China

China, from an investor's perspective, is far more than just a country; it's a colossal and complex economic universe with its own set of rules. As the world's second-largest economy, it represents a gigantic market undergoing a monumental shift from a low-cost manufacturing hub to a global powerhouse in technology and consumer spending. For decades, its jaw-dropping growth rates have lured investors seeking spectacular returns. However, investing in the “Middle Kingdom” is a high-stakes game. The market is characterized by heavy state intervention, a unique political system, and corporate structures that can be opaque to outsiders. For a value investor, China presents a fascinating paradox: the potential for finding deeply undervalued, world-class companies, set against a backdrop of risks that are unlike anything found in Western markets. Understanding this duality is the first step to investing there successfully.

Why does China continue to captivate investors? The opportunity set is, in a word, massive. The sheer scale is hard to comprehend: a population of over 1.4 billion people with a rapidly expanding middle class creates a consumer market of unparalleled size. This has fueled the rise of domestic giants in e-commerce, social media, and gaming that rival, and in some cases surpass, their Western counterparts. Furthermore, China is no longer just a copycat economy. It is a leader in critical future-facing industries like Electric Vehicles (EVs), renewable energy, and FinTech. Companies in these sectors are not just serving the domestic market; they are increasingly competitive on a global scale. For portfolio managers, Chinese assets have also historically offered diversification benefits, as their market cycles have not always moved in lockstep with those of the U.S. and Europe. The allure is simple: the chance to buy into the biggest growth story of our lifetime.

As Warren Buffett famously advises, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” When looking at China, this mantra is more critical than ever. The potential rewards are matched by equally potent risks that demand a healthy dose of skepticism and a wide Margin of Safety.

Navigating the Chinese market means being acutely aware of several unique and significant hurdles.

The Chinese Communist Party's influence is absolute and unpredictable. The government can, and does, enact sweeping regulatory changes overnight with little warning. We saw this with the sudden crackdown on the private education sector, which decimated stock values, and the heavy-handed regulations imposed on tech giants like Alibaba and Tencent. This Geopolitical Risk also extends to tensions with the U.S. and other nations, which can lead to sanctions, tariffs, and other investment barriers. The government's priorities can shift, turning a favored industry into a pariah almost instantly.

For a value investor who relies on trustworthy financial statements, China can be a minefield. The history of accounting scandals, with Luckin Coffee being a famous recent example, serves as a stark reminder. Many of the most popular Chinese tech stocks listed in the U.S. use a VIE Structure (Variable Interest Entity). This is a complex legal workaround that allows foreign investors to invest in restricted industries. However, it means you don't own the actual Chinese company, but rather a shell company with contractual rights to its profits. This structure's legal standing has always been a gray area in Chinese law.

China's rapid growth was fueled by an immense amount of debt, particularly in the real estate and construction sectors. The high-profile struggles of property developers like Evergrande highlight the systemic risks bubbling under the surface. A potential real estate collapse or a broader credit crisis could have severe ripple effects throughout the entire economy, impacting even the highest-quality companies.

If you've weighed the risks and still see opportunity, there are several ways to gain exposure.

• Direct Stock Purchase: The most direct way is to buy shares. A-shares are listed on mainland exchanges in Shanghai and Shenzhen and are priced in yuan. They have become more accessible but can still be difficult for individual foreign investors to buy. H-shares are Chinese companies listed on the Hong Kong Stock Exchange, priced in Hong Kong dollars, and are much easier for international investors to access.
• American Depositary Receipts (ADRs): Many of China's biggest tech companies, like Alibaba and JD.com, trade on U.S. exchanges as ADRs. This is often the most convenient method for American investors. However, be aware of the delisting risk posed by regulations like the HFCAA (Holding Foreign Companies Accountable Act), which requires foreign companies to comply with U.S. auditing standards.
• Funds and ETFs: For most investors, the simplest and most diversified approach is through ETFs (Exchange-Traded Funds) or Mutual Funds. Broad market ETFs (like MCHI or GXC) give you exposure to hundreds of Chinese companies at once, while sector-specific ETFs (like KWEB for internet companies) allow for more targeted bets.

Investing in China is not for the faint of heart, nor is it a place for casual speculation. It demands an exceptionally large Circle of Competence. The legendary investor Charlie Munger was a long-time bull on China but also acknowledged the inherent risks, stating that the required “risk premium is higher.” Our view aligns with this cautious optimism. China undoubtedly holds some of the most compelling growth opportunities on the planet. However, the risks—political, legal, and economic—are real and substantial. A value investor must demand a significant discount to intrinsic value to compensate for these uncertainties. This means doing deep, independent research, being highly selective, and never, ever investing more than you can afford to lose. In China, more than anywhere else, the price you pay determines your return, but understanding the value you're actually getting is the key to survival.