We Study Billionaires - The Investor’s Podcast Network - TIP384: Evergrande, Alibaba, and the Collapse w/ David Stein

Starting point is 00:00:00 You're listening to TIP. 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, David will break down what is going on with Evergrande, and in Libaba, 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.

Starting point is 00:00:27 You are listening to The Investors 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. Welcome to The Investors Podcast. I'm your host, Dick Broderson, 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. It was great to be here. Thanks for having me, Stig. So, David, let's set the scene for this conversation. So the Chinese equituary 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 to the S&P 500 that already looked somewhat expensive.

Starting point is 00:01:24 And so far here in 2021, it's up another 20%. So let's try and zoom out for 2021 and say, is the Chinese stock market cheap historically? 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's the big tech stock that make up, you know, are 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, you know, the China 50, the biggest names are down 17% year to day. 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. Longer term, though, China has been a profitable place to invest. If we look at the 10-year annualized return for the Chinese stock market overall, MSCI China Index, it's been about 8% annualized, so less than the U.S. over that time frame. But certainly competitive. and I think most investors would be happy with an 8% annualized return if it was broadly diversified.

Starting point is 00:02:40 If we think then about valuations, and the Chinese stock market is not that old. So it reopened again back in the early 90s. 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. 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 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 Schiller price-to-earnings ratio, which is the PE,

Starting point is 00:03:26 or price to earnings of stocks, but using the average earnings over the past decade, Right now, China's 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. But that's looking at 10 years worth of earnings. And to put that into comparison, the U.S. Schiller P.E. is at 37, 1.8 standard deviations above its average.

Starting point is 00:03:57 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 to 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 11.5%. So by that measure, and with these yields, the higher the yield, the more attractive to valuation. Even on a earnings yield basis, the Chinese stock is, 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

Starting point is 00:04:50 ratio. And I like to look at valuations on a yield basis just because then we can compare to interest rates and what those are doing. So at a six point, 9% earnings yield, Chinese stocks, the longer term average is about 7.5% going back to 1995. So it's not cheap. It's still more expensive than average. If we look at a period like from 2012 to 2018, the Chinese stock market was much cheaper with an earnings yield of double digits. And so putting in a longer term perspective, even with the sell-off year to date in Chinese stocks, they're not cheap. They're not incredibly expensive. expensive like you see in the U.S. and some other countries, but they're not a bargain by any means.

Starting point is 00:05:36 So if we look at the U.S. stock market, you know, you mentioned like the Shilapia that's 37, you know, 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, so low. So how does that work with China? Like, whenever you say it's not that cheap, you said it was like half standard deviation cheaper? Perhaps you can first talk about, like, what do we really mean when we talk, oh, it's like 1.8 standard deviation or half standard deviation, what does that mean? But also, like, how does that relate to the interest rate level in China?

Starting point is 00:06:10 Well, by standard deviation, a statistical measure. And so you might have heard of three sigma or two sigma. So three sigma is really a shorthand for three standard deviation. So something that is far away from its expected or its average, the wide. that standard deviation. And so in the KCOS stock market, 1.8 standard deviations for the Schiller PE, that's extreme. Only a certain percentage, you know, typically for two standard deviations, only about 5% of the observations would be more expensive than that. 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

Starting point is 00:06:54 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 1.5%. 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 interest rate. 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, like, it doesn't mean don't, you know, sell all U.S. stocks.

Starting point is 00:07:45 It just means your expect to return for the U.S. stock market is, is expensive. 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. And it's hard to argue that with the extreme valuation of 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

Starting point is 00:08:26 stock market and that has allowed for greater price appreciation. If we assume the US stock market is going to get cheaper and let's say fall PE by 10 points, then that brings to a stock market down to sort of low single digit returns over the next decade. And so as an allocator and we're all allocators, we kind of have to weigh these different markets, what are the risk and the rewards? And from a purely evaluation standpoint, China is more attractively price in the US. 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. You're definitely right. There are so many red flags and seems like all over the news,

Starting point is 00:09:08 all you hear our bad stuff come out of China. But before we get to that, David, I would like to take the contrary to you if we can call it that. And let's talk about Bull case because You have several prominent investors, including China Monker, who have been very vocal about the attractiveness of Chinese equities. So before we get to all the bad stuff, why are some people really bull on Chinese equities? Well, one thing they look at is they see that the Chinese economy is huge. So 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.

