Investing Through Geopolitical Risk
Owning Chinese Stocks in 2023
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Hello fellow investors!
Welcome back to the JB Global Capital Newsletter:
When analyzing investment opportunities, we focus on the fundamentals of individual businesses such as financial ratios, management quality, capital allocation, and the like. We find these aspects of business analysis relatively easier to quantify and link directly to our valuation models. However, as global investors, we are highly impacted by a variable that is not as simple to analyze: Geopolitics. In today’s article, we will be examining our current approach of investing through rising geopolitical risk with an emphasis on Chinese equities.
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TL;DR Version:
Heightened geopolitical risk increases financial market volatility and induces delays in corporate investment decisions, and, as a result reduces equity valuations.
Negative geopolitical events historically have had a short-lived impact on markets and economies. However, since the Russian invasion of Ukraine and the tensions between the U.S. and China, geopolitical risk has heightened for global equities in alarming ways that are causing investors to now question whether these risks are structural in nature and long-lasting.
Economic competition between the U.S. and China is driving global fragmentation as both nations aim to boost self-reliance and decouple various sectors of their respective economies.
Long term investors who are willing to bear the U.S.-China risk have an opportunity to purchase high-quality operating businesses at a significant discount.
Part One: Geopolitical Risk Defined
Geopolitical risk refers to the uncertainty and instability in the global political environment that can negatively impact the investment climate. Some factors that have traditionally given rise to geopolitical risk include:
Government Instability
Trade Tensions
Sanctions
Regulations
Military Conflicts
When considering the valuation process for individual securities, it is intuitive that geopolitical risk lowers the value of equities due to increased uncertainty for operating businesses and the functioning of capital markets. The nature of geopolitical risk makes it difficult to predict ahead of time and can lead to material investment losses in quick fashion. Academic studies have gone through great lengths to show the correlation between geopolitical risk and investment returns. In a 2021 academic study published by the IMF, titled, The Impact of Geopolitical Risk on Stock Returns, researchers analyzed the effects of geopolitics through Inter-Korean relations. The study looks at how corporate stock returns respond to geopolitical risk in the case of South Korea, which has experienced large and unpredictable geopolitical swings that originate from North Korea. The conclusion showed that negative geopolitical events such as military tensions and sanctions reduce stock returns, and that this reduction is greater especially for large firms. Conversely, positive events such as constructive dialogues and economic cooperation led to increases in stock returns for all firms in the study.
In summary, heightened geopolitical risk increases financial market volatility and induces delays in corporate investment decisions, and, as a result reduces equity valuations.
We believe that as long-term investors, the pertinent question to ask then is, how long do these geopolitically induced effects last? According to analysis conducted by the investment management company Blackrock, geopolitical events historically have had a short-lived impact on markets and economies. A key takeaway from the study indicated that the average market response to unexpected geopolitical shocks has historically been relatively modest and short-lived. Equity prices tend to take a hit in the immediate aftermath, but these moves often dissipate quickly. For example, the S&P 500 Index fell almost 12% in the first week of trading after the September 11th attacks of 2001. Yet the stock market had recouped all of these losses within 25 business days after the event.
Historically speaking, investors who purchased equities during or immediately after negative geopolitical events were quickly rewarded with increased returns when risk subsided. However, since the Russian invasion of Ukraine and the tensions between the U.S. and China, geopolitical risk has heightened for global equities in alarming ways that are causing investors to now question whether these risks are structural in nature and long-lasting. Even Warren Buffett, who is famous for focusing solely on individual businesses and ignoring the macro-environment, has recently called geopolitical tensions "a consideration" in Berkshire Hathaway's decision to sell most of its stake in the Taiwanese chipmaker TSMC.
In the most drastic geopolitical event, military war, foreign investors risk losing 100% of their investment value due to government sanctions that can limit or outright restrict citizens from owning foreign securities of an adversarial nation. As a recent example, the U.S. Treasury Department banned U.S. money managers from buying any Russian debt or stocks in secondary markets through sanctions on Russia over its invasion of Ukraine. Speaking to the sanctions against Russian investments, a Treasury spokesperson stated,
“Consistent with our goal to deny Russia the financial resources it needs to continue its brutal war against Ukraine, the Treasury has made it clear that U.S. citizens are prohibited from making investments in the success of Russia, including through purchases on the secondary market.”
As business analysts, we find it much simpler to calculate free-cash-flow yields or interest coverage ratios than to analyze the probability of a military conflict between nations or to predict changing government policies in emerging market countries. However, while not simple to do, we need to consider geopolitical risks when making investments, especially in our foreign businesses. As our current investment portfolio has significant exposure to China, we find it necessary to analyze a major geopolitical risk associated with Chinese equities.
Part Two: The Current State of U.S./China Relations
The relationship between the United States and China has been deteriorating materially over the last decade. This deterioration is the direct result of mistrust between both nations amid accusations of espionage, multiple human rights violations by the Chinese Communist Party , and intellectual property theft by Chinese corporate entities. The negativity toward China in the United States is currently at its highest level as Gallop polls indicate that Americans View China as the U.S.'s Greatest Enemy , even higher than countries such as North Korea, Russia, and Iran.
