Retirement Investor

Trust China? That Requires a Significant Discount

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Chinese GDP has grown twice as fast as U.S. GDP over the last 10 years, but the S&P 500 has more than doubled the average annual performance of the MSCI China index (MCHI). The outsized performance has led to a 361% gain for the S&P 500 vs. a 107% gain in MCHI. How can we have such rapid growth in GDP without seeing the performance in the stock index? Are Chinese stocks just very undervalued? Should we be buying these ‘cheap’ stocks, or should we expect another decade of underperformance?

The Lemonade Parable

Imagine living in a neighborhood that had one family that was very large. So large, in fact, the Brady bunch, the Duggars and the Gosselins think they have it easy in comparison. The Big family is very industrious. They win the holiday lighting contest every year, the yard is always landscaped, and the driveway cleared of snow. To try to maintain the family order and structure, the parents keep a very close eye on the family, and they are wary of them talking with neighbors.

The family has one particularly entrepreneurial child. The child no longer wants to landscape and dreams of providing the neighbors with the delicious lemonade that she has concocted. The Big family reluctantly agrees to let the child set up shop to sell the lemonade to the neighbors if all the profits go toward supporting the family. The child sets up shop and she is a huge success selling to her Big family and neighbors alike.

The Rich family looked upon the child and thought, “With some investment, we could get a contract packer, a company that manufactures and packages products for clients, and start to mass market this lemonade to national chains.” The industrious child loves this idea, but she needs to be honest about her agreement to give all the profits to her family. The Big family sees the success of the child. They are encouraging but nervous about the new interactions with the Rich family. The Big family decides to let the child pursue the new opportunity but does not guarantee that they will ignore their rules. For some reason, everyone involved is content with this agreement. The child’s success continues. The Rich family continues to invest. The family interferes just enough to keep the Rich family on notice but stays away just enough to continue the flow of lemonade.

The Lesson

In the lemonade story, the Big family represents China. The child may represent Jack Ma or another successful Chinese entrepreneur. The Rich family is from the United States. The agreement, where the child and the family own the entire company and the Rich family continues to invest is known as a Variable Interest Entity (VIE). The VIE shares are listed on exchanges and are known as American Depository Receipts (ADRs).

You may be thinking: “ADRs have to be worth SOMETHING!”

ADRs are worth exactly what the Big family decides that they are worth by the enforcement or lack of enforcement of their long standing rule. It is nearly impossible to know what that value could be.

There was the assumption by some that the Chinese would not want to limit access to capital so they would not enforce their laws. We have seen that those assumptions are incorrect. DiDi’s business was pulled from app stores for listing in the United States. Ant Group’s IPO was cancelled before being listed.

Ultimately, the structural reason for the dramatic underperformance of Chinese stocks is due to the additional risk associated with the one-sided agreement. Investors would need to trust that the Chinese government will not enforce their laws and that trust requires a significant discount.

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Adam Mesh

Adam Mesh is the founder and CEO of WealthPop.com. Adam has extensive experience in the stock market, as well as being a options trading coach for many years. Our mission is to empower the average, everyday individual to become a better investor and trader.

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