Climbing The Great Wall of Worry (Again)

The Spectator recently asked me to contribute an article on China for its investment section.  You can read it here, with some subsequent comments of my own at the end.

One tried and tested rule in investment is that the bigger and more widely shared the worry, the less likely it is that the concern will be realised. Remember Y2K and the Sars epidemic? Both produced warnings of apocalyptic disaster on a global scale. Neither turned out to be anything like the threat in reality that doomsters had originally predicted.

Contrast that with the sub-prime banking crisis, whose dimensions only became popularly apparent some time after the crisis had already broken. In the years when investors should have been worrying about the uncontrolled lending habits of the biggest banks, most were too busy loading up on anything they could buy with cheap credit to take any notice of the impending disaster that their own insouciance was helping to bring about.

On this measure, if nothing else, investors considering putting their money into Chinese shares today should not have much to worry about. In the media, and in dealing rooms around the world, whether China’s economy is overheating and the Chinese stock market moving into “bubble” territory have been popular topics for months. Industry data shows that foreign investors have been pouring money into funds that invest in China for some time, reinforcing the increasing involvement of domestic Chinese investors.

The amount invested in China funds doubled in the course of 2009, driving the Chinese stock market higher, and prompting concerns that it could crash for a second time, just as it did in 2007-08, when the Shanghai Composite Index fell by 70% in 12 months. Market pundits such as Jim Chanos, a New York hedge fund manager, and economist Nouriel Roubini, both notable for being among the few to predict the global financial crisis, have lent their support to the proposition that China could be the next big stock market “bubble”.

On the other side of the argument are those, such as Jim Rogers, co-founder of the Quantum fund, or Jim O’Neill of Goldman Sachs, who argue that what the world is witnessing in China is a spectacular change in economic status that offers investors opportunities on the same scale as, say, the United States in the late 19^th/early 20^th century. Those who focus on the short term risks –corruption and cronyism, the lack of transparency, dodgy accounting, intrusive government – are, they say, simply missing the point.

After 30 years of rapid growth, the Chinese economy is poised to overtake Japan this year as the second largest economy in the world, and in two decades or so is likely to catch and overtake the United States as well. While there is no guarantee that economic growth will produce correspondingly high returns for investors, a point that is reinforced by numerous historical studies, it does not mean there won’t be many moneymaking opportunities in the years ahead.

The United States in the early 1900s, says Rogers, are “right where China is today - a Wild East compared to the Wild West”. Investors should not lose a sense of perspective. “Imagine how uncertain America’s world appeared to the world in 1908. China seems just as fraught and chaotic and fraught with challenges today..…In 1907, in fact, the US economy collapsed and the naysayers were jubilant. But even those who bought at the top [of the stock market] came out way, way ahead” over time. In other words, even if the Chinese stock market were to fall again by 50%, which it could well do periodically in the years ahead, those with the patience and the nerve to see it through could still be considerably richer than when they started.

This ongoing debate has been fanned afresh by the news that Anthony Bolton, arguably the most successful investment manager in UK history, has been tempted out of retirement to manage a new China fund for his employers, the giant American fund management group Fidelity. His China Special Situations fund is looking to raise $1 billion, some £650m, from UK investors between now and the end of the current tax year.

That makes it the largest investment trust launch in UK history, and as befits Mr Bolton’s reputation is being given the full-on marketing push that only the largest global fund management groups can muster. As well as blanket advertising in the media, this includes making commission payments to brokers, dealers and bankers who recommend the trust to their clients, something that is rare for an investment trust launch (although standard practice for unit trusts and other types of funds).

With Mr Bolton pinning his reputation on its success, and Fidelity taking no chances that it will fail for lack of marketing effort, nobody seems to doubt that the fundraising will meet its target. The question is what happens after that. Could the Chinese fund conceivably prove to be a success to match that of his UK and European funds, both of which produced exceptional returns over a long period? £1 invested in the UK fund grew in value 160 fold over the course of Mr Bolton’s 28 year tenure as fund manager, beating the UK stock market by an unprecedented margin of 6% a year.

Could he repeat the trick this time round? One obvious problem is that while he is uprooting his family to move to Hong Kong, Mr Bolton has only committed to run the new fund for a minimum of two years, leaving what happens subsequently open to doubt. Another is that he does not speak Chinese, or indeed any foreign language, and will need to rely on his local colleagues for scuttlebutt and face to face dealings with the management of local companies if they do not speak English (though many do).

There are unhappy precedents of similarly high profile funds being launched and then coming a cropper. The fund industry has an unfortunate reputation for tapping private investors for money when it is easiest to do so, rather than when it is in the investor’s best interest. Typically this means after a particular market or sector has had a spectacular run of good performance, which by its nature increases the likelihood of future disappointment.

The sceptics argue that this could be just such a time as far as China is concerned. The Chinese stock market is still at barely half the level it reached at its peak during the speculative run up in 2008, which is a long way from any sensible definition of a bubble. Yet several well respected professional investors who have managed funds in Asia for many years, such as Angus Tulloch at First State Investments in Edinburgh, or Hugh Young of Aberdeen Asset Management, have been urging caution.