This general view has been supported by U.S. policy makers by actions directly aimed at slowing China’s economic ascension through export controls restricting U.S. firms and engineers from assisting Chinese production of semiconductors, a vital component for future economic development. U.S. President Joe Biden is expected to introduce a new investment ban on China at the upcoming G7 event on May 19th, set to limit U.S. investments into Chinese companies that are directly related to advanced technologies such as quantum computing, artificial intelligence, and semiconductor manufacturing.
One of the largest concerns over the past year of owning Chinese stocks has been the delisting risk stemming from financial audit inspection rules. Under Sarbanes-Oxley, if a company wants to issue securities to the public in the United States, its auditors must be subject to inspections and investigations by the PCAOB. Jurisdictions around the world understand and accept this basic bargain. The only outliers are China and Hong Kong. The Chinese government has historically cited national security concerns and has not allowed U.S. auditors to directly inspect working papers for Chinese businesses. This led to the United States threatening to delist Chinese companies trading on U.S. exchanges if the government did not agree to cooperate. A forced delisting of Chinese companies would have been disastrous for U.S. investors and the future of U.S.-China relations. Ultimately, China capitulated and U.S. regulators gained full access to the audits of Chinese companies, providing much relief to all parties involved.
More recently, the highly public congressional hearing of Tik-Toks CEO, Shou Chew, showed members of congress, democrats and republicans alike, grill the CEO over the companies suspected relationship with the Chinese government. Even as the CEO claimed that American Data was stored on American Soil and rejected the idea of spying for the CCP, the lawmakers appeared dismissive and actively hostile throughout the five-hour testimony. My own personal opinion is that the Tik-Tok hearing showed just how strained U.S-China relations have become; when an app that is popular for viral dance videos among teens is now considered among many Americans to be a threat to U.S. national security.
It appears that economic competition between the U.S. and China is driving global fragmentation as both nations aim to boost self-reliance and decouple various sectors of their respective economies.
On the military front, tensions have been steadily increasing as Taiwan remains the most volatile flashpoint between the nations. China’s President Xi has reaffirmed his commitment to Taiwan’s unification with China and has not explicitly ruled out the use of force if necessary. While the U.S officially recognizes the One China Policy, which acknowledges that Taiwan is a part of China and not an independent country, recent actions by U.S. officials have signaled political support for Taiwan should they declare independence from China. For example, on September 18th 2022, President Biden said that U.S forces would defend Taiwan in the event of a Chinese invasion, creating much confusion over official U.S. policy related to Taiwan. China has responded to these actions with military drills in the Taiwan-Strait and economic sanctions in retaliation to what they perceive to be a threat to Chinese sovereignty.
Even as military tensions over Taiwan rise, recent surveys of Taiwan's people do not reflect a strong enough preference for the democratically elected leaders to declare independence from mainland China. However, Taiwan will hold presidential elections in January 2024 and independence may be discussed. Any talk of Taiwan independence could weigh on market sentiment, stoking concerns of the prospect for a tense four years, with the threat of Chinese military action increasing.
Owning Chinese Stocks in 2023
In our previous article, Contrarian Investing we have described our approach of looking for high-potential investment opportunities. This approach involves looking for bargains in areas that most other investors avoid or discard as “uninvestable”. We find that the contrarian approach to investing is logical in our understanding of how assets are valued; i.e. with known risks priced in and short term expectations dictating stock price fluctuations over any single year. As a result, we look to profit by investing in what we believe to be high quality durable businesses during a time of wide-spread negative sentiment. Howard Marks, in his memo It's Not Easy, explains this approach best when he write,
“Most people don’t understand the process through which something comes to have outstanding moneymaking potential. The very coalescing of popular opinion behind an investment tends to eliminate its profit potential. Superior investors know – and buy – when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit.”
Speaking directly to our Chinese investments which include a large position in Alibaba and smaller positions in Tencent and JD, we think about different outcomes concerning geopolitical risks. Our thought process is as follows:
(A) What is the worst-case scenario?
(B) What is the probability of this outcome occurring?
The worst-case scenario for our Chinese equities would be a full-scale military conflict between the U.S. and China. If this were to occur, the effects would be disastrous for our fund, and in all likelihood, the entire world-economy and global financial system, saying nothing of the tremendous loss of human life that would result. This scenario would be so catastrophic that it almost all but guarantees that it will not occur, should rationality and self-preservation prevail. If, on the other hand, the U.S and China choose to enter into a mutually destructive military conflict, then investment values will be the least of our concerns.
Outside of a full-scale war, we find it probable that U.S.-China tensions will remain high for quite some time. Taiwan continues to be a major risk and the current political climate makes it likely that tensions will continue to be high. It is our belief however, that over the fullness of our investment outlook, economics will prevail over politics, leading to continued strategic economic cooperation between nations. Recently, the U.S. has signaled that it does not want to decouple economies and instead wishes to engage in fair competition, not destructive conflict with China.
In summary, we find a few key points evident about our investments in Chinese equities:
There are significant geopolitical risks associated with investing in China.
Capital markets have priced in many of these known risks, leading to an undervaluation for Chinese equities as a whole, based on earnings potential.
Large cap Chinese tech stocks like Alibaba and Tencent have been especially discounted due to these risks.
Outcomes related to U.S.-China relations are unknowable, but have been largely negative to this point.
Long term investors who are willing to bear the China risk have an opportunity to purchase high-quality operating businesses at a significant discount.
Thank you for reading! We hope that you found this discussion valuable. All feedback is welcomed in the comment section below. Until next time!
Sincerely,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.