China’s crackdowns on its technology and education sectors have had repercussions across global markets. The fallout? The Nasdaq Golden Dragon China Index, which tracks 98 of China’s most prominent firms listed in the U.S., plunged 7% on Monday, June 26th. Added to the previous Friday’s 8.5% drop, puts the two-day decline to 15%, its biggest since 2008. That is a $769 billion drop in value from U.S.-listed Chinese stocks. This happened after regulators in China unveiled an overhaul of its education sector. It bans firms that teach school subjects from making profits, raising capital, or going public.
At the risk of tooting our own horn, this is why we avoid investing in regions without adequate property rights, investor protections, or predictable rules of law. For the last few years, various market pundits talked up the attractiveness of Chinese companies, many predicting that big tech Chinese firms and indeed the Chinese economy would soon displace the U.S., both in economic and technological preeminence. Indeed, many fund managers, including some of our competitors, took sizeable equity positions in Chinese companies based on this hype and premise.
We are not saying that Chinese tech firms cannot recover, nor that Chinese GDP cannot catch up to U.S. levels. But investing is about valuation – essentially forecasting a company’s future earnings and discounting the forecasted earnings by the company’s cost of financial capital. The critical assumption in the valuation exercise is that businesses (and hence the earnings) belong to their legal owners. The only way a transfer of ownership is possible is through a voluntary exchange at mutually acceptable prices between buyers and sellers.
The Investment team at Trajan does not have full confidence that property rights in China are backed by predictable and durable legal processes. Indeed, China’s political system of unelected “leaders” holding absolute power does not inspire confidence in fair outcomes regarding private investments. We at Trajan cannot ever guarantee that our client’s capital will not be expropriated in a system with weak property rights, limited due process, and absolute power concentrated at the hands of one party. Neither do we believe that any of our competitors can make such guarantees. As such, we think investors who take positions in Chinese stocks are speculators rather than investors, hoping for free market outcomes rather than being confident that free-market outcomes will unambiguously transpire. As fiduciaries, we feel we owe our clients the duty of skill and care in everything we do, translating into due diligence rather than hope. Yes, I know it’s a cliché, but hope is not a strategy.
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We will continue to remain prudent stewards of our clients’ capital and never invest in questionable jurisdictions just because our competitors may be doing so. Please let us know if you have any questions by contacting us here, or calling 1 (800) 838-3079.
Udayan Mitra, CFA – Chief Investment Officer, Trajan Wealth