Calling PMs/buyside Analysts - The whole China thing

wanting to get some opinions from people who also have to make capital allocation decisions. I'm becoming increasingly conflicted about China and its role in investment portfolios for clients. since my job is to allocate capital as best I can with regard to the risk the client's comfortable with, the potential returns of the area are attractive and therefore we have an allocation to emerging markets (of which china's the obvious 800lb gorilla).

at the same time, the talk of common prosperity, the lack of legal protections for equity holders, the presence of the communist party in every private enterprise gives me tremendous pause. combine that with the known atrocities being committed in NK which is essentially a puppet of beijing, and there's a big moral dilemma I'm feeling. finally, while I've rarely agreed with soros on anything in the past 10y, his pieces in WSJ on china were very compelling. pasted below if you've not read.

https://www.wsj.com/articles/blackrock-larry-fink…

https://www.wsj.com/articles/xi-jinping-deng-xiao…

on the other hand, literally every single company in the USA has some ties to china, be it parts from suppliers that their vendors use, direct customer interest (movies, apparel, etc.), direct investment from china, and so on, it's a completely unavoidable thing, so part of me goes "well if I can't be 100% out, then what good does an imperfect moral stand do?" and let's not forget my job is to allocate capital, so I'm cognizant that I don't want my personal misgivings to negatively affect my investment decision making.

so, other PMs, how are you navigating the china minefield?

GoodBread ke18sb Addinator [Going Concern] Jamoldo 

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Comments (39)

Most Helpful
  • Analyst 1 in HF - Macro
Oct 9, 2021 - 5:36am

Get investor capital out of China. Seriously. Any PM would have to be an absolute moron to keep money there after what they've seen the last 6 months. There's a reason why Chinese investors will crawl through broken glass to invest capital outside the mainland if they have the means to do so. Do you think you have any information advantage over domestic investors?

There's no rule of law at either the corporation or the government level. It's hard to understand for western investors who, despite all the imperfections of our legal and governing systems, still generally have respect for contracts and property rights. 

This is an organization chart from Evergrande from 2017: 

Image

This is not unusual for HK-listed or ADR-listed Chinese companies. Do you really think you have any claim to the actual business, if it isn't semi-fraudulent to begin with? 

It will probably take at least 5 years of reforms before China becomes remotely investable, if ever. China was never "stable" before this point either, but you just had idiotic equity investors thinking they could go long Alibaba, Tencent, etc. with 0 consequences from investing in a communist-run country with no concept of property rights. It's not even a moral issue, it's just common sense. You can trust individual companies operating there to have a more thorough understanding of dealing with China, as they're probably greasing the hands of whatever CCP official they need to in order to continue to operate with or within China, but investors have absolutely no leverage. 

If your clients really want something more risky/speculative but that isn't just like lighting their money on fire, I would seriously consider crypto a better investment than China at this point.

Oct 9, 2021 - 6:57am

By saying get investor capital out of China I'd also have to avoid nearly 100% of the russell 3000 since they all do business with China, and therein lies the problem. If I simply sell my EM investments, we're still tied, so your PMs that have no direct Chinese holdings still have Chinese exposure, no?

Of note, I do not have direct investments in Chinese equities, but instead use EM funds

  • Analyst 1 in HF - Macro
Oct 9, 2021 - 7:33am

Like I said:

You can trust individual companies operating there to have a more thorough understanding of dealing with China, as they're probably greasing the hands of whatever CCP official they need to in order to continue to operate with or within China, but investors have absolutely no leverage. 

You don't need to avoid Nike because they use slave labor in Xinjiang (from an economic point of view, morality/political views are another matter entirely obviously), because you can trust that Phil Knight or John Donahoe is kissing the proper CCP official's ass so that they don't get screwed. You're outsourcing your China expertise to these companies and their executives, whom you can trust because they have incentives more or less aligned with you (if they get assets confiscated or booted out it's bad for their business and for investors). 

Index ETFs aren't really my area of expertise, but I'll give it a shot with something I'm more familiar with.