With the Chinese authorities now attempting to rein in the spectacular lending spree that Chinese banks were ordered to embark on in the autumn of 2008 (a commandment which, unlike Gordon Brown’s pitiful attempts in the UK to prod the banks into lending more, the banks have implemented with frightening efficiency), their argument is that Chinese shares have run ahead of themselves and look vulnerable to China’s new monetary squeeze. This may not therefore be the best time to be moving into the Chinese market.

While he is well aware of the risks, Mr Bolton remains undaunted and indeed enthused by his new venture. He has no financial need to return to fund management and the decision to put his reputation on the line in a country that he has only got to know in any depth over the last few years reflects his confidence that hunting for undervalued companies in China will prove to favour his contrarian stockpicking style.

If the timing of the launch is not perfect, in his view there is no compelling evidence that the Chinese market is seriously overvalued. One comfort for sterling investors, he points out, is that that the Chinese currency is sure to strengthen, even if nobody knows exactly when or how the Chinese authorities will sanction the move. When that happens it will boost returns to sterling investors, which are likely to be considerably higher than those on offer from mainstream equity markets in the UK and US.

An important consideration in taking the plunge into China, Mr Bolton argues, is that with GDP of $6,000 per head, China has now reached the point at which, historically, developing countries have entered their fastest period of economic growth. If past precedents are anything to go by, this will also be the period during which an emerging middle class will embrace the consumer society, leading to the rapid appearance of many profitable new businesses in sectors such as retail. While the risks of corruption, collusion and political interference are all too real – many of the largest companies listed in China are former State-owned enterprises - he reckons he only needs to find a relatively few big winners to generate above average long term returns.

The track record of Chinese funds is impressive enough to give some credence to sceptics about the timing of Fidelity’s launch. Most China funds have delivered five-year returns of between 10% and 20% per annum, notwithstanding the emerging market meltdown in 2008-09. Many of the funds with longer track records have doubled their investors’ money, albeit with considerable volatility. Over the last ten years Wall Street and the London stock market have by contrast returned next to nothing.

The one certainty is that the Chinese stock market, like Wall Street in the early 1900s, will be volatile for many years to come. Those with a limited tolerance for that kind of risk should obviously steer well clear. For those who understand the nature of the beast, whether they buy into Mr Bolton’s new fund now, or wait for a better opportunity to invest in one of the many other readily accessible China funds now on offer, the upside remains considerable.

Update/latest view: A number of financial advisers appear to be cautious about investing in the new Fidelity China Special Situations fund run by Anthony Bolton, preferring to wait and see how the launch plays out before committing client money. Their worry is that the Chinese economy may be overheating and this is not the best time to be putting money into an untried fund. The argument on the other side is that  Mr Bolton, though a relative novice in China, is a tried and tested  stockpicker whose methods are well suited to exploiting anomalies in an emerging and inefficient market – a good bet for risk-tolerant investors with long term horizons.

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The Great Wall of Worry (FT Column)

If my experience is anything to go by, few recent events in fund management have aroused as much interest as Anthony Bolton’s decision to return to full-time investment management with a new China fund for Fidelity. By doing so he seems to be breaking Jeremy Grantham’s golden, and all too well evidenced, rule that the biggest dynamic shaping the fund management business is career risk (avoidance thereof).

Why on earth is such a celebrated stockpicker taking a chance with a new venture that could so readily backfire and jeopardise the remarkable reputation that he has spent 30 years acquiring? After all, when Mr Bolton retired at the end of 2007, his track record was second to none. His Special Situations fund outperformed the FTSE All –Share index by an extraordinary 6% per annum over a period of 28 years. The European fund he ran for 13 years until 2003 also beat its benchmark by a handsome margin.

Having timed his exit from fund management with impressive prescience, handing over his Special Situations fund just in time to avoid the savage 2007-09 bear market, it is certainly a high risk strategy to come out of retirement and launch a new fund whose mandate is to invest in what many believe to be an already overvalued emerging market on the other side of the world of which he has only limited knowledge and experience.

Mr Bolton speaks no Mandarin or Cantonese and by his own admission has always been terrible at foreign languages. He won’t be learning the mother tongue of the country in which he will now be spending his time looking for investments. By any stretch of the imagination, this is what Sir Humphrey of Yes Minister fame would have called a “brave decision”.

The prospectus for the new closed end fund will be published this week. The target Fidelity has set for the launch is raising $1 billion. This makes it not only one of the biggest investment trust launches of all time in the UK, but ensures that if it fails it will do so in the most visible way – career and reputational risk, in other words, on a grand scale.

Nobody who knows him will assume that Mr Bolton is taking on his new venture lightly. It is a safe bet that the timing of his China fund launch has been carefully considered. The idea that he is moving to Hong Kong solely to take advantage of a lower tax regime, however appealing that may be to a citizen of the near bankrupt UK, does not stand up to scrutiny. Nor, despite the huge marketing push behind it (Fidelity is paying trail commission to intermediaries for the first time on an investment trust launch), is it credible that he has been somehow bullied into running the new fund to boost his employer’s flagging UK sales.

