certainly have learned over decades as investors is when you try to clamp down on volatility usually there’s some type of unintended consequences, and China has been incredibly successful at balancing allowing for innovation while also trying to keep social cohesion.

David Stein (17:10):
But now some of the things they’re doing, even just stuff they’ve done in the past few months is incredible in let’s just say the crackdown on trying to tell production companies, media companies, “Don’t show this person anymore because we don’t like how they think.” Or ostracize famous people. And just this micromanaging thing, and this is a country of billions of people. You have a government micromanaging certain things from a social perspective, that you can do this, you can’t do that. And that can weigh on people over time.

Stig Brodersen (17:46):
David, let’s stay in the doom and gloomy world because it’s about to get worse here. Let’s talk about the debt situation in China. You have private non-financial sector debt of 222% of GDP in China. And let’s compare that to the U.S., 164% in the U.S., and that’s already very high. I don’t know if the right benchmark is necessarily the U.S. because that’s also high. So we’re really looking at this at a different level. We also look at specific companies. I know you’ll specifically look into Huarong, which was a company that was set up by China to purchase bank loans and it doesn’t look like it’s in good shape.

Stig Brodersen (18:26):
Another company that’s really… it’s all over the news here, that’s Evergrande. And we recorded this 27th of September. This goes out here at the end of this week. Could you talk to us about the debt situation perhaps specifically about those two companies, and what are the implications for investors interested in investing in Chinese equities?

David Stein (18:48):
Well, first off the debt. It is true that China’s private sector debt as a percentage of GDP is some of the highest in the world. Back in 2010, it was about 120% of GDP, now it’s over 200% of GDP, as you mentioned. But we also have to keep in mind that the Chinese economy’s per capita GDP is $10,000. If that debt is used productively to invest in infrastructure, to invest in technology, things that will allow the Chinese workers to produce more than that debt is serviceable. The overall debt isn’t so much a concern as long as it’s being productively used. And it’s just like in our own lives. If we go out and borrow and invest in our human capital by taking out a student loan, that can be a very good debt. If we’re taking out a bunch of debt to go on vacation or buying other consumption items, then that’s not great debt because it’s not a productive use of taking those potential future earnings and using them in the present. That’s one of the things to consider.

David Stein (19:56):
The other is that China Communist Party, controls the banks and so Huarong is a great example. This was a company set up by the Chinese government. There are reports it was buying 30 to 40% of the bad loans of Chinese banks. And I remember back earlier in my career we would research and recommend hedge funds so I would often go to New York and meet with hedge funds and just get their thoughts and get their ideas. And there was one Chinese-focused hedge fund or Asian-focused hedge fund and he was pounding the table. He mentioned, “People are so worried about this debt situation and they don’t realize that the Chinese government trolls the banks.”

David Stein (20:32):
And this is a great example. So they set up this company around, they’re buying all these bad loans and then the bad loans go bad. And what does the Chinese government do? They basically order state-owned enterprises, and this was just in August 2021, to bail out the company. And so the state-owned enterprises have stepped up and basically kick the can down the road, which is what often see when you have a debt crisis of course.

David Stein (20:56):
In the case of Evergrande, they are the largest property developer in China. They operate in over 250 cities. They’re building houses. Chinese citizens are putting deposits with Evergrande to buy these houses, but in China, their construction market, their housing market is much larger as a percentage of the economy than in other countries. And China government a year ago, regulators wanted to clamp down on the property developers. Because China has had great economic growth but that economic growth has come from infrastructure spending, it’s come from construction, it isn’t driven by the consumer. And one of the things that China has to do is rebalance its economy so it’s more consumer-driven, just like the U.S. is because that’s what successful developed economies have done. They become more consumer-driven.

David Stein (21:54):
Well, China has not. The household savings rate in China is 31%. In the U.S. it’s 14% because of all the stimulus, but typically it’s been five to 8%. So you have Chinese citizens that are saving 31% of their income mostly because there isn’t a big social safety net and it’s just how that economy is. And so what China did a year ago is they passed something called the three red lines, basically a mandate to reduce the amount of leverage in the property development sector.

David Stein (22:29):
And so Evergrande has spent a year trying to reduce its debt, and it actually has been able to reduce its debt. But when you’re a debt-fueled company, it takes a lot of effort to reduce that debt and now some of that debt is actually a risk because they’ve not been able to sell as many houses and you’ve got this pressure from the government. And it appears that Evergrande will need to be restructured, so then it’s a question, will this be a restructuring like Huarong where the state enterprises will step in, or there’ll be aspects that will be allowed to fail?