What you need to avoid is any index (say like TAN - the solar ETF) that invests in things like Xinyi Solar Holdings (968.HK) or Daqo New Energy Corp (DQ. ADR). Any index or ETF that has assets in HK-listed companies which are shell corps for predominately Chinese assets or Chinese ADRs are what you'll want to avoid. 

One of my friends had this to say recently during the Evergrande saga and I think it's apt:

Hello tourists, welcome to the Chinese high yield market. Then throw everything you know about markets out the window. This is a mafia state.

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Oct 9, 2021 - 1:16pm

At the institutional level, we don't have direct equity exposure - it's all, similarly, through a variety of funds or managers - in that case, we have tilted away from China for actually quite a while now. In most cases that looks like underweights by active managers to Asia or China directly (depending on the strategies) while trying to keep a consistent allocation to EM. That is driven more by the economic growth in China vs. the risk at this point than it is any moral issues with Xi or the overall Chinese state. It's somewhat like SRI and Oil - you can't entirely get out of fossil fuel exposure, so you exclude, tilt away from or invest in renewables to compensate in the majority of cases. Domestic equities - I just don't think it's practical, underweighting anything with significant Chinese exposure (revenue, suppliers, etc.). I also don't think performance would be great - best case, you get fired - worst case, you get fired with a 'we really support what you are doing, but...' Maybe someone has done that and can prove me hilariously wrong, but on it's face seems like a tough sell. 

The world has made a Faustian bargain for decades now with them. We will overlook your transgressions and in return we will get access to your markets, cheap labor, etc. The list goes on and on. Their appetite for progress and growth outweighed their ideology - though it was always there as a risk, it was at least muted. With those risks back on the table and, frankly, returns in China moderating anyway - you probably want exposure, as there is upside there, but limiting it is the game. 

Goodbread makes a great point - the narrative of Xi basically reasserting the governments ability to forcibly curb and route investment to industries it deems forward looking - i.e. rare earths, renewable energy, doing away with the massive building or development projects, reigning back in the loosening of capital, tech companies getting restricted - does lend itself to opportunities... it's just very hard to get at it from over here. I also, well, don't quite believe that this is all a well intentioned green new deal. It's also similar to the actions states take when they decide they want to start tramping over other countries or, simply, ensure the regime retains control. I'm not a Chinese political scholar nor expert - but again, the risk just keeps going up. 

Also - and now I'm starting to ramble - I'm not sure it's a good thing for America to, broadly, pull out of providing capital to countries like China. I don't consider myself a rampant globalist, but if you are at least at the table you can influence or do something - the last thing we need are countries with strong militaries that are isolated from one another and in constant competition.. that's generally a recipe for, well, you know. 

Oct 9, 2021 - 9:50am

Living in Shanghai at the moment. It's very risky to do business in China, in any industry. There is no separation of business and government. If you're doing any kind of transaction with any kind of business  you're dealing with the government. The government can decide to shut down a business at any point in time for any reason, and there's nobody you can go complain to. You can't predict when or to what extent the government can interfere with a company's operations and therefore it is impossible to actually plan investment strategies or plan anything really. Not only that Chinese companies don't adhere to foreign/internatuonal reporting standards. Even if you get info on a company it could be completely fraudulent and there's no way of verifying the data.

I would go far as to say all foreigners should just completely avoid doing anything China related in the future.

  • Analyst 1 in HF - Macro
Oct 11, 2021 - 1:10am

IDK WSO deleted my first comment, I'll try again with pinyin instead of hanzi.

Also based in the mainland and couldn't agree more. All these laowai quite frankly have no idea what they're dealing with or talking about. It's fine if you recognize that you're speculating via greater fool theory to pass the bag of shit onto someone else at a higher price, but recognize what you're doing and the very real chance that your trade goes to 0 while you're holding. For the people who think China has great economic "fundamentals," you realize that respect for contract law and private property rights are the pre-requisite for making capitalism actually functional, right? Literally nothing else works without this. They are the most "fundamental", fundamentals, so to speak. This is how the UK and the US were able to outperform the rest of the world in the 19th century, and why most EMs are still shitholes today despite favorable demographics trends, overvaluation and financialization in DMs, etc.