Having first taken an interest in the Chinese equity market several years ago, there is no question in my mind that Mr Bolton’s enthusiasm for the stock picking opportunities in China is genuine. While he has only committed himself to two years running the new fund, something that makes many advisers nervous, it is inconceivable to me that he would abandon the fund in the event that the Chinese stock market were to crash, as many sceptics seem to think is likely.

Having interviewed him recently for Independent Investor, I suspect that Mr Bolton regards talk of a bubble in Chinese stocks not as overdone – clearly, it could happen any time – as somewhat beside the point. It is inevitable that Chinese stocks, like all emerging markets, will be more volatile than developed markets, but that is part of the price you pay for potentially exceptional returns. If the market does fall a lot, it can also rebound even more strongly. By choosing a closed end structure, Fidelity is presumably guarding against such an outcome.

For all the talk of a bubble, the Chinese market remains at barely half its all-time high; its economy is poised to reach the level of GDP at which historically an emerging economy makes a decisive shift towards consumerism; the stock market is far from efficient; and the currency over time is a near certainty to appreciate, providing a built-in safeguard for UK investors. All these are positives for any investor prepared to look beyond the very near term.

In advance of the prospectus, it is impossible to judge how well the new fund will perform. What can be said for sure is that Mr Bolton is staying true to his own principles. 30 years ago he concluded that the only way to outperform the market was to do something different from the market. That, after all, is what being a contrarian means. Whether it succeeds or fails, the new fund guarantees that his name will be remembered long after many lesser mortals have taken their consensus thinking and risk aversion to the grave, lamented by few.

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Pricking China’s Bubble Won’t Be Easy

I share the view of my friend and colleague Edward Chancellor, the financial historian now working for Jeremy Grantham at GMO,  that it will take more than one interest rate rise by the Chinese authorities in order to prick the blatant bubble that is developing in Chinese real estate and the less obvious one that may be developing in the Chinese stock market. You may find it interesting to compare Edward’s view in his latest Financial Times column with that of Angus Tulloch (posted at the weekend) and the interview with Anthony Bolton that I expect to post tomorrow. What happens in China matters because what the authorities do there is most likely to be echoed before long by their slower moving Western counterparts.

By Edward Chancellor

Recent moves in Beijing to tighten lending conditions have spooked Chinese investors. Given that easy money fuels asset price bubbles, it is tempting to believe that the withdrawal of liquidity signals an imminent end to the good times. However, history suggests that once a boom has got going, it takes several sharp blows with the monetary cudgel to extinguish the speculators’ animal spirits.

Around the middle of January, Beijing made clear that it wanted to bring to a halt what one regulator described as a domestic lending “binge”. Admittedly, this declaration only took place after a pick-up of lending in the first two weeks of the year, which saw more than Rmb1,000bn (£90.7bn, €105bn, $146bn) of new loans originated. This rate of lending growth was some three times higher than last year’s already inflated levels.

Several banks have apparently been ordered to suspend all new loans. Credit Suisse reports that letters of credit have suddenly been withdrawn. “Mortgage lending has been virtually suspended,” claims the investment bank, “leading to a slowdown in property transactions”. The Shanghai Composite has swooned in sympathy.

This lending diktat coincides with other measures, including an increase in bank reserve requirements and stricter mortgage rules, to tighten credit conditions in China. Beijing apparently wants to control the various real estate bubbles that are popping up around the country. Home prices in the coastal regions were up more than 20 per cent in the last year. Despite low interest rates, new homebuyers in Beijing are spending up to 70 per cent of disposable income on servicing mortgages, says CLSA. High end property sales more than doubled in 2009, says the brokerage firm. A large portion of these purchases were made by investors.

The lack of affordable housing is fast becoming a political issue in the capital. A popular television drama, Snail House, which deals with the travails of “mortgage slaves”, has recently been taken off the air. Furthermore, inflation is picking up, hardly surprising given that the money supply growth approached 30 per cent towards the end of last year. In theory, tighter monetary conditions should raise the cost and limit the supply of credit, thereby helping to cool the financial markets. In practice, however, great booms tend to continue long after policy has become restrictive.

For example, the Federal Reserve raised interest rates in January 1928 with the intent of halting speculation on the Big Board. Despite this, US stocks rose by a further 70 per cent over the following 20 months before finally peaking in September 1929. The end of the tech bubble followed a similar course. Although the Fed Funds Rate was increased in June 1999, the Nasdaq nearly doubled over the following 10 months. Other stock market booms have likewise continued long after tightening commenced.

Real estate booms appear even less responsive to the initial tightening. In 1989, the Bank of Japan started a series of five hikes that saw interest rates climb from 4.75 per cent to 6 per cent. Although the Nikkei peaked towards the end of the year, Japanese commercial real estate continued rising until late 1990, by which time land prices had risen a further 45 per cent.

The recent US housing bubble also took a long while to cool. The Greenspan Fed raised rates in June 2004. Some 24 months and 16 rate rises later, US home prices finally ground to a halt. The S&P/Case-Shiller Composite Home Price index had climbed 25 per cent since the first rate increase.

The last time the Chinese authorities attempted to deflate an asset price bubble was in January 2007. At that time interest rates were raised, bank reserve requirements increased, and important officials spoke openly about the need to quell speculation. Several commentators anticipated an imminent collapse of the Chinese stock market, which had doubled over the previous year. The outcome was rather different. Over the following months the Shanghai Composite entered a period of exponential growth. The market finally peaked in October 2007 after five rate hikes and 13 increases in bank reserve requirements since the beginning of the year.