David Stein (23:04):
And one, at least indications are, and what’s different from Evergrande is they have $21 billion of foreign debt, so not denominated in the Chinese currency. But a big portion of their debt is these housing deposits. And again, China, they want social cohesion, the Chinese citizens if they get ticked off, they do, they don’t necessarily rebel but they do protest in their own way. And so more than likely these housing deposits that the Chinese had put deposits for new houses will be refunded. Potentially foreign owners of the bonds will lose money but China would like a gentle landing for Evergrande but the risk is, it isn’t, that there is a contagion, there’s fear. And we’ve seen this in the past but oftentimes then, just like in the U.S. and the central bank steps in to provide some liquidity, they cut interest rates, they do everything to calm things down so the fear is lessened.

David Stein (24:07):
And that’s probably what will happen here, but we’ll see. We do have a volatile Chinese market. But the debt is manageable, again is a bottom line if it’s used in productive ways and it’s used in a way that eventually the Chinese economy rebalances to be more consumer-focused.

Stig Brodersen (24:27):
I think it’s important to understand how significant the real estate market is in China and you could of course argue that… show me a country where it’s not significant, but it truly is. You have families in the States, they rely on real estate as savings, even to a larger extent in China that’s how you’re supposed to save up. That’s how it’s been done for generations. 20% of economic activity in China is from the real estate from builders to playoff pains, and so on and so forth.

Stig Brodersen (24:58):
It’s really important to understand that part and also, as you mentioned, David, a lot of those deposits are already made so you have that system to some extent but not for the same lead time in the west, and specifically for Evegrande’s 1.4 million private homes has already been paid for, and they’re just nowhere to be found. And so I can’t help but wonder, this is a company, the most indebted property company in the world, more than $300 billion in liabilities. Do you think there’s any probability that Evergrande collapsing would lead to a stock market crash in China or even spread?

David Stein (25:34):
Well, it’s possible but it could be a catalyst, but we don’t know. When you see the pattern in China in the past, because people are talking about this is their Lehman moment, this is where the Chinese government lets a too big to fail company fail. And yeah, I don’t see China doing that and I don’t have any insight, obviously. But just based on their pattern they might let the foreign bonds default. They will more than likely not return those housing deposits.

David Stein (26:02):
But one of the problems with companies like Evergrande and other property developers is that we’re at a tailwind of 25 years of growth in the housing market. You’re not seeing… The population isn’t growing like it was. One of the things… people talk about is the housing market in the U.S., that it’s in a bubble. Well, there’s a shortage of housing in the U.S. If you look at the household formations every year, there’s about a 3 million shortfall of dwelling units in the U.S. In the home construction companies, the home builders are not houses. Because that’s what drives the housing market, it’s households formations, it’s people married, forming a house or partnering and wanting to establish a household away from their parents.

David Stein (26:49):
If you look at China, there were 31% fewer marriages in 2019 China than there were in 2013. So you don’t have the same level of household formation. We already saw some data showing the working-age population as a percent of the total, so you don’t have a bubble but the housing growth. It’s slowing and maybe that’s why the Chinese government was saying, “Property developers you need to reduce your leverage because we see where the demographics are going.” But overall, again, the Chinese government doesn’t want chaos, they want social cohesion.

David Stein (27:26):
And they have stepped into the stock market before and provided liquidity and other things potentially that will happen here, so we’ll see. But it’s not systematically like Lehman was that led to that contagion because that was much more global. The Chinese housing market is much more just centered in China. There’s less interconnectedness around the world than you saw with the housing crash and the Lehman, the fall back in 2008 in the U.S.

Stig Brodersen (27:59):
On top of all of this, for some period of time now there have been talks about the U.S. potentially delisting Chinese companies. And so what happens to us if we, say, bought stock in Alibaba or perhaps another company through an ADR bought on U.S. exchanges but in Chinese companies?

David Stein (28:19):
Well, there are two things going on. When we’re going to talk about delisting companies, back in November 2020 the Trump administration issued an executive order basically saying that Chinese companies that are listed in the U.S. that have ties to the Chinese military will be delisted. And they came out in January 2021 and said there were 31 companies. Some of them like China Telecom, for example, some very large companies that were delisted, so you can no longer buy them on New York Stock Exchange or other U.S. exchanges.

