Geopolitics, China and the fallacy of ‘Chinese’ company risk

22 November 2022

Giles Worthington
Senior Fund Manager

Recent weeks have seen global investors focus on the geopolitical risks posed by China – and in particular President Xi’s moves to consolidate his power base. Inevitably, some investors have started to re-appraise their exposure to China and whether they want to be exposed to it at all, even though it is a huge economy and a world leader in a number of technologies. For global investors, it is always worth remembering that:

  • The further one moves from an investor’s domicile (both geographically and intellectually), the higher the risk

  • Global revenues, supply chains and domicile are now so intertwined as to be hard to disaggregate meaningfully

  • Investors’ capacity to predict “black swan” events tends to be limited, let alone timing the occurrence of such events with any accuracy

These investment issues should be considered in terms of an investment product’s aims generally, then explained and quantified through risk analysis on a more detailed basis. A blanket statement on China and what you should or should not do would be too blunt and of limited benefit to investors.  For example, Apple is as linked and dependent on China (both in terms of sales and supply chain) as many wholly domestic Chinese companies.  It is important to separate the various factors and therefore levels of investment risk.

Levels of investment risk 

At the simplest level, there is broad geographic-level risk, as exhibited by Xi’s apparent assumption of total control of power and what this could mean.  This could obviously have knock-on ramifications for Taiwan (and Hong Kong) and our capacity to invest there as global investors. This first set of assumptions are reasonably foreseeable.
At a level down from this, there is company risk and the need to break this down on a granular basis: where the company is domiciled, where it conducts its business, and where its supply chains are and therefore how exposed it could be to geopolitics:

  • A company’s domicile and where it conducts its business: for example iFlytek is domiciled and has 100% of its revenues in China. The likes of PDD and Nio are Chinese domiciled and have revenues which are mainly Chinese but they are expanding into the US and Europe in terms of revenues

  • A company’s supply chain and how exposed it is to international tensions – the likes of Baidu and indeed most Chinese technology-based companies have a potentially critical dependence on “western” semiconductors

  • Wholly Chinese companies – such as Ping An – have no obvious dependence on international supply chains or technology and all of their revenue is domestic Chinese. However, even Ping An prices its insurance products using globally understood insurance asset pools

From a geographic point of view, it is reasonable to assert that China is less transparent and higher risk than it was years ago. We think it is reasonable position to hold as a global investor that the PE ratio on a Chinese company could be lower than a North American company – all other things being equal. The degree of that discount is, though, clearly a moot point.

Supply chain risk

The high level of geopolitical risk rapidly bleeds into company-level risk, but on a global basis. The world’s supply chains and trade relationships have strengthened and intertwined since the end of the Cold War. Simply put, US and European businesses are very reliant on Chinese factories – and vice versa.
For example, the specific consideration of Chinese company risk could also bear in mind the fact that over 40% of the luxury sector’s revenues come from China and Asia Pacific.  This is just one example of how single company risk cannot be restricted merely to Chinese-listed companies. A slightly lower level of revenue is at risk for the auto sector than for the luxury sector, but that is before you consider supply chain risk for the auto OEMs sector – as Covid showed, the unavailability of just a single semiconductor can prevent the completion of a whole vehicle.
Similarly, there is significant supply chain risk for Apple regarding China, as with the whole mobile industry, due to its dependence on rare earths from China in the manufacturing process.  In addition, around 20% of Apple’s revenues are from China, with another 7% coming from the broader APAC region (ex-Japan).

Investor concern

As an indicator of the degree of investor concern previously priced into the Chinese markets, the Hang Seng Index has bounced almost 20% from the post Xi pessimism on the party congress.  This reflects how investors’ perspective of risk has changed markedly in a short period of time.  It is also a clear indication that investor understanding of China’s Covid restrictions was unduly short term and emotional rather than weighing a longer-term understanding that China is moving towards unlocking the economy.  This is said with a full comprehension that this may reverse again in a further month.
Any investment product should invest its risk budgets and manage its exposures with a clear and unambiguous reference to the aims of what that fund is trying to achieve – for example, an Asia Pacific fund can have a higher tolerance of Chinese risk than a global fund, reflecting its more confined investment universe.  Diligent active managers understand and explain risk in terms of the risk tools and analysis at the fund level, all the way down to company specific attribution to fund performance.  Company-specific risk is managed through stock-level research conducted on a day-to-day level.
Geopolitics (as expressed through trade and tariff wars) is, unfortunately, a rising global factor currently and one that looks like it will persist. But it is not limited to a single country.  Robust businesses will have dual supply of components and a spread of customers; the ability of the company to achieve this will be reflected in its relative valuation.  China, Covid and Ukraine are the latest (very significant) expressions of geopolitics but they won’t be the final expression of it.
Stocks and regions mentioned are for illustrative purposes only and not a recommendation to buy or sell.

14 December 2022
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