Starting point is 00:09:52 But the Chinese economy is 17%. So they just look at those numbers and say, well, this is out of whack. We have the U.S. comprising 22% of the global economy, but is 60% of the global stock market from a capitalization standpoint. 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 capitalization being size, 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 weighting 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 a reflective of how expensive U.S. stocks are.

Starting point is 00:11:02 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 per capita GDP is only $10,429. So much less. So 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 U.S., I remember being in, we were vacationing Mexico or spending a couple months there, and I was talking to a security guard on the beach.

Starting point is 00:11:58 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, like, who's taking the money? Was like, 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, how mechanized it is, 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. If you have a very highly productive tech sector, they pay everybody more money.

Starting point is 00:12:41 So it's that per capita GDP, that growth, the potential for China there is what makes it very bullish, if they can increase the productivity. One of the challenges that we'll discuss is the government's pushing back and doing things to actually potentially reduce productivity of some very, very successful Chinese companies, such as Alibaba that you alluded to. And I think there would be a nice segue way into the other side of the coin. You know, we will be talking specifically about Elibaba and Ivo Grande, but before we talk about that crackdown on everything that has happened, we also hear that there's a general Chinese bear case, like even before like all the skeletons have been falling out of the closets here or the, well, I guess it's over a year now, if you're kind of from the very beginning. But David, what is your bear case for China?

Starting point is 00:13:30 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 sort of agnostic. I'm looking at the data. I see some uncertainty. I don't see an inexpensive stock market in China that can sort of mitigate some of the risk we're seeing. So I'm sort of just waiting and seeing. But one of the things that you're seeing in China is the population growth is slowing.

Starting point is 00:14:03 For decades, China had sort of 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. And so one of the things that I look at longer term that can influence the stock market, that certainly influenced this economic growth. There's many other things that influence it, but certainly the working age population are what drives economic growth long term 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

Starting point is 00:14:47 economic growth. What we see in China, if we just look at the working age population, sort of ages 15, the 64, right now it's about 68% of the population. By 2050, it'll be down to about 60%. So the working age population as a percent of the total is actually shrinking. It's very similar to what you see in Europe, Germany, Poland, Switzerland, China. They all have shrinking, working populations as a percent of the whole, whereas there's 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. And then you have

Starting point is 00:15:42 sort of the frontier markets, you know, 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 thing. But just purely on a population basis, China's population growth is shrinking for working age individuals, and that becomes somewhat of a headwind. Now, they still have this opportunity to become way, way more productive. And so you've got both of those sides. You've got the population growth as a headwin, but you have potential productivity as a tail win. 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

Starting point is 00:16:32 try to clamp down on areas that they feel like is negative to the populace? Because the Communist Party, their biggest fear is social uprising. So they do everything they can to try to just, in some way, smooth out the volatility. The volatility of the citizenry. And what we certainly have learn 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. But now some of the things are doing, even just stuff they've done the past few months is incredible in, let's just say the crack down on trying to tell production companies, media companies, like, don't show this person

Starting point is 00:17:22 it anymore because we don't like how they think or to sort of ostracize famous people. And just sort of this micromanaging thing. This is a country of billions of people, yet 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. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer.

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Starting point is 00:22:03 Let's talk about the debt situation in China. So 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 US. And that's already very high. It's not, I don't know if the right binge mug is necessarily the US because that's also high. So we're really looking at this at a different level. We can also look at specific companies. I know you're specifically looking 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 a good shape. Another company that's really like, it's all over the news here.

Starting point is 00:22:40 That's Eva Grande. And we're recording this 27th of September. This goes out here later this week. So 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? Well, first off, the debt, it is true that China's private sector debt as a percent of GDP is some of the highest in the world.

