In order to be a long-term investor, one generally needs to trust in three things:
- The numbers
- The management
- The sustainability of a company's competitive advantage
These three factors are why Warren Buffett has been such a long-term holder of Coca-Cola
In fact, we recently purchased shares of Coke for our Million Dollar Portfolio as it was sold off for poor performance in the U.S. market. The reasoning was that revenue growth at the company should accelerate as per capita consumption of Coke beverages in key emerging markets such as China and India increases from well below the global average to approximately the global average. As investment analysis goes, that's pretty basic and reasonable stuff.
This does not apply to the Middle Kingdom
China, however is anything but basic and reasonable. As commentator Michael Pettis pointed out in a recent article, there is a dearth of value investors in China because it's next to impossible to get comfortable with the numbers, management, and sustainability of a competitive advantage at any Chinese company. The reason for these deficiencies is lax regulatory oversight and a government that changes the rules of the game on a whim. This makes for rampant speculation, volatile stock prices, and an unattractive environment in which to raise capital or build a reliable base of shareholders.
This means that our research team at Motley Fool Global Gains is fighting an uphill battle. That's because the approach we take to Chinese stocks is that of long-term, value-oriented investors. We accept, of course, that there will be volatility along the way and that we will suffer from an information disadvantage from time to time. To address these realities, we have some coping mechanisms and believe that the potential long-term rewards of participating in China's development outweigh the near-term risks -- particularly if we're able to mitigate those risks.
Here's how we try to do it
There are three simple strategies we use to stay comfortable with our exposure to Chinese stocks. First, we diversify. This means we identify broad themes that we believe have tailwinds in China and then buy a variety of companies, both Chinese and multinational, with exposure to that theme.
An example: We believe rural China has a bright economic future thanks to rising food prices that have enriched farmers as well as government efforts to help even out economic development in the country. As a result, we've recommended that Fools purchase shares of companies such as Coca-Cola, which has excellent distribution in rural China, and China Mobile
Second, we keep our positions small and consider them all part of a collective basket. While most value investors -- notably Munger -- preach the merits of a concentrated portfolio, the fact is that one can only run a concentrated portfolio if one knows and is able to know every minute detail about his or her holdings. This simply cannot be the case when it comes to Chinese companies, and the list of Chinese companies that have been attacked for poor corporate governance or questionable use of shareholder capital is a long one. So rather than buy one 5% position in a company, we try to buy five 1% positions and then measure the performance over time not on a company by company basis, but rather basket-wide. This helps minimize the drama associated with any single position.
Third, we demand extremely high rates of returns from any position we take. What is "extremely high"? Generally, our answer is 15% to 20% depending on the traits and track record of a specific company. While this is well above the prevailing cost of capital in China, we demand to be compensated for all of the added risks we are taking in China. This is why it seems to be asking for trouble to pay 100 times earnings for a company such as Baidu.com
Now you're ready to buy China
Diversify across small positions in companies with significant return potential and then measure your results holistically rather than on a company-by-company basis. That's how we think about being long-term investors in China, and the framework has helped us minimize losses while still making good gains on stocks that have doubled, tripled, and quadrupled for us at Global Gains over the past few years.
Of course, investing in China still won't be drama-free, but the potential rewards make it worth a little heartburn.
Tim Hanson is co-advisor of Motley Fool Global Gains. Coca-Cola is a Motley Fool Inside Value pick. Baidu and Google are Motley Fool Rule Breakers recommendations. Coca-Cola and Procter & Gamble are Motley Fool Income Investor picks. The Fool owns shares of Coca-Cola and Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. Click here for an explanation of how you can disclose like a Fool.