Climbing The Great Wall of Worry (Again)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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