Experience suggests that recent tightening in Beijing is unlikely to mark the immediate demise of the frenzied Chinese real estate boom. Nevertheless, it brings that end one step closer.

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Reasons To Be Cautious About China

Angus Tulloch, joint managing partner of First State Investments in Edinburgh, is one of the UK's best known and most experienced Asian investors, having first moved to Hong Kong as long ago as 1981. Debating the outlook for China with Anthony Bolton of Fidelity last week at an event organised by fee-based advisers Saunderson House, he gave his reasons for being cautious about the prospects for China and the rest of the Asia Pacific region. (I was chairing the Q and A session at this debate. You can read a full length interview with Anthony Bolton about China here shortly).


Setting the scene

If any of you be hoping for a confrontational debate, you are likely to go home disappointed, because I am a dyed in the wool Asiaphile! Ever since I moved to Hong Kong in 1981, I have been a passionate advocate of the Asian growth story. I have watched China develop from an iron rice-bowl, inward-looking economy to becoming the undisputed factory of the world. I have witnessed India emerge from the fetters of the licence Raj to produce some of the globe’s most confident, dynamic, effective and internationally aware business leaders around.

Every time I return from a trip to the region, I despair at the way we are living on past glories and on the family silver. The growth pendulum seems to swing ever further in an easterly direction. I certainly do not believe that this good news story is over – for China, India or indeed any other part of Asia. In Vietnam, for instance, it has hardly begun.

However, I see my role today as that of Devil’s Advocate. The best stories usually contain a dark chapter or two. Even where this is not true, a good story – as we all know to our cost – may prove a poor investment. In playing this role, I will first ask the question “Is the Chinese Economy in Trouble?” Secondly, I will highlight some of the political factors that might yet derail progress in the region. These are too often overlooked. Finally I will make a few observations on valuations and other relevant stockmarket inputs.

Is the Chinese economy in trouble?

It is a well known fact that China has embraced stimulative financial and fiscal policies with the same, if not greater, fervour than we have in the West. Fear of unemployment leading to social dissent has always been at the heart of Chinese economic policy.

The Global Financial Crisis struck China with the same collapse of business confidence and paralysis of liquidity as experienced elsewhere. Its Government thus moved rapidly to prevent growth falling off a cliff. Banks were told to lend and this being China, they did (well over one trillion US dollars worth of loans were made in 2009, almost double the figure for 2008). Purchase taxes on cars and household durables were reduced and, together with the banks, the public authorities orchestrated a massive housing construction program. The pace of domestic economic recovery has been truly remarkable.

But, as in the developed world, the jury is still out on the long term success of quantitative easing. China like the West has yet to jump off the treadmill of artificial stimulus. It remains to be seen whether the huge amounts of liquidity that have been injected into the system, will cause speculative bubbles in the real estate and stock markets. Recent evidence suggests that loan growth continues at an unsustainable level, and that residential property prices are still rising too rapidly.

A report issued last year by Pivot Capital Management provides a welcome counterpoise to the usual ‘China is wonderful’ commentary issued by deal-seeking investment banks and we asset gatherers as well. The author points out how much of China’s recent growth has been dependent on capital spending, and on how well developed the country already is in terms of physical infrastructure. He argues that capital spending will fall sharply and that, as consumption growth cannot take up the slack, we should expect much slower rates of growth in the future.

In support of these arguments the report points out that capital spending accounted for over 70% of growth in 2008 and 90% in 2009. The ratio of gross capital formation to GDP is expected to exceed 50% in the current year, a much higher level than ever recorded in the German, Japanese or South Korean development boom periods.

Since the beginning of the decade, domestic credit has expanded at 50% more than GDP. With a credit to GDP ratio of 140%, China is already beyond the levels where credit crises have occurred elsewhere in the past; indeed if loans were to continue growing at their historic rate of 35% per annum, the credit to GDP ratio in China will be close to 200% by the end of 2010 – and that is even assuming 10% economic growth in the current year.

Among other highly relevant points evidenced in the Pivot Report are the following:

• Chinese exports have benefited enormously from the global credit bubble with net exports rising ten times between 2003 and 2008;
• The effectiveness of domestic credit in generating growth in China has collapsed;
• Chinese Government debt is vastly understated (by as much as 40%) as is the degree of the country’s urbanisation (by 20%);
• China has 32% excess capacity in steel and 25% in cement, but already produces more steel and cement per capita than the USA (although China’s GDP per capita is one eighth of the USA’s);
• China has been building 15,000 bridges every year for the last decade and now has more bridges than the USA, though boasting only one fifth of its rivers.

To add to this gloom, I would point out that a number of observers, including the Government and industry participants, are already indicating that they regard the local property market as overheated. Real estate prices have trebled over the last five years. Moreover, we can only expect the USA to become much more aggressive on the dollar/renminbi currency link in this congressional election year.