For all the fundamental equity investors here, where are your returns going to come from? Do you think that you have any actual claim to cashflows from the business (dividends, buybacks) or are you knowingly just playing hot potato? How do you know that the cash flows from these businesses even exist if the financials haven't actually been audited (note: Gensler isn't requiring audits of US-listed Chinese co's for THREE more years)? If you know that you're speculating and that falls within your mandate, go for it. But to fool yourself into thinking that you're "investing" into China is grossly irresponsible.

Like I said earlier, crypto honestly offers a better risk/reward (at least you can hit a home run with a 10x or 100x) with similar downside IMO.

Oct 9, 2021 - 10:27am

I don't love the idea of single stock names there given all the idiosyncratic risks people have mentioned. But there are some really interesting narratives going on, particularly the fact they are doing their own version of a "green new deal" right now. There could be a huge shift in capital from what seems to have become dead-ends (property developers, older manufacturing assets...) towards what will be the big winners from China pushing in on cleaner energy and modernizing its metals sector. I haven't really done any leg work on how to trade that, but there are big things afoot, including a move away from exports of critical minerals (just look at the price of some metal adders the past month).

Oct 9, 2021 - 3:23pm

The only thing you need to see is the number of CCP members that are what is known as "ghost officials" or something like that.  They have basically moved their entire families out of the country and are hanging around to continue their corruption and will split as soon as they get wind of an investigation.  It is estimated that since 2008 these types of party memebers have grown in number by 25 to 50 fold and have extracted an estimated 5 to 6 trillion USD from the coffers of the CCP.  When combined with a government spending of GDP that is around 40% or more by conservative numbers why anyone has money in China is beyond me.  It is so bad that people in China don't even put money into China.  This idea that the country is a stable growing economy is a joke.  It is powder keg that is going to explode if any sembelance of a decline in economic growth.   The country is estimated to spend between 12 and 15% of GDP on "stability" programs, i.e. the internal secret police that stamps out dissidents.  There are African dictatorships that are a better place to put money than in China.

  • Associate 2 in PE - LBOs
Oct 9, 2021 - 3:25pm

All these comments make me so bullish china

WSO was prob mad negative tech in 2014 calling for a tech bubble 

  • Analyst 3+ in HF - EquityHedge
Oct 16, 2021 - 9:55am

1000% this is so contra. calling China uninvestable comes in cycles. 

  • Analyst 1 in IB-M&A
Oct 9, 2021 - 4:28pm

Currently recruiting for HFs, so take my input with a grain of salt (only money I manage at the moment is my personal money). 

I have a slightly contrarian view on China in that I believe it offers tremendous opportunity given recent crackdowns on a number of industries (tech / for profit education etc.). Someone mentioned KWEB above (ETF that tracks China tech), and if you look at it from a fundamental perspective, it seems to me that a lot of the regulatory risk is already priced in and the underlying equities in the index look very attractive. Tech will be an important industry to drive continued China growth and as such I think that the existing players in the industry have strong competitive positions that are incredibly valuable (similar to a Facebook / Alphabet). 

With that said, you need to be really conscious of two main risks in China: 

1. CCP - Important to hedge your bets accordingly to limit your downside. The communists can kill an industry with the stroke of a pen, so ensure you have downside protection via put options or some other instrument

2. Growing debt burden - At the moment looks to be limited to real estate and lateral industries, but the situation is fluid and you need to monitor it closely

As mentioned in your original post you need to take your feelings regarding Chinese atrocities out of the equation (I am an Aussie, so I have some very strong feelings towards China), and I think if you do you will be able to see the potential large payoffs that exist if you hedge your investments appropriately. 

As mentioned, I'm pretty young / don't manage outside money / don't know shit in the scheme of things so appreciate anyone challenging my above points. 