Starting point is 00:23:06 Back in 2010, it was about 100. 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 per capita GDP of $10,000. So 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. So 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 that can be 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

Starting point is 00:23:57 because it's not a productive use of taking that potential future earnings and using them in the present. So that's one of the things to consider. The other is that China, communist parties, party, they control the banks. And so Haurang is a great example. So this was a company set up by the Chinese government. There's reports it was buying 30 to 40 percent, 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 it was one Chinese-focused hedge fund or Asian-focused hedge fund. And he was pounding the table, I mentioned, people are so worried about this debt situation and then realize that the Chinese

Starting point is 00:24:40 government controls the banks. And this is a great example. So they set up this company along, 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 20-21, to bail out the company. And so the state-owned enterprises have stepped up and basically kicked the can down the road, which is what you often see when you have a debt crisis. In the case of Ever Grande, they are the largest property developer in China. They operate in over 250 cities. They're building houses. Chinese citizens are putting deposits with Ever Grande to buy these houses. But China, the construction market, the housing market is much larger as a percent of the

Starting point is 00:25:31 economy than in other countries. And China, government a year ago, go regulators, wanted to clamp down on the property developers. Because China's a great economic growth, but the 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 their 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. Well, China is 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 sort of 5 to 8%. So you have Chinese citizens that are saving 31% of their

Starting point is 00:26:19 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. And so Evergrandi 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 at risk because they're not been able to sell as many houses. And you got this pressure from the government.

Starting point is 00:26:58 And it appears that Evergrande will need to be restructured. So then it's a question, will this be a restructuring like Harang where the state enterprises will step in or will there'll be aspects that will be allowed to fail? 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 are 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

Starting point is 00:27:48 have 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 Evergrandi, 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, provides liquidity, they cut interest rates, they do everything, to sort of calm things down. So the fear is lessened. 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 the bottom line if it's used in productive ways

Starting point is 00:28:30 and it's used in a way that eventually the Chinese economy rebalances to be more consumer-focused. I think it's important to understand how significant the real estate market is in China. And you could, of course, argue that, you know, show me a country where it's not significant. But it truly is, you know, you have like families in the States, you know, they rely on, real estate as savings, even to a larger extent in China. Like, 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 real estate. So, you know, from builders, supply of paint, and so on and so forth. So it's really important to understand that part. And also, like you mentioned, David, a lot of those deposits are already

Starting point is 00:29:14 made. So you have that system to some extent, but not for the same lead time in the West, specifically for Ivergarde's 1.4 million private homes that's already been paid for, and there's just nowhere to be found. And so I can't help but wondering, like 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 Evacrante collapsing would lead to a stock market crash in China or even spread? Well, it's possible, but it could be a catalyst, but we don't know. When you see the pattern in China the past because people talk about this is their Lehman moment. This is where the Chinese government lets a too big to fail company fail. And I don't see China doing that. And I don't have any insight,

Starting point is 00:30:01 obviously, but just based on their pattern, they might let the foreign bonds default. They will more than likely not, you know, will return those housing deposits. But one of the problems with companies like Evergrandi and other property developers is that we're at a tailwind 25 years growth in the housing market. You're not seeing that the population isn't growing like it was. So one of the things, you know, people talk about 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. And the home construction companies, the home builders are not houses.

Starting point is 00:30:49 Because that's what drives housing market. It's households formations. It's people getting married, forming a house or partnering and wanting to establish a household away from their parents. If you look at China, there were 31% fewer marriages in 2019 and China than there was in 2013. So you don't have the same level of household formation, We already saw some data showing the working age population as percent of the total. So you don't have not a bubble, but the housing growth.

Starting point is 00:31:19 So 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 the social cohesion. And they have stepped in to the stock market before and provided liquidity and other things. Potentially that will happen here. So we'll see.

Starting point is 00:31:45 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 that like you saw with the housing crash and the Lehman default back. in 2008 in the US. On top of all of this, for some period of time now, there's been talks about the US potentially delisting Chinese companies. So what happens to us if we say bought stock in Alibaba or perhaps another company through an ADR, bought on US exchanges, but in Chinese companies?

Starting point is 00:32:28 Well, there's two things going on. So when we 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. 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

Starting point is 00:33:20 that they 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, companies were starved 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. And what it is is a company will raise 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. So they'll form the company the Cayman Islands. They'll list the stock, raise capital in the U.S.

Starting point is 00:34:06 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, they'll pass on revenue. 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.

Starting point is 00:34:54 One of the big venture-backed industries in China was online tutoring, where billions of dollars were raised. And they used 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 of millions of students taking these college entrance exam.