I certainly do not think that we should assume Chinese growth rates of 10% per annum from now on. A soft landing (6%-8%) would be tolerable and should allow careful stock pickers to produce reasonable returns. A hard landing (under 5%) could give rise to serious social unrest and political turbulence. It is of course impossible now to look at much of Asia, or even the world, separately from China. If China sneezes much of the world, especially commodity producers such as Australia, Brazil and Russia, will catch a cold. In Asia, the Indian sub-continent would be least affected and Hong Kong, Taiwan and Korea the most. Cyclical industries everywhere would suffer.

Will politics become more relevant?

We have become very blasé in Asia, and for that matter, in all emerging countries on the subject of politics. The region has been largely free of major strife for many years now and democracy seems embedded in most countries of the area, albeit in some places more firmly than others, Burma, China, North Korea and Vietnam being the exceptions.

There are, however, a number of geopolitical issues which we should not overlook. Pakistan is far from stable, and the Kashmir issue continues as a running sore between that country and India. With the Himalayan glaciers providing the main water source for almost half of the world’s population, arguments between China, India and South East Asia over river diversions have already begun. There is no sign yet of North Korea wanting to behave as a responsible international citizen. China is inevitably becoming more conscious of its economic power, and is no longer prepared to let ‘Pax Americana’ rule the waves. Problems with minorities such as the Tamils in Sri Lanka, Uighurs in China and Muslim secessionists in the Philippines are unlikely to disappear overnight.

The most likely source of major political difficulty in East Asia over the next decade is Mainland China. I believe that it is only a matter of time before the Communist Party’s hegemony in that country will be challenged – probably at a time when economic progress falters and a leadership contest ensues. This fear is clearly at the forefront of the current leadership’s thinking. Although some progress has been made in terms of elections at local level and also in tackling corruption, there have been no signs under President Hu of a more tolerant approach to political dissidence. Recently, the opposite appears to have been the case.

Very few surrender absolute power voluntarily, and it is hard to see a transfer of power taking place in China without significant accompanying turbulence. Such turmoil preceded the establishment of democracy in both South Korea and Taiwan, and there is no reason that China will be any different. Yet, overlooking the very sad human dimension that such turmoil involves, this transition will provide one of the most exciting buying opportunities of the twenty-first century.

With the benefit of hindsight, one would of course have been much better ignoring this and other latent political issues over the last twenty years. However, I suspect that if we did see an economic slowdown in China, political developments could suddenly have a seriously negative impact on Chinese and most, if not all, regional stock markets. Inflation could well be key here – Tiananmen Square was preceded by a period of rising prices.

Are Asian stockmarkets overpriced?

The brief answer, taking a short view at least, is yes but not ridiculously so. On trailing price to book and price earning ratio terms, the Asia ex Japan Index is priced near the top of normal range but somewhat below its peak. Earnings growth estimates come in at over 20% for 2010 and most observers expect a currency fillip too; but we all know that such projections can prove very mercurial at the best of times. Asian governments are showing very little desire to raise interest rates in the fear of attracting hot currency flows, though both China and India now appear to be trying measures other than interest rates to pre-empt the formation of bubbles. Higher food and raw material prices are already leading to sharp upward revisions of inflation. From the bottom-up, we currently find it particularly difficult to find reasonably-priced companies in China and India; wage pressures and skill-shortages have also recently emerged in both countries.

Fund flows from abroad have been substantial with GEM funds overall taking in four times as much in 2009 as they lost in 2008. GEM markets tend to perform best when the global appetite for risk is increasing; judging by the very low current VIX Index level, and the spreads between GEM and US Treasury debt, it is hard to envisage that this appetite can grow much further. A major short-term concern is the large amount of GEM capital raisings in the wings figures of around US$250m in the region, of which US$150m relates to China, are currently being forecast. Anecdotal evidence of hubris would include large amounts of empty and underutilised commercial property in China, and the Rusal aluminium flotation in Hong Kong and Paris. With Asia Emerging markets up 84% from their March low, I would not be adding aggressively to the region as a whole, especially China, at this time.

But money can still be made

Putting aside these potential pitfalls, careful stockpicking can make all the difference in this area. The region is much less well researched than the West, and what research exists is much more deal driven too. With Asia’s large aspirational population, the scaleability of successful concepts, (such as the Li Ning brand in China) never ceases to amaze. Above all the calibre of company management and corporate governance is improving at an astonishing pace. However prone to hubris these markets may be, anomalies still abound. Contrarian investors like Anthony will flourish in these markets...... but we at First State would hope to do even better!
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Q and A on China and Markets: Anthony Bolton

Anthony Bolton of Fidelity needs no introduction to investors, having managed the UK’s most successful equity fund for 27 years from 1979 to 2007, during which period Fidelity Special Situations outperformed the FTSE All-Share index by the extraordinary margin of  6% compound per annum. Late last year, to the surprise of many professionals, he announced that he was coming out of retirement in order to launch a new fund to invest in China. In these exclusive extracts from an extended Q and A with Independent Investor he explains why – as well as what he is expecting from developed markets in 2010.

You have nothing to prove as a fund manager. What is the attraction of managing a Chinese fund?

There are several reasons. The first thing is the general case for China. Here is the third biggest economy in the world, which is likely, either last year or this, to have overtaken Japan and become the second biggest economy in the world. It’s currently the ninth biggest stock market, and in the next 20 years or so, it will become the second or third biggest stock market.