David Stein (28:54):
That’s different from what we’re seeing with Alibaba and these other companies that also trade as ADRs in the U.S. China, when they reopened their stock market, there were certain sectors that restricted foreign ownership of the companies, and the tech sector was one of those sectors. But this is back in the early to mid-2000s, companies, private companies, tech companies for a start for capital, they wanted to raise capital and they used an obscure method that had been used in the past. Enron used the same method, it’s called a variable interest entity, or a VIE.

David Stein (29:38):
And what it is, is a company will money overseas, such as the Cayman Islands, and then they’ll issue stock in, let’s say the U.S., listed on the New York Stock Exchange. They’ll form the company that came in the Cayman Islands, they’ll list the stock, raise capital in the U.S., but the actual intellectual property, the operations of the company is based in China. But that company is not owned by the Cayman Island entity, it’s not owned by the registered security, the stock in the U.S., it’s owned by individuals, often founders of the companies in China, in their name. All that exists is a contractual agreement between the offshore entity and the individuals in China that they’ll pass on the earnings or pass on revenue.

David Stein (30:30):
And FASB, the U.S. accounting body, has ruled that… They’re close enough that they can consolidate the financials, but in reality, legally, they don’t have any standing in China, and we saw this in July. One of the big venture-backed industries in China was online tutoring where billions of dollars were raised. And they use this structure. They raised money overseas, they listed in the U.S. as VIEs and China came out in July, again, with the idea of social cohesion because you have millions and millions of students taking these college entrance exams. It’s extremely competitive. Parents are paying for tutors, online tutors, online tutoring classes. So this is a big billion-dollar industry and China comes out and says, “This industry will go nonprofit and we will not allow online tutor companies to raise money through VIE or raise any money at all because you’re no longer a for-profit company.

David Stein (31:30):
And what happened was those VIEs as ADRs, these online tutoring companies trading in the U.S., fell 90% immediately because they don’t have a legal means, because they set up these VIEs really to skirt the rules to avoid these foreign restrictions. And so they’re still listed, you’re going to still buy the company so the enemy did listen. It’s just that it’s not worth anything because the actual company itself, the operations are in China and now they’re not even for-profit. And so one of the fears is that China will crack down on more of these VIEs because that’s how Alibaba and these other tech companies are set up, there are be VIEs. The operations in China are owned by individuals, so not owned by the company itself.

David Stein (32:16):
And China has come out this summer and told Tencent and told Alibaba that they shouldn’t focus exclusively on profits anymore, that they have other missions in terms of just keeping the social cohesion, making sure that… Help with income inequality within China and other things rather than a pure focus on profit. And as a result, you’ve seen some big sell-offs in Alibaba and some of these other tech companies because of the uncertainty. They haven’t said you can’t be a VIE anymore but certainly China has cracked down on these companies, and I’m sure we’ll talk a little bit more about that.

Stig Brodersen (32:55):
I think that’s a good segue because that specifically talked about everything that’s happening in the tech sector. I think for here in the west, or perhaps the U.S., primarily me being a shareholder in Alibaba, which I was at the time, I was very much looking forward to this year. It was November 2020 and you had this IPO, Ant financials. This is an affiliate company of Alibaba and among its many assets, they have China’s largest digital payment platform, Alipay. This is a massive, massive system, more than a billion users, 80 million merchants.

Stig Brodersen (33:27):
And so just if you were raised before it was just like, no, it’s not going to happen and the world was like, “What? What is going on?” And so, could you please, David, walk us through what happened back then and then to today. What is happening in the tax sector from an investing and regulatory perspective?

David Stein (33:46):
Well, at first Alibaba, for example, I think you had discussed it back in 2019, it was a good deal, $165 per share for the ADR. It got up to $317 in October 2020, but then Jack Ma and the Ant Group were going to do their IPO. And you’re right, the Chinese government said, “No, you’re not.” And this was the first pushback against some of these tech companies which control a large part of the financial system. And Alipay is very commonly used as a payment mechanism. Alipay and Ant had loan products that you could borrow money and one of the struggles in China right now are who is going to control the financial system. And if you have what are known as shadow banks, shadow banks are non-traditional banks that perform a banking-like function and Alibaba is an example of that, or these pay apps or the ability to borrow from another company. Apple Pay is a shadow bank effectively.