Starting point is 00:35:17 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 non-profit. And we will not allow companies to raise online tutor companies to raise money through VIE or raise any money at all because you're no longer a for-profit company. And what happened was those VIEs, those ADRs, these online tutoring companies trading in the U.S. They fell 90% immediately. because they don't have a legal means because they set up these VIEs really to skirt the rules,

Starting point is 00:35:56 to avoid these foreign restrictions. And so they're still listed. You're going to still buy the company. So they haven't been listed. 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 a profit. And so one of the fears is that China will crack down on more of these VIEs because that's how Alibaba and its other tech companies, are set up. They're VIEs. The operations in China are owned by individuals, they're not owned by

Starting point is 00:36:24 the company itself. 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, you know, 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 its 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. I think that's a good segue because that's specifically talk about everything that's happening

Starting point is 00:37:08 in the tech sector. I think for here in the West, or perhaps it was primarily me, like being a sharehold in Alabama, which I was at the time, I was very much looking forward to this year. It was November 2020, and you had this IPO of Amfinancials. This is an affiliate company of Alibaba, and among its many assets, they have China's largest digital payment platform, Elipay. This is a massive, massive system, more than a billion users, 80 million merchants. And so just a few days before, it was just like, no, it's not going to happen.

Starting point is 00:37:42 And the world was like, what? Like, what is going on? And so could you please, David, walk us through what happened? Back then and then today, like what is happening in the tax sector from an investing and regulatory perspective? Well, first, Alibaba, for example, I think you had discussed it back in 2019. No, it was a good deal, $165 for share for the ADR. It got up to $317 in October 2020.

Starting point is 00:38:10 But then Jack Ma and the Ant Group was going to do their IPO. And you're right. The Chinese government said, no, you're not. And this was sort of the first pushback against some of these tech companies, which control a large part of the financial system. And Ali pay is very commonly used as a payment mechanism. Ali pay and aunt had loan products that you could borrow money. And one of the struggles in China right now is who is going to control the financial system. Then if you have what are known as shadow banks, shadow banks are non-traditional banks.

Starting point is 00:38:47 that perform banking-like function. And Alibaba is an example of that, or these pay apps, or the ability to borrow from another company. You know, Apple Pay is a shadow bank, effectively. And so that was the first push. And then, so 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 an app into a separate app. And we are going to be co-owners of your new company and your new app. And we

Starting point is 00:39:23 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've seen Alibaba fall 54% since last October. And 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 to 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, just like we've seen in online tutoring, they'll make it happen. There are private schools in the Financial Times reports in China that

Starting point is 00:40:15 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 in public school, you're not profit, and we own you, and didn't give any compensation for that. So that's the kind of thing going on. And it's hard. It's certainly, you've got two systems here. You have very entrepreneurial companies, innovative companies like Alibaba, 10 Cent.

Starting point is 00:40:45 that we're kind of given free reign to innovate. And now they've gotten so powerful and big that China said, no. We 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 it in the same thing in the crypto space. It's like who controls a legal tender? Who controls the financial system? And that's why these companies have been cracked down.

Starting point is 00:41:07 We don't know how it will end. So, yeah, Alibaba is cheap, but what's going to look like a year or two from now. That's just 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, I pitched this back in, I think it was the Q3, mass buying discussion. I am adding to my position now. The price is trading 145. So 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 be listening to this and they're thinking, well, you know, it's Alipay, you know, it's an app.

Starting point is 00:41:47 Like, what's all the fuss about? But it's really such an integrated part of the society that it's really difficult to explain. And I could you come up with this like, it seems like a silly analogy or I don't want this to come up as disrespectful whenever I'm saying this. But just to give you an example, like AliPay and WePay, we pay that's owned by Tencent. And there's such common method of transferring money and fiscal casts are just so non-existent that you have beggars on the street in bigger cities. They have QR codes that are eliminated with their ID for we pay and alipay. And again, I don't want to sound disrespectful as I'm saying this because it's not like

Starting point is 00:42:26 Mendez Entertainment. But it's just to say like it's so ingrained into society and the Chinese government and do not want that control to be in the hands of people like Jack Ma to rival the government. So you mentioned here before that you had several companies most noticeable Adibaba and Tencent who have been encouraged to contribute to common prosperity. And let me just put your encouraged in quotation marks. I'm pretty sure this is what's going to happen. It wasn't like an up-in system.