There is also the S-curve effect. There has been a lot of research into emerging markets and when they tend to have their best phase of growth. It seems to be when GDP per capita is in the $4,000-$10,000 range. As the average income goes up, you get a significant and disproportionate increase in the number of wealthy people. That’s what happened to Taiwan and Korea 20-30 years ago, and to Japan before that. The exciting thing is that we’ve never seen an economy as big as China go through this phase.

Although China is a command and control economy, which has some negative aspects to it, what also impresses me is that the top politicians in China are well-educated and international in their outlook. Their plan for what they want China to be in the future is really exciting. When they do things, when they say “we’re going to change the hospital system, we’re going to put in a high speed electric train network” or whatever, it tends to happen, and happen quickly.

The public spending on infrastructure is hugely impressive, as anyone who goes there can see. India and other countries are also exciting, and though I don’t know them so well, it seems that they do get very bogged down in politics. There are obviously some long term questions about the Chinese system of benign dictatorship. Once people become better off, at some stage they want more freedom, and so that’s a challenge for China down the road. But it is still a few years off.

And China looks a more attractive place to invest than many developed countries?

Yes. The second reason is very much what’s happening in the West. My view is this has been a different type of recession to a normal recession. It has been the most extraordinary 18 months, and quite unlike most recessions that I’ve experienced, which tend to creep up on you slowly. You often only realise you’re in one when you’re halfway through it. What happens then is that the consumer tends to lead you out of it.

This recession is different because it’s been very much driven by corporates, not consumers. My explanation is that when the financial crisis hit the headlines in the third quarter of last year, CEOs immediately said “We’ve got to batten down the hatches”. They cut inventory, they cut cap ex, and they cut labour, and for the first time ever, that happened globally all round the world. That’s why we had such desperate economic figures in the fourth quarter of last year and in the first quarter of this year.

Now we are experiencing the reverse of that. Obviously, not all the economic data is universally bullish, but the stuff that we look at suggests that there’s a pretty strong recovery and we think earnings are going to surprise on the upside because corporates, particularly in America, have really cut back so far and so fast. So while in some ways, the situation wasn’t quite as bad as it looked in the headlines at the end of last year, and at the beginning of this year, I think the reverse is true now. This fast upturn is making things look better than they really are.

What does that mean for stock markets over here?

My view is that what we’re going back to once this recovery phase has run its steam, which I think will last through the first half of this year, is lower growth in the West. Particularly in the UK, the US and Europe, governments have mortgaged the future to get us out of this crisis, so they’ve got to increase taxes or reduce spending. Secondly, consumers are over-indebted and have had a shock. They need to rebuild their balance sheets. I don’t think they’re going to lead the recovery. Thirdly, there’s less credit available for everyone because of the banking crisis than there would be in a normal cycle. What that all means, as far as I am concerned, is not that we are heading for a double dip or going back to a recession, but that what we are facing is a period of slow growth.

That has got quite big implications for the leadership of the bull market. Once this becomes apparent during 2010, the stocks that are leading the market are going to change. There will be a broad move away from cyclical companies, and commodity companies in general (though there could be some exceptions to that), towards more growth-oriented stocks. If you’re in a low growth environment, predictable high growth is going to have rarity value and that will be bid up by investors. I don’t think it’s a bad environment for equities generally.

Does that mean a renewed bear market, as many are predicting?

I don’t think the bull market is about to end, but it might have a big pause. We haven’t had a big pause yet, so as the leadership changes, we could have a three month or so of setback and consolidation in markets before the next stage. In this lower growth environment, governments are going to be very slow to exit their support measures. I think that markets can take some rise in interest rates. I don’t think the first rise would kill the bull market, but if we then get into a succession of interest rate rises, at some stage that will stop the bull market. I suspect that is a 2011 rather than a 2010 story.

Meanwhile all this is positive for China and Chinese equities in particular?

Yes. What it means is that if China can continue to grow, it will look increasingly attractive. While it is obvious that emerging markets are not immune from growth trends in the West, if an emerging market, through the momentum in its domestic economy, can continue to grow at above the world average rate, that will make it more attractive to Western investors. The net effect of what I see in all this is that more money will flow from Western investors into markets like China.

At the same time, while there seems to be a case against every other currency, most people would agree that the remnimbi is undervalued. It seems likely therefore that if you invest there, you are going to make a currency gain there. Nobody quite knows when they’re going to relax their currency policy, but it is almost inevitable that they will. Their programme is to gradually open up the currency, and that must lead it to appreciate.

What sort of fund do you expect your fund to be?

It is going to be volatile, and so you’ve got to know the animal. That’s one reason why I have something of a preference for a closed-end fund, or an open-ended fund that has some restrictions around it. You need that as China is a market where people can panic very easily, and if something goes wrong, you don’t want to have to liquidate everything you own. Continued growth is near the top of the list of what the regime wants. (Editor’s Note: At the time of the interview, the final details of the fund had still to be detailed. It will be launched formally in the second week of February 2010).

Your focus will be solely on Chinese companies or will you playing the theme other ways as well?