Oct 14, 2021 - 9:46pm

yeah I agree this was a pretty mature view - good stuff man

Big4 Audit --> TMT L/S

Oct 18, 2021 - 5:28am

Great analysis. What concerns me about China is that all companies which mean something are generally SOEs and as a result their health can be masked or shrouded in a false reality as long as the govt wants them to continue existing. So in an Evergrande situation where the biggest developer is defaulting on their debt, I know that if Xi wants them to survive then their ability to pay creditors is moot. Basically selective survival chosen by the govt is scary af in public markets

  • 1
Oct 18, 2021 - 2:19pm

How do you know to what extent pricing-in is appropriate? I.E. if it's under-priced-in or over-priced-in? Seems the outcome with China is very binary (either obliteration of industries and nationalization of certain companies, or slap on the wrist fines). If the long-term outcome for a given stock is binary but the inputs are unknowable -- for example you don't know the inner-workings of the CCP or their thoughts on what to target next and how to enact their policies -- then the entire space becomes univestable.

My 2 cents.

Oct 10, 2021 - 12:03am

Totally outside my wheelhouse from a work perspective. Personally, I think China is hard to trust, certainly I don't think they give two cents about foreign investors. However, the flip can be that they are coming off such a low base (any developing economy) that by default they should out pace developed economies through cycle until the reach more of a steady state. So hard to predict more near term vol but through cycle should be growing. This is more shooting from the hip vs having spent a lot of time researching and developing a view. 

  • PM in HF - Other
Oct 10, 2021 - 3:14pm

I think China is a trading environment but I would agree with the more real investors on here that China is very dangerous. First I think US/China are going to fight each other to death over the next 10-15 years and outspend each other to death to win. Additionally China has all these demographic issues around the population make up and the future population, Xi is all about vertical integration and betting on the right industries to lead them forward he knows the traditional ways cannot work, demographics alone. 

So for these reasons I am not totally bearish China as mentioned they are going to be a world leaders in rate earths, prolly will majorly involved with driverless vechiles. Politically they have gained way more control in Africa and plan to bankroll the taliban here.

So while yes investing in single names is scary long-run as Xi can take over the firm overnight and screw you. Saying china is going to keep declining I do not agree with this they are going to get stronger and more important and should not be ignored when look at longterm investment themes.

Oct 10, 2021 - 8:19pm

It is really hard to invest in single stocks in China right now given it is not a free-market economy and politically unpredictable, so how can you properly assess risk? Secondly, what edge do we have trying to invest in China? 

Covered Casinos on the sell-side. The ones with Macau exposure like LVS, WYNN make me leary right now. Sure Macau needs the operators but the operators need the concessions more and they are coming up for renewal in 2022. The government can do anything, tax the shit out of them, require massive amounts of CAPEX etc.  Worst case they strip the concession completely which would destroy significant amounts of EBITDA overnight but likely wouldn't happen because it would destroy any foreign investor confidence in the country. But how do I handicap that risk, why not spend the effort elsewhere?

Brofessor, they do make ETFs that are emerging markets ex China. https://www.ishares.com/us/products/288504/

Oct 16, 2021 - 10:07am

Honestly, wasn't much different than everyone else trying to break into ER. I got into the Leisure/Gaming space simply because I interviewed with 2 analysts at the firm and the analyst covering that picked me. At a junior level, your coverage is harder to choose and more often chosen for you. If you have specific industry experience then it is a different story because you have value to add above the typical candidate for a given coverage group.

  • Partner in HF - EquityHedge
Oct 10, 2021 - 8:58pm

Invest in China through low-net equity long/shorts that have done well in extracting alpha by picking the right industries and shorting/avoiding stuff like Evergrande.  

Despite the majority of Greater China funds being plain vanilla long-biases with index hedges, dig around and you'll find some true hedge funds in the region.  This year's volatility in the region has been great for those that did what they were supposed to be doing, as opposed to levered-longs taking fees merely on cultural/language barriers.  

A lot of these comments here are pricing in the bearish market consensus and what has been known forever about investing in China, showing the worse is near an end.    