Starting point is 00:42:56 And we're talking about fines here of Friday Baba is $15.5 billion. dollars, 1010 is 7.7. And this is for a number of years. I think for Alibaba, it's five years. But what's the intention behind common 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? 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. You know, part of this common prosperity is just do things that seems like taking the economy

Starting point is 00:43:43 or the country in the way that the Chinese leaders want. For example, a crackdown on online gaming occurred this year. There has been a crackdown on celebrity fan clubs. There's 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. They're offering weekly classes to elementary school students on Xi Jinping thought, like the thought of the Chinese premiere. So you could say these contributions by wealthy companies, however, it's just like,

Starting point is 00:44:28 taking on debt, right? If it actually does improve society, improves the social cohesion, I suppose that can be helpful, but certainly investing those 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, you know, I think overall it's not great for the stock market, but there's a lot more going on in China than just the stock market. 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 another 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,

Starting point is 00:45:21 they want to be entrepreneurial. They want to have their own business. They want to do those things. And sometimes it can be very frustrating when they couldn't. And I saw some of that frustration, 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. That doesn't seem to be the case yet. But if, I'd say a contagion happens or there's a crisis, the Chinese citizens, they do protest. I mean, they get on Wibo and other.

Starting point is 00:45:54 They will protest. You know, 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. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up.

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Starting point is 00:49:41 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, simply because data is your commodity, your raw material. So they had a leg up compared to the States, and you could even say that the US have the same thing with Europe, where you're not allowed to collect as much data. So 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't necessarily do in the West. The Chinese government has said that it needs to be a market for data. It can't just be for that specific companies. It's like economists traditionally have looked at four factors of production, land, labor, capital, and then

Starting point is 00:50:27 entrepreneurship. But now it seems like China wants to add a fifth factor of production, which is data, and you need a market, otherwise it can be a factor of production. So I'm not sure what to read into this. It could look like the individual company might be more challenged, but perhaps Chinese companies all would still have a leg up. I'm not really sure how to reach the situation. So I'm curious to hear your thoughts. Well, I still think we're in the early days of AI.

Starting point is 00:50:56 There is so much more training that needs to be done, so much more data that we need to actually have things produced based on AI. And so, I mean, we've seen it some, certainly the loan products. It can be AI-based to figure out who's going to default or not. But I think we are in the early days of the AI revolution. And we'll see whether the Chinese way of going about it, where maybe it is more common data or the U.S., where you actually are seeing, even in the U.S. pushback on data collection with Apple's, some of their privacy enhancements and how that

Starting point is 00:51:29 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. We'll see if there's actually even more effective uses for AI that actually enhances the lives, you know, not just the profits of companies, but actually enhances the lives of individuals. In 2002, the United States Secretary of Defense, Don Rumsfeld famously said, there are no-knowns, known unknowns, and unknown unknowns. So, listener, please stay with me here, as I'm going through this. So by definition, we do not know the unknown unknowns.

Starting point is 00:52:06 But what are the known knowns and the known unknowns when investing in China? Well, the known knowns 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 subscribe to capital economics. And they do a Chinese proxy. So they're basically, if you're an economist in the U.S., you can get data issued by the US to know how GDP, it's always an estimate, but you know it's as accurate as it could be. In China, when the official GDP numbers released, it's massaged. Now, generally, the trend is probably fairly accurate, but any given year or a quarter, maybe not so. And so you actually, as an economist,

Starting point is 00:52:50 you actually have to use other data sources to kind of estimate what the official numbers are in the directions. And that's always a challenge in investing in a country where you can't even trust the economic data makes it very, very difficult to do. 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, the trades in New York doesn't own anything, that it doesn't have a contractual right to property and physical property or intellectual property in China. It 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.

Starting point is 00:53:41 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 that at least the confidence that you can in other countries. Now, all countries pass legislations, but you can see the process playing out and then can make your adjustments along the way. With China, you don't see it. It's just, boom, online tutoring companies are not-for-profit.