David Stein (34:48):
And so that was the first push. And then they scrapped the IPO. And then just this month or last month, China came out with Alibaba and Ant and said, “You’re going to have to split off your loan portion of your app of the payment app into a separate app, and we were going to be co-owners of your new company and your new app. And we want your data that you have on all these Chinese citizens and their borrowing habits and everything, basically your algorithm that you’re using to issue these loans.” And so you see Alibaba fall 54% since last October.

David Stein (35:29):
And, well, if you look at valuations, Alibaba is cheap. It has been in five years on a price to cash flow basis, price to sales, price to earnings, but you have this huge uncertainty because now you have the government saying, “You’ve gotten too powerful and you control too much of the financial system, we want a stake in that, and we’re going to force you to do that.” And that’s what you’ve seen. If the Chinese government wants something, it’s like we’ve seen online tutoring, they’ll make it happen. There are private schools in the Financial times’ Report in China that because China didn’t like the percent of the populace that was going to private schools instead of public schools, their solution was to tell hundreds of private schools around the country that you’re now a public school, you’re not profit, and we own you, and didn’t give any compensation for that.

David Stein (36:25):
That’s the kind of thing going on and it’s hard. It’s two systems here. You have very entrepreneurial companies, innovative companies like Alibaba, Tencent, that were given free rein to innovate and now they’ve gotten so powerful and big that China said, “No. You can’t just focus on profit anymore and we want a piece of the action because we want to control the data,” and you see the same thing in the crypto space. It’s, who controls the legal tender, who controls the financial system, and that’s why these companies have been cracked down and we don’t know how it will end. Yeah, Alibaba is cheap, but what’s it going to look like a year or two from now?

Stig Brodersen (37:03):
That’s such a good point. It does look cheap but what are you buying? I think that’s the big question. And just for the record now that we are talking about that, I pitched this back in, I think it was Q3, mass buying, a discussion I am adding to our position now. The price is trading 145. Just know all my biases as I continue with the rest of this interview. But clearly, the company isn’t as valuable as it was some time ago simply because the outlook has just dramatically changed. And people might listen to this and they’re thinking, well it’s Alipay, it’s an app, what’s all the fuss about?

Stig Brodersen (37:38):
But it’s really such an integrated part of society that it’s really difficult to explain. And how could you come up with this… It seems like a silly analogy, or I don’t want this to come off as disrespectful when I’m saying this, but just to give you an example, Alipay and WePay, WePay that’s owned by Tencent. They’re such a common method of transferring money and fiscal cash is just so non-existent that you have beggars on the street in bigger cities, they have QR codes that are laminated with their ID for WePay and Alipay. And again, I don’t want to sound disrespectful as I’m saying is because it’s not like Mendez Entertainment, but it’s just to say it’s so ingrained into society and the Chinese government does not want that control to be in the hands of people like Jack Ma to rival the government.

Stig Brodersen (38:29):
You mentioned here before that you had several companies, most noticeable Alibaba and Tencent who have been encouraged to contribute to common prosperity. And let me just put you’re encouraged in quotation marks. I’m pretty sure this is what’s going to happen, there wasn’t an opt-in system. And we’re talking about fines hereof, for Alibaba, it’s $15.5 billion, for Tencent it’s 7.7. And this is for a number of years, I think for Alibaba it’s five years, but what’s the intention behind come prosperity, and should we as investors look at this as a pure penalty for regulators that are not going to yield any type of return if we invest in, say, Alibaba?

David Stein (39:12):
Well, the point is to reduce income inequality. And so to come up with ways, like China, for example, has encouraged firms, wealthy individuals to make charitable contributions and you’ve mentioned some of the big dollar amounts. Part of this common prosperity is just do things that seem like taking the economy or the country and then the way that the Chinese leaders want. For example, a crackdown on online gaming occurred this year and there has been a crackdown on celebrity fan clubs. There has been a crackdown as they blacklisted actors that have incorrect views on the Chinese government opinion, so basically, anything that appears to be opposite of social cohesion, that isn’t what the Chinese government wants.