Oct 11, 2021 - 9:19am

One of my LPs works for a very well known L/S equity fund with significant Chinese exposure. They've crushed it but they are an L/S fund...so not really an investor per se. 

Oct 11, 2021 - 12:24pm

China and the US are effectively on a collision course. As Soros' articulates far better than I can in his Op'ed, China's approach to governing and managing itself as a country is fundamentally incompatible with Western democracy. As China continues to grow, it will increasingly threaten the US' supremacy as the world's most powerful Nation. Although it's unclear as to how things will ultimately play out, it's hard to envision a scenario in which US-China relations improve. 

This brings me to your point on company's earnings being tied to China. Ultimately, US companies either can't or won't accept that at some point, they're going to be forced to choose a side. There have been a handful that have done a very good job playing both sides while sitting on the fence (e.g. Apple), but in the long run, a reliance on China to generate earnings represents a huge liability that your average CEO is unwilling to address because there's so much money to be made within China in the short run. 

Oct 11, 2021 - 1:38pm

When talking about a country the population of China is easy to talk in superlatives but my 2 cents is that China is going to go down as probably the architect of the biggest misallocation of capital ever seen in history.  There is no way that hundreds of billions of dollars spent in ghost cities, inefficient belt and road projects and liquidity infusions to zombie companies wont come back to bite it in the butt in a major way.  Yes, on the way up China saw the biggest growth story in the history of humanity but I dread to think of the consequences for the world (black swan event) when the cracks in their credit markets become unstainable and their whole economy comes tumbling down like those cheap concrete buildings we see on YouTube. 

Oct 11, 2021 - 10:03pm

When I first learned about Enron and Madoff, I felt the same towards Uncle Sam as well. :P
Joke aside, generalization is the easiest way to avoid the hard work. 
Investment is all about discovering truth and finding the hidden gem amidst the "smoke", it's only up to your gut and real effort for the attractive treasure hunt.

  • Research Analyst in AM - FI
Oct 15, 2021 - 9:08am

Worthwhile topic here. As way of background I am an EM macro investor with a global mandate. 

This is highly simplified but basically look at EM's on a continuum from "wouldn't touch" to "would build a factory/start a business here" with buying single name equities, indices, FX, sovereign debt, corporate credit, PE/VC investing all somewhere in between. Basically, the more stable the political/economic/legal regime the more willing I would be to take higher/illiquid/concentrated/non government risk. Let's leave the "is China an EM?" debate for another day, but policy uncertainty/ad hoc legal decisions that turn firm's equity values to 0 would certainly qualify in my view.

Not sure China was ever really in "would start a business here" (as a foreigner) category in my book, but has moved a lot more towards the "wouldn't touch at all" though is not there. Similar to as others have alluded I wouldn't do single name equities, PE/VC, corporate credit. Taking the Russia playbook I would feel comfortable investing in anything you are aligned with the government so sovereign debt/FX, quasi sovereign debt though can be a wild ride (see Huarong), and a basket equity approach to the sectors highlighted in the last national development plan (hard tech, AI etc). I don't agree with the disaggregate oneself from all China risk b/c as you mention pretty onerous as you'd have to divest of a lot of US equities.

Oct 18, 2021 - 2:00pm

The problem with investing into china (buying chinese stock or debt) is that you cannot predict who will be the next Evergrande, and risk of getting wiped out overnight is extraordinarily high (vs buying any member of the Russel 3000).  Its one thing to invest into Nike who outsourses labor to China, and might take a hit to earnings some year because the head of the CCP decides they don't like Nike anymore and want to extort them, but Nike stock won't ever goto zero and become worthless because its a giant fraud...but buying Chinese assets is playing Russian Roulette with a fresh spin on every trigger pull.  You might never never fire a bullet into yourself...but you know its coming at some point...the only question is "how many times can i pull the trigger and not catch the bullet, that i know is in the cylinder."

You might earn 20% /  year for a while, and then one day poof...its all gone...and there is no recourse...no bankruptcy...its just all gone.

Oct 22, 2021 - 2:45am

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