I’ll have some room. The bulk of the fund will be in Chinese companies, by which I mean (a) the ones listed in China either H-shares, A-shares or B-shares; (b) Chinese companies that are listed in America (there are quite a few of those in the technology area); (c) and Hong Kong listed companies that are a play on China. I see that being the main part of the portfolio. I will have some room though to buy Chinese plays elsewhere in the world. What I mainly want to do is focus on a smaller universe than I’ve been used to. I don’t want to have to look at every market in the world. I mainly want to focus on listed Chinese companies, but if something comes up elsewhere that has a strong Chinese angle to it, I don’t want to rule it out. I could have 10 or 20% in those stocks. The prospectus may alter that slightly, but that’s the sort of range I have in mind at the moment.

What resources will you have to help you manage the fund?

We’ve been investing in China as Fidelity for about 15 years. We have three managers there who run Chinese-focused or Greater Chinese funds, about $4 billion in total. There are five analysts who focus solely on Chinese shares plus our sector analysts. The oil analyst for example covers all the oil shares, including the Chinese ones. We’ve also had a private equity business in China for 14 years. We only do private equity with our own money. It’s a way of diversifying the balance sheet as a private company. We own property, such as this building, and we also have private equity, including some interests in the UK. What the private equity people have is a god network. Knowing who you can trust and who you can’t trust is very important. Being able to plug into that network will help me a lot in the corporate governance area.

I’ve already seen a lot of companies with H-shares, well over a hundred in the past six years. I need to do more work on A-share companies. As you know, for A-shares you need a quota. We’re negotiating one now. You never know when or how you’re going to get it, but in the meantime, you can use broker notes as an interim measure. I have invested in some A-shares in the Special Situations Fund. It’s quite a big market and it’s one of the areas I’m going to be focusing on in the run-up to the launch of the new fund.

What about the trading characteristics of these shares: are they not less liquid and so on?

The trading is tougher. You need traders and you need to be patient. You can’t always buy them on the good days. You may have to buy them on the bad days, but I am used to that in medium and small-sized stocks here. Taking a slightly longer approach should help with the trading, so I’m going to be a bit contrarian in the trading. Relative to the funds we have, I will have a higher tracking error and more active money, and probably more in medium and small sized stocks.

There are some very lumpy shares at the top of the list. China Mobile is nearly 10% of the index, and some of the banks are 6% to 7% of the index. China Life is a similar size. So if I like them, I might want to have quite big holdings. I used to start at 25 basis points in Special Sits. I’d hope I might be able to start at 50 basis points here. We will have a more concentrated portfolio than I did in Special Sits, but it depends on the amount of money we have, and other things. I very much want to cap the amount of money. That’s my ambition.

What do you say to those who say you will not be able to succeed in China – the different culture, the language and so on?

There are obviously some factors that are unique to China, and it doesn’t have the really attractive valuations that Europe had in the 1980s, when I started my European fund. But while China is different, I feel strongly that the basics of investment are the same whichever market you’re in. There are also many similarities to the situation in a market like Germany at that time. I remember in Germany, when I first started going there, that local investors were very short-term. They couldn’t understand why were we interested in meeting the companies and understanding them and trying to work out where they were going over the next one or two years.

At the time all they were interested in was trading. I see that as one of the characteristics of a market that has not yet fully evolved. China is at a similar stage. Part of the Chinese trading mentality is to do with that. Also, there’s an issue of loss of face. They don’t like to be associated with things that are not doing well. All that makes it an interesting place for a value investor such as myself, despite the conventional wisdom being that you have definitely got to do it differently in China.

An American organisation called Empirical Research, which is very quantitative in its approach to markets, has done some excellent research on emerging markets. They did a big piece earlier this year on emerging markets, which showed that valuation is a major driver of returns in emerging markets, and that it’s an even bigger driver of returns in emerging markets than it is in developed markets. It applies both in general and specifically to China H-Shares. (They haven’t analysed the A-shares yet). So that’s exciting.

The other aspect is that China’s going to have a lot more IPOs, and more of them are going to be coming in the companies which are oriented towards the domestic economy and service industries. Again, that’s a bit like Europe in the 1980s, where the history was manufacturing, and to some extent financial, but then you had more and more companies coming to the market from retailing, advertising, media or whatever. China is going to do the same thing.

I think that people like me who have seen similar companies over so many years have an advantage. For example, the first Chinese drug distributor, Sinopharm, was listed recently. It has gone to a very high valuation today, so in the short-term it’s probably not that interesting. But the point is that Chinese investors had not seen a pharmaceutical distributor before, so they are not sure how you should value this kind of company. There will definitely be cases where my knowledge of those industries in other markets will help me locally.

On the negative side, policy is undoubtedly both a risk and a reward in China. Because it’s so centrally driven, they can change the rules overnight. The first thing to be aware of is that that’s a risk. You’ve got to try and work out which companies are more exposed to that risk than others. Obviously you need to do some listening to people who are close to the politicians, to get an early warning of change.

What about corporate governance? Surely that is a big concern for any Western investor?