David Stein (40:03):
They’re offering weekly classes to elementary school students on Xi Jinping thought like the thought of the Chinese premier. You could say these contributions by wealthy companies, however, it’s just like taking on debt. If it actually does improve society improves social cohesion. I suppose that could be helpful but certainly investing that money in productivity-enhancing improvements and innovation is going to be better off for shareholders of Alibaba and now they’re not. And so that I think overall it’s not great for the stock market, but there’s a lot more going on in China and than just the stock market.

David Stein (40:47):
And that’s why China is trying to make these changes so that things move in the direction that they would like but oftentimes, and we’ve seen this in other countries. I was in Cuba in 2017, another notorious communist country with a lot of centralized planning, much, much poorer than China. But just talking to individuals, they want to be entrepreneurial. They want to have their own business. They want to do those things and it sometimes it can be very frustrating when they could. And I saw some of that frustration that at least some that they could express to me. So if the Chinese government pushes back too much, you could also see frustration from citizens where, well, we actually want more choice.

David Stein (41:33):
That doesn’t seem to be the case yet. But if let’s say a contagion happens or there’s a crisis, the Chinese citizens, they do protest. I mean, they get on Weibo and others, they will protest. Any controlling government’s biggest fear is to lose the faith of their citizens and then China doesn’t want that and they fear that. And one way they react to that is to try to put down anybody that seems like they’re getting too popular.

Stig Brodersen (42:02):
David, I remember whenever I was looking at big tech some years ago, at the time I was confident that China would have a leg up over the west in the AI race because the Chinese companies were allowed to collect more data, it seems, because your data is your commodity, your raw material. So they had a leg up compared to the States. And you could even say that the U.S. had the same thing with Europe where you’re not allowed to collect as much data.

Stig Brodersen (42:30):
Now, it’s become a bit more complex for me to analyze because whereas you are still allowed to collect a lot of data in China that you can as well do in the west, the Chinese government said that needs to be a market for data. It can’t just be for that specific company. Its economies traditionally have looked at four factors of production, land, labor, capital, and then entrepreneurship. But now it seems China wants to add a fifth factor of production, which is data and you need a market otherwise it can’t be a factor of production. I’m not sure what to read into this. It could look like the individual company might be more challenged, but perhaps Chinese companies will all would still have a leg up. I’m not really sure how to read that situation, so I’m curious to hear your thoughts.

David Stein (43:20):
Well, I still think we’re in the early days of AI. There is so much more training that needs to be done, so much more data than we need to actually have things produced based on AI. And so, I mean, we’ve seen some, certainly the loan products, it can be AI-based, figuring out who’s going to default or not. But I think where you are in the early days of the AI revolution, and we’ll see whether the Chinese way of going about it where it maybe it is more common data or the U.S. where you actually you are seeing even in the U.S. pushback on data collection with Apple’s… Some of their privacy and enhancements and how that all is going to work in their battle with Facebook. It’s fascinating to watch but I still think we’re in the early days to see how it evolved, to see if there are actually even more effective uses for AI that actually enhance the lives. Not just the profits of companies but actually enhances the lives of individuals.

Stig Brodersen (44:15):
In 2002, the United States Secretary of Defense Donal Rumsfeld famously said, “There are no knowns, known unknowns and unknown unknowns.” Listener, please stay with me here as I’m going through this. By definition we do not know the unknown unknowns, but what are the known knowns and the known unknowns when investing in China?

David Stein (44:39):
Well, the known unknown is that you can’t trust the data coming out of China, the official economic data, for example. And one of the things that I do is, for my research service I subscribed to Capital Economics and they do a Chinese proxy. They’re basically, if you’re an economist, in the U.S. you can get data issued by the U.S. to know how GDP… It’s always an estimate but it’s as accurate as it could be. In China when the official GDP number is released it’s massaged.

David Stein (45:09):
Now, generally, the trend is probably fairly accurate but any given year or quarter, maybe not so, and so as an economist you actually have to use other data sources to estimate what the official numbers are and the directions. And that’s always a challenge in investing in a country where you can’t even trust the economic data, which makes it very, very difficult to do.

David Stein (45:32):
And even the entire structure, this VIE structure. I suspect most people have no idea if they’re investing in Alibaba, that this is a VIE structure. And technically the ADR that trades in New York doesn’t own anything, that it doesn’t have a contractual right to physical property or intellectual property in China, that doesn’t exist. And if the Chinese government just said, “Alibaba, you will be a not-for-profit and you no longer can raise capital via VIE,” just like they did for the online tutoring company, then Alibaba is going to go from $150 per share down to 10 quickly. And that’s the risk of investing in China. So we talk about the unknowns. We don’t know ultimately what the Chinese government is going to do. You just don’t have the same rule of law, it’s not the same rules at all that you can get at least the confidence that you can in other countries. Now, all countries pass legislation but you can see the process playing out and then can make your adjustments along the way.

