Grab the Chinese dragon by its horns!

Why China is important for stock investors.
Everyone is talking about Bitcoin—you’re better off keeping your eyes on oil.

This is not about your kids learning Chinese or about you buying Alibaba stocks. This may or may not make sense. Twenty-five years ago, China was, from an economic standpoint, as big as Turkey. Since then, the Chinese have been knocking on the door of the U.S. and are asserting their influence. China’s GDP is already amounting to approximately 60 percent of that of the U.S.

Mellinckrodt initiator Daniel Flaig is not only a private equity pro but also a seasoned China expert. He took his first trip to China as early as in 1984. Daniel travels to Shanghai and Beijing for business several times a year—the private equity company Capvis, where he holds the full-time position of Managing Partner for the acquisitions of companies, has an office in Shanghai. The Chinese site has been supporting Capvis’ portfolio companies in the expansion of business activities in China.

In addition, since recently, Daniel is the only non-Chinese member of the strategic advisory board of an investment company of the China Aerospace Investment Holding (CAIH), managing funds for the acquisition of companies in a volume of currently $16 billion.

What has happened that is prompting us to direct our attention to China?

Daniel Flaig (DF): China is a very old country, placing much value on history. The Chinese are looking back on a history of thousands of years, during which they were, for the most part, the most important country in the world—and China wants to regain precisely this position with all its might. President Xi is probably the strongest Chinese leader since Mao.

Why is this relevant?

DF: In the past, the Chinese weren’t members of the world’s first league. Among the BRIC countries, the C stands for China. But China doesn’t want to be an emerging market any longer now. The Chinese let others go first and were second in line when it came to world problems until now.

Xi Jinping has changed this. At the National People’s Congress, he declared that he’s now ready to take on the role of a global leader when it comes to topics such as climate or trade. And China has the economic power to do so. The country is a giant state capitalist, investing worldwide and making history. We’re not anticipating an adaption of the Chinese system to western structures.

And how does this affect companies’ markets worldwide, whether they’re publicly listed or not?

DF: China operates based on plans and determines accordingly in which areas specifically it will invest. For starters, there’s the directive, which we reported on in September, to not invest abroad but rather to invest in China.
The HNA corporation has not only stopped its investments, but according to rumors, numerous international holdings are now being sold. The prohibition of cryptocurrencies in China has not been able to halt their success. But this, too, was a measure to ensure that cashflows generated in China will primarily be invested in China.

Which areas do the Chinese invest in at home?

DF: Apart from an expansion of the consumption and services sectors, state-of-the-art equipment goods, robots (not only Kuka), 3D print, and everything summarized by the term Smart Factory are key sectors. Aerospace and navigation systems are part of it, too. China is focusing on electric mobility, and one of the biggest hurdles in this area are the corresponding electrical grids called Smart Grids. The Internet of things and everything that has to do with mobile communication is part of the key topics. And, last but not least, solar technology, solar thermal technology, and many types of new materials.

And how do the Chinese want to implement all this?

DF: China’s approach is multifaceted. The country’s own innovations are combined with the import and export of technologies. Company acquisitions across national borders and the use of the capital market for financing are additional elements. This results in diverse opportunities especially for non-Chinese nationals.

But the Chinese are state capitalists. How are we going to profit from this?

DF: The country China is a big state capitalist, that’s true. There is, however, a private sector that does invest, in compliance with the government guidelines. In addition, the Chinese depend on the collaboration with western companies if they want to achieve their ambitious goals.

Give us an example.

DF: Let’s take investments in new factories. They are operations that oftentimes are initiated at the beginning of an economic cycle but whose implementation usually occurs much later. Involving big investments, these types of projects drive the economy and result in a financial boom. The global economy is in this very phase at the moment. Needed in this situation are, for example, factory certifications—otherwise products can’t be sold.