Corporate governance, the quality of the information, the quality of management, etc is a much debated issue. Hong Kong listings certainly provide better quality information than the Shanghai and Shenzhen listings. My experience of the companies that I’ve seen, and there are a few now that I’ve seen half a dozen times, is that the good ones are as good as anything in the UK or Europe. Quite often, these are private companies run by Chinese people who’ve lived in the West. When China has opened up, they’ve come back to China, seeing the opportunities. On the other ones, the bad ones are pretty bad. There’s a wide spectrum.

If we had met a year ago, I would probably have said that I would mainly want to focus on private companies. I spent quite a lot of time talking with my analysts about that when I was in Hong Kong. They persuaded me that avoiding all state-owned companies was too black and white a view of the world. Some of the state-owned enterprises are actually run by decent people. Some of the people who run companies are quite politically ambitious and they want to prove themselves as a stepping stone to bigger political ambitions. So, if they mess things up, that’s a problem.

There are also specific issues for specific industries. The one that my colleagues particularly talked to me about was property development, where, they say, the state-owned enterprises tend to get better deals because they’re closer to the local politicians. If you’re a private company, it’s more difficult to get the good land deals that are at the heart of successful property development. But the last thing they pointed out is that the biggest scandals over the last couple of years have mainly been in private companies rather than in state-owned companies. I am going to buy some private companies and some state-owned enterprises. They both have their risks and rewards. I’ll put a lot of time on trying to work out who’s good and who’s bad.

Have you come across corruption issues? People have had those issues in Russia and elsewhere…

I was debating with one of our analysts about a stock that she was following. It was on six times earnings, and she said: “It’s really cheap – should I recommend it?” I said: “What’s the snag?” She said, “The management’s been moving interests between the listed company and their private companies, to the expense of the listed company.” My reply was: “If they’re doing that sort of thing, you shouldn’t buy it at any price. There isn’t a known valuation that compensates for that.”

There is also the case of Gome,, which has been in the papers. It was the Dixons of China, the biggest of the electrical/electronic retailers. I met them three times. I met a lady director, and it was only on the third time that I clicked who she was. She was the wife of the Chairman. (Husbands and wives have different names in China). I said to her in the meeting: “I wish I knew that before because that’s a material fact“. But she couldn’t understand why it was relevant. She said, “Just because I’m married to the Chairman, what’s that got to do with it?” It so happened that Gome then blew up and the Chairman’s currently in jail, so I was lucky to avoid that one.

So yes, there are risks there, and I’m sure we won’t discover every one. We will make some mistakes, but hopefully not too many. When I am talking to the team, if I go through the list and come up with the stocks that look really cheap, one of the three fund managers may say to me, “Anthony, we don’t really trust them. Make up your own mind, but our advice is don’t invest in that.” I’ll normally go by that.

How much time are you going to be spending in China as opposed to working from Hong Kong?

I haven’t finally worked that out. Hong Kong is a pretty good place to see Chinese companies, because one of the problems in China is that companies are quite spread out geographically. I will definitely go to China, but how often I haven’t decided. It must be at least every six to eight weeks, I would have thought. I want to go to some of the second and third tier cities, which I’ve not been to before. Nevertheless, if China companies go anywhere to see investors, they go to Hong Kong, and then there are quite a few key conferences which is a very efficient way to see a lot of companies in a short space of time. We tend to go and have our own agenda of one-to-one meetings at the conferences.

Have you found that getting access to people is any easier than it was in Germany in the 1980s?

Access can be an issue, but companies are starting to find it more interesting to meet. They’re also at the stage where they’re now realising too much of it can be rather a bore as a management, so they’re getting a bit more discerning about who they see. With Fidelity’s influence, and hopefully now with me going there, and all the publicity around that, if anyone can get access – well, if we can’t, I don’t think anyone can. All three of the managers and the five analysts in our team are all Chinese, and I’ll work pretty closely with them. The language is obviously an issue. I’m not going to learn it. I’m not good at languages. But that was an issue, again in Europe, and that never seemed to be a problem. I will need to use the team to help me on the nuances that don’t come across in the translation.

How well did you do with the Chinese companies you invested in through the Special Situations fund?

I did well. I don’t have any detailed attribution statistics to prove that to you, but were a couple of pretty successful domestic companies. Li Ning, which is a sportswear retailer, which did pretty well for us. Another retailer called Ports Design is China’s only women’s fashion retailer and they’re trying to build their Ports brand, which they want to become a world brand in women’s fashion. And there were others. The market is definitely inefficient when you get outside the leaders and the very fact that you can have the same company with A-shares and H-shares on completely different valuations is a reflection of that.

There’s a company in one industry that I’m interested in and it’s on about 11 times earnings and some of its competitors are on 30 times earnings. I can’t currently understand why there is such a big difference. There are going to be a few outright value stocks, but my approach will I think be more of a GARP-like approach than pure value. There are a group of stocks in China which have potentially 10 years of growth ahead of them. They are not cheap, but they’re not highly valued as similar US and Australian companies whose valuations might be in the high teens or low twenties.

If the long term story is good enough, I’d be prepared to buy stocks like that, even on a 20 multiple, if the franchise and the long term prospects are good enough. Value doesn’t mean it has to be only a single figure multiple. I can’t argue that the whole market is very cheaply valued. It’s more in line with its average over history.

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