David Stein (46:44):
With China, you don’t see it. It’s just boom, online tutoring companies are not-for-profit, stock falls 90%. And that’s the biggest risk of investing in China. It’s that unknown and the whimsy that just things come out of the blue. The Ant IPO, out of the blue, two days before, no, you’re not going to do an IPO. And that makes it very, very difficult to invest which is one reason why the Chinese stock markets should be less expensive than the U.S. stock market. I would argue that the Chinese stock market probably should be even cheaper than it is now, closer to the valuations we saw in 2012 to 2014 as opposed to where they’re at currently.

Stig Brodersen (47:25):
I think you bring up a great point, you really need to be aware of the risk. And you have so many bureaucrats right now in China assuring foreign investors that, no, you’re not going to see you more crackdowns, you’re not going to see bad stuff happening. And it just seems like that trust, if there ever was one, that has been eroded. I think everyone expects something worse to happen, and perhaps they can eat into your margin of safety.

Stig Brodersen (47:55):
But, David, a known unknown for me, and I’m shifting gears here a bit, but I can’t help but ask now that you joined here on the show, because a known unknown for me is China’s new digital currency. This was something that was unveiled back in 2019. And this digital currency began its trial in April 2020 and has slowly been rolled out in the major cities. This cyber yuan stands to give Beijing power to track spending in real-time, plus its also money that isn’t linked to a dollar-dominated global financial system. I’m not sure what to make of this. Do you have any thoughts on the currency itself but also whether or not it has any implications for us as investors?

David Stein (48:38):
First, we have to step back and think about the types of money that there is. For example, in China, the U.S., there’s the actual currency that the bills, the coins, they are liabilities of the central bank. In the U.S. the U.S. dollar is a Federal Reserve note. And we can use it, we can buy things with it, but most currency is actually created by the banking system as they make loans. In the U.S. 90%, digital currency, including, it’s private, it’s created by the banking system. Now, it’s still it’s called a dollar, but it’s actually a demand deposit against the private banking system.

David Stein (49:22):
The third type of currency is what is known as central bank reserves. The only people that can access that right now are the private banking system. The Chinese banks they’ll have some reserves. Basically, they have an account at the PBOC, the People’s Bank of China. The U.S. banks have accounts at the Federal Reserve and as part of QE and other things they have these reserves, which are basically their liabilities of the central bank. Just like the currency is a liability the bills and notes are a liability of the central bank as reserves are liabilities of the central bank.

David Stein (50:02):
What individuals don’t have in China nor in the U.S. and other countries is we don’t have access to those central bank reserves. We just get these notes, the coins and bills, and what a central bank digital currency will do. It will allow individuals and businesses to have access to central bank currency, the central bank for every power to create as much currency as they want. So you don’t have to worry about if you have a liability at a bank, or you have a deposit at a bank, we need government insurance to protect against that bank going bankrupt.

David Stein (50:38):
If you invest in BlockFi and put money at a BlockFi cryptocurrency lending, there is no insurance there which is why they have to pay 8% interest. But we don’t have access to central bank reserves at the base level of currency other than just holding notes and coins. We don’t digitally get to hold central bank currency. And what a central bank digital currency like China’s Central Bank’s experimenting with is exactly that, the ability to have access to a digital version of the yuan or a digital version of the dollar that’s not actually a liability of a private banking system, it’s a liability of the central bank. And will we be able to make payments and have the payments clear through the central bank? We don’t know how it’ll be structured. Will we have an account at the central bank that we can earn interest on our central bank digital currency?

David Stein (51:38):
I think we’re very much in the early stages, but China is leading the way because there is Alipay. You have this huge tech companies controlling a big portion of spending and transactions and they have the data, and China wants to push back against that. They wouldn’t want to control who owns the currency, who controls the currency. And part of that solution is the central bank digital currency and part of the solution is telling, and this just came out last week, where the People’s Bank of China said it’s illegal to transact and own in cryptocurrency, in Bitcoin and others, and you’ve seen Bitcoin cellar.

