Newsletter commentary Apr 2022

Fear and Anger: Contagious and Self-magnifying Diseases

Different from previous monthly commentaries, we add a title this time to express our views on the main contradictions currently in the market. We believe that the problem with the market is not the problem itself, but the way people look at it. Fear and anger are clouding their judgments.

Same as in March, the market fell sharply in April due to three main causes: external relations, epidemic, and economic expectations. Our views on external relations remain the same. From the opponent’s perspective, if they could find a way to overpower China without great losses of themselves, they would have already used it. But this was not happening, meaning the trick doesn’t exist, at least for the moment. For China, changes in the external environment are objective and some are hard to ameliorate because interests are changing with the balance of power. China needs to make it an attractive investment destination – although voices of doubt, data such as FDI suggest this has been done well. In addition, China has its fate in its own hands thanks to its size and structure.  The market, the industrial capacity comparable to the entire G7, and the status as the largest trade partner of nearly 140 countries determine that maintaining a free trade system is of great benefit to China. We believe that this is the only way to go. For investment, a risk to occur immediately means way differently from risk to develop slowly over 20 years.

In April, the epidemic had a great impact on economic expectations, possibly due to the unexpected outbreak in Shanghai. In fact, the situation in the city has been gradually under control. Some worried about an even bigger impact if the emergence of cases in Beijing eventually went the same way as in Shanghai. But the situations in Suzhou, Hangzhou, Guangzhou, Shenzhen and Beijing were mostly controlled within a week. Shanghai has been an exception but has also been improving with logistics gradually recovering. The covid impact on the economy is not going to be a long-term and substantial reduction in the national capacity utilization, but a short-term shock. With vaccines popularizing and drugs getting ready, we are expecting new anti-covid measures that better balance the epidemic prevention and the production and life. The central task of economic construction will be re-focused. For investment, it is also different between short-term shocks and long-term losses. We even believe that after the epidemic, reaching consensus in certain areas would be easier, which leads to better development.

Let’s take an example to illustrate the damage to the market caused by fear and anger brought by inaccurate information deiminated. The Shanghai Composite Index first reached 3,000 points in 2007, but many years have gone and it is still less than 3,000 points. For this, some people said that the market did not create value, which seems flawless in logic. But in fact, this logic is not even a lie, but pure nonsense. Nonsense is different from lies in that it does not care about the fact, but only about the traffic brought by the communication. Firstly, the Shanghai Composite Index consists of a sample of eligible stocks and depositary receipts listed on the Shanghai Stock Exchange, reflecting the overall performance of companies listed here. Apart from them, companies listed on Shenzhen's SME board or ChiNext are not in the index. This means the Shanghai Composite Index does not reflect the major outcomes of China's economic transformation, hence not a good indicator of the overall Chinese economy and of the securities market. The broad-based CSI 300 and CSI 500 are more extensive, but even these indices may underestimate the profitability of the market due to their rules of compilation. For example, a car power battery company was not included in the relevant index until its market value reached trillions, meaning the previous high growth period was not captured in the index. Secondly, the treatment of total but not outstanding share capital while compilating Shanghai Composite Index may not fully reflect the market's feeling about profitability. For instance, the stock price of a large oil company was declining from 48 yuan to 5 yuan, it would make negative contributions to the index any time it was included. Due to the high weight of the company in the early years, the impact was large, which would be again substantially overestimated through the weighting based on total but not outstanding stocks. Finally, due to the way of issuing new A shares and the mysterious tradition of speculation after listing (the myth has finally been busted recently), prices of many new shares rose after IPO and then kept falling for a long time. Usually, these stocks have been dragging the index. However, as long as they stay above issue prices, holders of the outstanding shares as a whole won’t make a loss. Only the index was negatively affected.

In terms of CSI 300 and CSI 500, although they were not able to capture many growth opportunities due to the compilation methods, their performances were not inferior to Dow Jones, Nasdaq, S&P 500, Israel, France, or Germany's stock index over the past 20 years. Though from slightly different starting points, our indices were in relatively good shape.  Our problem was high volatility pulling down the Sharpe ratio and making the investor experience bad. Therefore, we should work on reducing the volatility through ways of long-term investment funds and mindset, better issuance system, better information disclosure, better quality of listed companies, good management of the pro-cyclical fund sales, respect for investment style variation and fund agreements, etc.

The CSI 300 and the CSI 500 have risen by about 30% from the trough in 2018. The rise of the indices over the past 3 years implied barely bubble compared to the development of the real economy. Only the epidemic and the Russian-Ukrainian war have been the new factors. We believe the former is manageable and the concerns about the economy will ease as a result. However, we would point out that the idea of large-scale stimulus might be unrealistic. With the current scale and structure of China’s economy, and with the consensus to pursue high-quality development, it would be ideal to see soft landings of some industries and breakthroughs in others. There would be no motivation to achieve a short-term recovery while leaving problems to the future. Risks have been greatly released with the return of the valuation of sectors such as Internet, Pharmaceuticals, Semiconductors, New Energy, as well as the electrification and intelligence of vehicles. The growth of these sectors has slowed down but matches better with the valuations than in the past. As to the Russian-Ukrainian war, its impact can be read as changes in the external environment and inflation.

In general, China's economy has shifted from investment oriented. A lot of upstream industries are under-invested while many companies have become cash cows. The problem of rush for and crowded transactions on high-growth names in the past few years has been easing. A large number of small and medium-sized companies have good prospects with attractive valuations. The worries in the market every few years all seemed excessive in hindsight. We have experienced financial crises, deleveraging, trade wars, concerns about "the state enterprises advance, the private sectors retreat", and the epidemic, and we think this time is no exception. The essence of our investment in China has not changed so far: we invest in its spontaneous and endless hard work to pursue a better life. For the external environment, it is already clear that China needs to have enough strength to get respect from its opponent. China’s development does not depend on others, but more on itself and the relationship around it. Stress tests have been in place for years, and it may be that the decline itself fuels the spread of fear and other emotions, which will eventually pass. Economic construction is still China’s most important KPI, and the country is capable to do it well. Relatively speaking, we are more concerned about the big inflation cycle.

In the medium and long term, we pay more attention to global inflation. We've been living in low growth, low inflation, and low interest rates for too long, and now it’s changing. This is going to have an impact on total demand and on the valuations that we feel comfortable with, which we think are inevitable. China's coal-dominated energy structure, complete industrial system, strong production capacity, and mostly self-sufficient agricultural system place it in a good standing. The recent FX rate changes, such as JPY to USD, have reminded us of the power of inflation. Everyone has stress, but we’ve got relatively less.

To continuously fear when valuation pressure has been largely released, crowded transactions have been greatly eased, short-term impact is about to fade, and building consensus to focus on economic construction becomes easier after a hard time is the same thing as to expect even higher returns when the overall market PE has reached 100x. Based on this view, we are willing to take risks and actively invest.