Starting point is 00:54:23 Stockfall is 90%. And that's the biggest risk of investing in China. that unknown and sort of 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 it makes it very, very difficult to invest, which is one reason why the Chinese stock market 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. You know, closer to the valuations we saw in 2012 to 2014, as opposed to where they're at currently. I think you bring up a great point.

Starting point is 00:55:01 Like, you really need to be aware of the risk. And you have so many bureaucrats right now in China assuring foreign investors that, no, like, we're not going to see 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. Like, it's not. I think everyone expects something more bad to happen, and perhaps that can eat into your margin of safety.

Starting point is 00:55:28 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 this show, because a known unknown for me is China's new digital currency. So this was something that was unveiled back in 2019. And this digital currency began its trial in April 2020 and has slowly been rode out into major cities. So this cyber one stands to give Beijing power to track spending in real time. Plus, it's also money that isn't linked to a dollar-dominated global financial system.

Starting point is 00:56:01 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? First, we have to step back and think about the types of money that there are. For example, China, the U.S., there's actual currency that the bills, the coins. They are liabilities of the central bank, so the U.S. dollars in 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.

Starting point is 00:56:41 So 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. The third type of currency is what are known as central bank reserves. So the only people that can access that right now is the private banking system. So 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.

Starting point is 00:57:18 And as part of QE and other things, they have these reserves, which is basically their liabilities of the central bank, just like the currency is a liability. The bills and notes are liability of the central bank. Those reserves are liabilities of the central bank. 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 as they want. Central banks that have been power to create as much currency as they want.

Starting point is 00:58:01 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. If you invest in BlockFi and put money at a BlockFi cryptocurrency lending, like 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 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 banks experimenting with is exactly that.

Starting point is 00:58:41 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? It's 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?

Starting point is 00:59:12 So 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. China wants to push back against that. They would 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 and Bitcoin and others.

Starting point is 00:59:52 And you've seen Bitcoin sell off. 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 AliPa and these other payment apps. 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 digital currency? And will they go as far as to say AliPay is now not legal? And you can no longer use that.

Starting point is 01:00:37 You have to use the central bank digital currency. And that's one of the, like I said, that would be a known unknown. We don't know. 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 an interesting experience was happening right now. But David, it's been really great talking about China, you know, a beer case, a bull case. So let me see if I can sum of that up here in my final question for you. How should investors think about whether it should invest in China? And if the answer is yes, could you talk to us about position sizing, which considerations

Starting point is 01:01:17 to make? The simplest way to invest in China is to own a global stock market ETF, such as Vanguard total global stock market ETF VT. It's about 4% China. In that case, if things work out 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. 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.

Starting point is 01:02:02 So 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 you like doing the research. 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.

Starting point is 01:02:45 I can look at drivers, 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 overweight 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. India stock marks a lot more expensive than China. So I've also used some active funds for active managers that are on the ground in India

Starting point is 01:03:17 trying to figure this thing out. So 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 like to do that and they find like they have an informational edge to add value. So those are kind of the ways to do it, passive, active, or just kind of go on your own and pick your own company.

Starting point is 01:03:44 Wow. David, thank you so much for joining us here on the show. You know, 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, like, what is going on in China right now. David, whenever people ask me which podcast to listen to, your podcast is, is one of them that I mentioned.

Starting point is 01:04:03 So I want to just say here to the audience, go check out money for the rest of us. It's an amazing podcast. I would like to give you an opportunity to tell the audience more about the resources, where they can find you, and more information about you. The podcast is called Money for the Rest of us.

Starting point is 01:04:19 We've been doing it for almost 80. years now. There's also our YouTube channel, also Money for the Rest of us. On the website at Money for the Restless.com, there's some free investment guide 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 podcast. And I'd welcome to check it out at Money for the rest of us.com. Fantastic. Well, again, David, thank you so much for coming to show. I hope we can invite you back one day. I'd love to come back. Thanks.

Starting point is 01:04:53 Fantastic. All right. So as we're soon living David Goh here, make sure to follow us of your favorite podcast app. And if you're watching this on YouTube, make sure to subscribe. We'll be back next week with the new episode of The Amherstas Podcast. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or course.

Starting point is 01:05:21 go to the investors podcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP384: Evergrande, Alibaba, and the Collapse w/ David Stein

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