David Stein (52:22):
And that’s part of this whole battle, is who’s going to control currency that is being used? And China wants control of their currency. They don’t want some tech company, they don’t want a private bank sector controlling it, they want the data and they want to control and they’re going to issue more than likely a central bank digital currency to facilitate that. Now, will people use it? Because they’re used to. As you point out, they’re used to using Alipay and these other payment apps.

David Stein (52:49):
So one of the questions is what actions will the Chinese government take to discourage the use of Alipay and to use the central bank’s digital currency? And will they go as far as to say, “Alipay is now not legal, and you can no longer use that? You have to use the central bank digital currency?” And that’s one of the, I guess, that would be a known unknown. We don’t know.

Stig Brodersen (53:12):
Good point. And one thing that they can do with this vehicle and they have, is to give people free money just to get in the hands of people and just for them to get started. It’s a disturbing experience of what’s happening right now. But, David, it’s been really great talking about China, your bear case, a bull case, so let me see if I can sum that up here in my final question for you. How should investors think about whether they should invest in China, and if the answer is yes, could you talk to us about position-sizing, which considerations to make?

David Stein (53:46):
The simplest way to invest in China is to own a global stock market ETF such as Vanguard’s total global stock market ETF, VT. It’s about 4% China. In that case, if things were down in China, China will become a bigger percent of the global stock market, and investors will participate in that. And that’s one way that I participate. If you actually want to invest in emerging markets directly, developing markets, if you buy something like the Vanguard, emerging markets ETF, VWO, in that case, it’s a pretty big bet, it’s a 40% bet in China.

David Stein (54:21):
And the approach that I’ve taken is I like emerging markets, I like the lower valuations of emerging markets relative to the U.S. I have exposure, for example, to an ETF like the Wisdom Tree Emerging Markets High Dividend ETF, where, because it’s focusing on higher dividend-yielding stocks, its weight in China is only about 20%. So there are ETFs out there that have an allocation to China but it’s not a big weight. And I find ETF asset class investing… I just prefer that over buying individual stocks. I think people can buy individual stocks if they like doing the research.

David Stein (55:01):
I just, I’ve spent so many years researching hedge funds and money managers looking at their investment process, I just realized I don’t have an informational edge. I don’t know what’s going to go on with Alibaba. I can look at drivers of economies. I can look at valuations of economies and stock markets and take positions that way. And so I tend to… For example, I have a big overweigh in India, because if I look at the working-age population growth expectation for India, it’s one of the highest growth rates in the world and does seem to be a little more receptive to capitalism than you’re seeing in China right now. And your stock is a lot more expensive than China so I’ve also used some active funds for active managers that are on the ground in India trying to figure this thing down.

David Stein (55:47):
I don’t think there’s one way to do it. I think sometimes a passive approach can be helpful. I think using an active fund to let them figure out which Chinese company or which India company to buy. I think individuals can do their own research too if they’d like to do that and they find they have an informational edge to add value. Those are the ways to do it, passive, active, or just go on your own and take your own company.

Stig Brodersen (56:11):
Wow. David, thank you so much for joining us here on the show. With everything that’s been going on it’s just so great to have a chance to speak to you and for you to simplify for all of us what is going on in China right now. David, whenever people ask me which podcasts to listen to, your podcast is one of them that I mention. I want to just say here to the audience, go check out Money for the Rest of Us. It’s an amazing podcast. I’d like to give you an opportunity to tell the audience more about the resources, where they can find you, and more information about you.

David Stein (56:44):
The podcast is called Money for the Rest of Us. We’ve been doing it for almost eight years now. And there’s also a YouTube channel, so Money for the Rest of Us. On the website, moneyfortherestofus.com there’s some free investment guides so people can learn about different asset classes and we’re always updating those. There’s different ways that you can sample some of the content that we produce on our site and podcasts and I welcome you to check it out at moneyfortherestofus.com.

Stig Brodersen (57:12):
Fantastic. Well again, David, thank you so much for coming on the show-up. I hope we can invite you back one day.

David Stein (57:18):
I’d love to come back. Thanks.

Stig Brodersen (57:20):
Fantastic. All right. As we’re soon leaving here, David, go here make sure to follow us on your favorite podcast app and if you’re watching this on YouTube, make sure to subscribe. We will be back next week with a new episode of The Investor’s Podcast.

Outro (57:35):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.


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