Rethinking the Growing Bubble in Chinese Markets

“It’s the only place we could take a company in a developed industry and double our business each year for five years. Where else can you start out with $5 million in sales and be making $35 million in practically no time?”

That’s what one of the world’s leading Chinese financiers told me over dinner last night.

It has caused me to rethink the growing bubble in Chinese markets. And that we may have thought a bit too much, looking too closely at key economic fundamentals like electricity consumption and age demographics in the past.

As we’ve professed throughout this rally, we should be looking at taking what the markets gives us. Here’s the new take on China.

Mainstream Media Signals

Just like U.S. stocks, Chinese stocks soared during the rally. Almost anything China related has more than doubled.

The primary catalyst was obviously a surge of cheap – really cheap – money into China’s economy. Banks, at supposedly government demand, ramped up their lending to historical proportions.

The cause was obvious and most pundits jumped on board. And just like they have prematurely called an end to the rally in the U.S., there have been even more who have called an end to the new China bubble.

In April, the Business Insider warned “China’s bubble will burst. And painfully.”

In July MSN stated, “Easy money inflates a New China Bubble” and how it saw an “overheated” China economy.

In August, Paul Krugman, Nobel Laureate economist and New York Times blogger, claimed, “[China] is blowing bubbles.”

They were all on top it. But they all forgot how markets work. The stock market doesn’t care about the long-run costs or impact of the bubble; they just care about the next move.

And right now and in the intermediate future, the trend is up. Here’s why.

It’s the Domestic Economy, Stupid

A lot has been made throughout this downturn of China’s declining exports. Granted, China’s export-fueled growth over the past 30 years has run into some serious roadblocks. But there is two ways to look at this though.

One view – the mainstream view – China’s economy is screwed. U.S. consumers are maxed out. And without them, there’s no one to buy Chinese goods. Sure, exports will not halt completely, but the boom years are pretty much over.

The other view – the one the market is taking – is that this means opportunity. As the thoughtful David Rosenberg points out, “Remember – consumption in China is only 33% of GDP, the lowest of the world’s leading economies.” That means there’s a lot of room to grow.

The key thing here is what is actually going on in China. From what I gather, there has been a fundamental shift in China’s industrial priorities over the past few years. It’s something anyone who merely looks at the GDP, retail sales, or electricity consumption data would completely miss.

The shift is away from the very low-margin manufacturing and into more value-added products. Vietnam has demonstrated its willingness to manufacture clothing, simple toys, and all sorts of low-margin, labor intensive products. The change frees up China, its more educated workforce, and better capitalized companies to manufacture more value added products like electronics, cars, etc.

Think of it like the U.S. during the turn of the century. The U.S. economy shifted from relying on production of steel, textiles, coal, and other raw materials and low-value products to making stuff on the higher end of the value spectrum. That’s what is happening in China right now. And having a willing and able partner like Vietnam who’s rolling out the red carpet (no pun intended) will only accelerate the shift.

It’s going to take time and there will be growing pains, but there are still plenty of growth opportunities in China. And now, China is making great efforts to ensure there is funding available for the upstart growth engines of China’s economic growth.

Go Small or Go Home

Earlier this week China’s financial markets took a giant step forward.

With relatively little international fanfare, the ChiNext stock exchange officially opened its doors for business on Monday.

The ChiNext is set aside exclusively for small, riskier ventures. It’s essentially the NASDAQ of China. The listing requirements are much less stringent than the Shanghai exchange. With the ChiNext up and running, smaller companies no longer need to grow for years to tap into the equity markets.

The ChiNext proved there is a big appetite for riskier ventures in China too. It started trading on Monday with 28 companies listed. The share values of all those companies doubled on the first day too proving there’s a lot of interest for real growth.

And it’s in the smaller firms where the real growth opportunities lie. Even though the big Chinese names get all the headlines, the Telegraph reports, “small- and medium-sized [Chinese] businesses account for 80% of jobs, 50% of tax revenues and 60% of GDP.”

Small businesses in China are the future. And they will be the best opportunities which will leave everything else in China far behind.

China’s Next Favorite Commodity

Over the last decade, China has been one hot sector. The storytellers have painted pictures of 1.1 billion Chinese people buying [insert consumer product here – cars, refrigerators, cell phones] to justify ridiculous valuations for shares of major Chinese companies.

It all made sense too and, for the most part, was real. It just makes sense that as you get more money, you want more stuff and services.

But there’s another sector the crowd isn’t paying much attention too and it’s shaping up to be more lucrative than any Chinese sector to date.

As a whole, China is still in the early stages of the quality-of-life uptrend. The important thing to understand is the demand for new stuff comes at different stages of this cycle.

We’ve all witnessed surging demand in China. Whether its food, homes, water, cell phones, refrigerators, TVs, air travel, insurance…you name it, they want it.

But I see a next step coming. The next natural progression is one I don’t believe “the herd” has really focused on yet. Although, it’s probably the biggest opportunity in the unfolding China story: healthcare.

That’s right healthcare. It’s the ultimate quality of life product that’s in demand once you get enough money.

The U.S., again, is the perfect example of what will unfold as China gets wealthier.

From a general perspective, the U.S. is a very rich country. We have high wages, standards of living, high everything.

Yet, right now, the main focus of politicians has been on healthcare. The most commonly figure trotted out by the healthcare reform pitchmen is how much the U.S. spends on healthcare.

Frankly, I still haven’t figured out how this is a “bad” thing. If we have that much disposable income that we can spend so much on healthcare, that’s a good thing? We spend more on TVs, cars, energy than everyone else, but spending more on healthcare is somehow bad? Yes, there are lots of inefficiencies too, but having a lot of disposable income is not a bad thing.

So that’s why, with China’s GDP growing, it’s ongoing increases in national wealth, and everything else moving right along, the next big China boom is shaping up to be in healthcare.

Also, demographics are in favor of a genuine healthcare boom too. China is not just getting wealthier, it’s getting older. And that’s the perfect mix for a real surge in demand for healthcare. It’s the next natural progression.

The New China Strategy

That’s where we’re at right now. Most of the mainstream media see nothing but a massive bubble in China. Frankly, we’ve seen it and tracked it too. Bubbles, however, are truly great opportunities.

Yes, the bubble will end. It will end badly. And it will come when most investors least expect it. But if this is the next great bubble, it would be tough to sit on the sidelines for the next two, three or five years watching fortunes being made just for the sake of being “right.”

As my dinner guest rightfully pointed out, there just aren’t too many places where you can find businesses that double themselves each year for countless years ahead. But China is one of them and I can’t recommend staying away merely because everyone sees a bubble emerging.

After all, if a bubble is forming…all the better.

In a bubble, there will be opportunities to buy on dips and a genuine bubble will just accelerate the gains, push valuations far higher than they should be (and our gains right along with them), and since we have the tools (i.e. trailing stop losses) to ensure we don’t ride it all the way up and then all the way back down, why not.

By Andrew Mickey

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