However, the global leaders in the certification business are in Europe. They are companies such as SGS in Geneva or Bureau Veritas in France. These companies are perfectly positioned to profit when China is investing at home. Bureau Veritas, for example, has been active in China for 30 years, is the market leader, and the corporation is achieving enormous sales over there. When we asked, the CFO, in a talk between investors, didn’t even rule out the possibility of an initial public offering of the Chinese subsidiary if business continues to do as well as it has.

And why not invest in China directly?

DF: I’ve been traveling to China regularly in the past 15 years. The market is huge with tremendous opportunities. But it’s also important to be able to gauge the stakeholders and to verify that you’re being treated fairly when investing in a company. That is much easier for us with our background Switzerland and Germany when we invest in world champions in export from our cultures. And there are plenty of them at the stock exchange.

In that case it’s more important to examine thoroughly if the respective world champion in export is strongly positioned in its niche in those countries where a good development is expected. That requires in-depth knowledge.

And the national debt of China—we keep hearing that it’s so big that this could trigger a crisis?

DF: It’s true that China shows a big national debt, which has increased drastically since the financial crisis. But the country also holds huge foreign exchange reserves. In addition, the financial sector is an area that can be bridled by a country that governs in a dirigiste manner and has extremely big capital reserves. It’s difficult to picture a case like Lehman. That would be the endpoint of a development leading to the replacement of the Communist Party. When something like this happens—and that can never be ruled out, of course—then it would be a process that occurs over longer periods of time and, as of today, such a development has not at all started. Quite the opposite is true. The Communist Party under Xi Jinping is as firmly in control as it hasn’t been in a long time.

So what are the risks for China?

DF: From my perspective, the main risks are external shocks. Although China is strengthening its domestic market, a recession in important developed countries is a problem for China as well, of course.

Or a steep increase in energy prices. Currently, things are happening in the Middle East whose end isn’t foreseeable yet. The U.S. recognizing Jerusalem as Israel’s capital is a symbol. And such high symbolic prices are only paid in special situations. Imagine what would happen if Saudi Arabia built a united front with Israel against Iran. The latter has been an enemy of both countries for a long time—just not a common enemy until now.

The price for oil is just starting to price in political risks again. All this is not bad for the upcoming Saudi Aramco IPO. Trump is not as crazy as most Europeans believe. In addition, he has many supporters in the corporate world. Maybe Trump will manage after all to reduce the gap between him and his role model Ronald Reagan more than seems possible today. Trump’s course, however, is risky, and the flight to the sun may end the way it did for Ikarus. Which, of course, takes us to China’s next problem: North Korea.

Kim isn’t crazy either. If on Korean TV during prime time 20 minutes of a 30-minute news show are spent on discussing in detail the differences between Kim’s last rocket and the one prior to that, then we just might all totally underestimate the North Koreans and simply deny—like a blind spot—the magnitude of the problem. And “we” probably includes China.

And how does the great outlook in China go together with the weak development of the technology sector in the past weeks?

DF: The small digression China in our interview touches on long-term topics and developments. The price trend at the stock exchange is oftentimes driven by completely different influences, too. The weakness of the technology stocks is probably a foretaste of what lies ahead as a result of the ETF boom.

We read that several big technology ETFs had to process the return of shares in a volume of several billion dollars. Tax aspects play a role for U.S. investors who suddenly realize that the taxation of price gains may be cheaper when they are not pushed back to 2018, and that requires a quick switch from one sector into another.

We at Capvis, together with the Partners Group, have listed the VAT Group, the world market leader in vacuum valves, at the stock market last year. I recommend reading the interview with CEO Heinz Kundert in the Finanz und Wirtschaft in late November. [“Finanz und Wirtschaft” is a Swiss newspaper—in print and online—specializing in and reporting on the global economy and stock markets.] The technological trends are being clearly defined in the interview, and if the stock exchange currently doesn’t like technology, then I only have one thing to say: Check if buying is a better option for you than selling. And if you don’t want to do this yourself, then go ahead and buy our Mellinckrodt fund.