Wednesday, May 11th, 2011
the china syndrome

Use the name of a well-known movie as the title of a posting and it’s likely that others have done the same regarding the topic at hand.  The first piece I came across was by Jody Eisenman, concerning accounting practices in China, some of the notable disasters in stocks based there, and the economic and political backdrop in the country that has attracted “billions of dollars in investment capital.”Jody Eisenman on Finance | This was my first exposure to Eisenman’s website.

A few weeks ago, I had done a “pix” showing the charts of four Chinese blow-ups,research puzzle pix | This site features a wide variety of charts about different investment ideas, vehicles, and asset classes. each of which remains halted, trapping the owners that had an interest in participating in the exciting stories the companies told.  (The prior edition of pixresearch puzzle pix | It was based on a great article from FT Alphaville. also dealt with perceptions and reality in China, in that case related to copper inventories being used as collateral.)

Just as a fraudulent stock can cause grievous harm to a portfolio, a widely-held investment thesis gone wrong can disrupt the very nature of the investment ecosystem.  I will state right up front that I’m not a China expert, know almost nothing about its economy, have not done due diligence on its companies, and have never been there.  I don’t know whether the gap between assumptions and truth is narrow or wide, or whether information that we receive is as accurate as is found elsewhere in the world.  In other words, I’m just like most people, whether they’ve invested in China or not.

As we do with other countries, we rely on Chinese government statistics to inform our decision making.  How much do we know about them?  How good are they?  While there are qualms expressed in some quarters, lacking other sources, most investors accept them as is.  Does that make sense?Bloomberg Businessweek | These questions go beyond China, of course.  This link connects to an important article about how the “public memory systems” in the developed world aren’t what they used to be.

It is important to ask the questions, since the assumption of a “Chinese bid” underlies much of the investment material that you read.  The nation’s demand for commodities takes center stage — as in Jeremy Grantham’s latest piece, which details the enormous percentage of global demand accounted for by China.GMO | The list is on the sixth page of this PDF. But the Chinese appetite for other things — industrial equipment, consumer goods, services of all types, and (hopefully) Treasury bonds among them — is critical to macro and micro forecasts alike.  And, on the supply side, the slightest of indications regarding its policies on rare earth minerals can send the prices of stocks in that business soaring or plummeting.

In terms of investment process, it’s important to decide how to approach this situation.  Conventional wisdom about the Chinese phenomenon is deeply entrenched and information about the nation’s economy and companies is generally being taken at face value.  Investors must consciously decide whether that is an acceptable strategy or whether a margin of care needs to be applied.

In The China Syndrome, the movie propitiously released just before the crisis at Three Mile Island, the public wasn’t being told the truth by the management of the nuclear plant.  I have no idea whether the analogy applies to China’s information strategy and am not predicting an economic meltdown for it.  But to leave the issues unexplored or not factored into the structure of risk management would be to place faith where it might not deserve to be.