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Emerging Markets
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International Investing

Does China Pass the Smell Test?
Smead Capital Management
By Bill Smead
December 12, 2012

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Dear Fellow Investors:

We at Smead Capital Management believe that prolonged faith in China's economy and the belief that emerging market growth will be an elixir for developed market multi-national companies is the erroneous gift that just keeps giving. If China's economy has been successfully soft landed from its boom, why is the internal Shanghai Composite index making new lows as recently as last week (November 29th, 2012)? From its peak on October 16, 2007 through December 3, 2012, the Shanghai Composite is down over 64.8%, whereas the S&P 500 is up 2.7% on a total return basis. We at Smead Capital believe that China's boom and the boom in commodity prices which it undergirded do not pass the smell test!

A quick review of our past thoughts on China would be helpful. All recorded economic history shows that booms of large magnitude end in busts of large magnitude. Michael Pettis, professor at the Peking University school of business, points out that every developing nation reaches a point in its emergence where GDP is dominated by unsustainable levels of fixed asset investment. This is true regardless of whether you believe Pettis or famous short-seller Jim Chanos. They state that deep research shows that 50-60 percent of GDP in China is fixed asset driven and GDP topped out in all prior emerging tiger boom nations at these levels. China has been there for a few years already.

We believe the drive to arrogantly present to western investors the invincibility of uninterrupted growth has poisoned the Chinese banking system. From 2008-2011, Fitch and others have estimated that $2.5 trillion of loans were made by the four largest Chinese banks to special purpose vehicles at the municipal level to build buildings, roads, railroads and other infrastructure. Fitch and party officials like Yin Zhongqing have estimated that 30-70 percent of these loans will never get paid back. These banks are 80 percent government-owned, 100 percent government-regulated and no participant in the system has any motivation to tell the truth. If Fitch's estimate is correct, there are $750 billion in defaulted loans laying on the bank's balance sheets along with $300 billion in equity. In other words, they are more insolvent than Washington Mutual was in mid-2008. WAMU didn't pass the smell test either, because they were claiming profit growth most of the way to the end, just like China's top four banks are today.

How does anyone believe anything reported by the Chinese government in the area of economic statistics? The New York Times writer, David Barboza, recently shared how remarkable it is that Wen Jiaboa's relatives have a combined net worth of $2.7 billion, even though none of them had any prior business or entrepreneurial skills. The fact that it was all created in the ten years Wen helped run the country shouldn't bother anyone! China's speech controllers shut down the New York Times website in China within minutes of Barboza's article being posted. It looked identical to the information shutdown following the high-speed rail disaster in 2011.

As we've written numerous times before (, we believe China's economy and high-speed rail system were both headed for a wreck. Now they have truth hurricanes from the New York Times website as well. Therefore, in our opinion, you have an unsustainable economic model trying to pretend it can go straight to the top of world economic success, with a poisoned banking system and no ability to tell the truth from the inside. This is where the behavior of Chinese Nationals is so critical.

First, they refuse to trust their own economy in the ownership of internal shares of China's largest public enterprises. The Shanghai index broke to lower levels on November 29, 2012, than where it was at the peak of the financial crisis in early 2009. Second, every indication is that the wealthiest Chinese citizens are moving massive wealth and residency out of China. This created ridiculous booms in high end homes and flats in Vancouver, BC, Singapore, Hong Kong and London. Lastly, Gordon Chang of Forbes magazine reports that more money has been moved out of China illegally in the last ten years than any country has ever seen.

If China doesn't pass the smell test inside its borders, why does it pass the smell test in the US? We believe at Smead Capital Management that asset allocators have sold both institutions and wealthy individuals on the concept that emerging markets and commodities add diversification and are essential for the long term. It appears easier to absorb the poor performance than to risk going back to the client (institutional or individual) and admit the mistake early on. Global wide asset allocation and commodity funds have performed poorly since July of 2011, but Lipper reports that US investors have continued to pour money into China-led emerging market funds and commodity-based alternatives, while liquidating US equity holdings to get the money.

The commodity part of this story might smell worse than all the rest. China is supposed to produce an unlimited number of newly-minted middle class folks. Our Malthusian friends and Peak Oil buddies will tell you that there aren't enough resources in the world to keep up with this explosion. They'll all have a car, they'll all want steak and they'll all want these things from a $10,000 income which Americans get from a $60,000 average household income. These brilliant long-term thinkers have one big problem which doesn't pass the smell test. If more people using commodities always meant higher commodity prices, then commodity indexes would have gone up every 20 years for the last 205 years. The chart below includes massive population growth, but enormous swings in commodity price levels occurred many times while population rose.

Source: Stifel Nicolaus Mid-2011 Macro Outlook Slide Deck, page 10 July 7, 2011

The USA Today featured a picture shown below which does pass the smell test, because it's the truth about what high commodity prices have done in the US. It has created huge income growth in about ten states and declining incomes in states which aren't among the list of high commodity production to state GDP. When what the internal Chinese Nationals know matches up with what US investors know, commodity prices will plunge, in our opinion, and stimulate the US economy just like it did from 1981-1999. We know some US political leaders who would enjoy that smell. It would be a massive tax cut to every American household without any internal policy argument. When picking stocks or asset allocating today, follow your nose.



Best Wishes,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.


(c) Smead Capital Management


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