SPENCE Asset Management

A Tale of Two Countries June 2009

In recent days we completed another reference book on China in the hopes of gaining a better understanding of exactly what makes this increasingly formidable world economic power tick. China - Getting Rich First - A Modern Social History, is an enlightening research piece written by former BBC reporter Duncan Hewitt.

As investors and students of history, we cannot help but be fascinated by the pace of change in China. For nearly forty years after Chairman Mao seized power, the People’s Republic of China was a proverbial billion-person plus version of George Orwell’s, Animal Farm. Finally, after being ruled by an army of communist party bureaucrats, the nation quickly began to break itself free from anti-competitive economic shackles. What began as basic reforms under Deng Xiaoping enabled China to position itself well on perhaps one of the great pivot points in world economic history.

Reforms in China for the last twenty years have meant that the authority of self-serving bureaucrats has gradually been released to free market forces. As a result, dramatic changes have taken place across virtually all aspects of Chinese society. And despite the fact that China continues to retain some rather stubborn remnants of a centrally-planned economy and has also adopted some of the more objectionable aspects of free-market capitalism, Chinese leadership has engineered one of the greatest domestic prosperity increases in human history. All that has been accomplished there has been done with breathtaking speed. And as the entire world emerges from a global recession, it now appears to us that China is just beginning to rise up to a standing position on its capitalistic surfboard. Its citizens and investors may well enjoy a great ride on a proverbial tidal wave of relative prosperity.

The key to China’s success has been the nation’s efforts to reduce the government’s share of employment and concede to its ambitious privately held businesses, the basic freedom to allocate resources.

As American-based investors with the opportunity to search the entire globe for opportunities, we cannot afford to ignore the potential folly associated with blindly assuming the results of the policy decisions of our lawmakers, chief executives, and judicial system will actually serve the “greater good.” From the beginning of recorded human history astute investors have weighed all costs versus all potential benefits (and all unintended consequences) when considering the body of laws and government policies affecting investments.

Nearly every day we find a more stark contrast between the trend of government’s influence in China and our own government’s growing influence here in America. While China has been releasing government control of one failing state controlled business after another to free market forces, over the last six quarters America has been seizing control of and propping up a growing list of failing U.S. businesses with borrowed money.

Some aspects of our government’s entanglement in our day-to-day lives are more subtle than the eye-catching revelations of the latest bailout schemes. We serve clients both active and retired from a wide range of occupations and professions. Literally dozens of people involved in our nation’s healthcare system complain to us regularly that they are required to perform activities designed not to provide better health care, but to insulate the deepest insuring pockets from being assessed legal liabilities in the U.S. tort system. The problem is not confined to healthcare. Descriptions of this sort of waste come from people in virtually all walks of life. For decades America has been gradually becoming a country that naively sinks deeper and deeper into the abyss of a wasteful tort system. Simply because the deepest financial pockets provide the necessary insurance, they can and do require everyone under their theoretical umbrella of “protection” to bear the added costs of legal liability avoidance activities.

Of course the mindset and counter-arguments that justify this antiquated system suggest it offers protection to the “little guy.” And in some instances this wasteful system actually does protect a few selected little guys. However, in the aggregate, these seemingly invisible costs are added to the ultimate price of virtually everything that everyone in America consumes. And it is the little guys that ultimately bear the greatest burden. In America virtually every activity must be insured. Even lawyers must insure themselves against “legal liabilities.” And the cancer of legal liability avoidance is not simply an ongoing burden. It is also a cumulative burden. The economic result is slow poisoning of the efficiency (and therefore the competitiveness) of the United States economy. The process has been going on for decades.

These same onerous costs are not piled on activities in China. And with far fewer overtly or even covertly oppressive economic burdens to bear, the advantages for any endeavor the Chinese engage in from education to manufacturing are enormous.

All of these deflating comparisons should not lead the reader to conclude that we believe there are no American companies capable of overcoming these economic burdens. However, in the aggregate, for the average American worker and all consumers, our nation’s economic trajectory has changed. It is not unlike the historical trajectory of the British Empire, Rome, Greece, or ancient Egypt. Each year the cost to consume in America goes higher while our ability to produce products or services others would willingly purchase is lowered. The long term effects of reckless government borrowing, wasteful government spending, and tacit acceptance of the massive costs associated with legal liability avoidance activities have now metastasized throughout our economy.

Contrarily, we think China offers investors diametrically opposing trend lines in the areas of government borrowing, government spending, and legal liability avoidance activities. Just a quarter of a century after beginning the process of abandoning central planning and making their country more business friendly, Chinese leaders have managed to tap into the inherent viability of a nation of mostly undereducated and underequipped agrarian and factory workers. As a result, China is an established global economic powerhouse bent on becoming better educated and better equipped. China already provides the lion’s share of the manufacturing in the world. And these days it is not U.S. universities that produce the greatest number of highly skilled science and mathematics graduates; that distinction also belongs to China. By simply grasping the broad implications of this simple measure of educational achievement, the alert investor is offered the clearest glimpse of the most likely direction of future global economic results.

The strongest national balance sheet, the greatest increase in aggregate income, and the fastest growth rate of living standards were once conditions enjoyed by the Egyptians, then the Greeks, then the Romans, then the British Empire, and most recently by Americans. Today these advantageous conditions best describe the characteristics of the economy in China.

Chinese policy makers seem to remain more intent than ever on continuing to promote the pronounced shift towards government policies that nurture the development of entrepreneurs. And as they continue to do so, the relative success of the Chinese economy will come at the relative expense of all other countries that are much less willing to adhere to policies that are focused on competing.

Perhaps the greatest clue of the unmistakable focus of the current generation of Chinese leadership has nothing to do with economics. Or does it? The recent diplomatic smoothing of strained relations with Taiwan is an equally remarkable achievement. We cannot recall any conflict between a large and small nation that was a better candidate for swift and decisive military action by the larger rival. Fortunately for world peace, and the sake of the safety of citizens in each nation, the latest generation of Chinese leaders appears to be much more interested in protecting its national balance sheet and competing economically, than in making war with a former rival. Accordingly, in recent months Beijing has forged cultural and economic cooperation agreements with Taiwan that are indicative of wise leadership. Apparently nothing, including the punishing of a formerly insolent Taiwan, is important enough to get in the way of China’s obsession with economic competitiveness.

In the meantime, a current review of trends in the United States reveals the continuation of a process that has now been in place for decades. In America, our legislatures, our chief executives, and our courts seem to make sure that the percentage of the economy dedicated to assessing legal liabilities to so-called deep pockets continues to increase. Bureaucrats acting as hapless stewards of a perpetually floundering primary and secondary public education system continue to be rewarded with more resources rather than reigned in. And at the same time our leaders in Washington D.C. openly choose to send their own children to private schools.

And so it is, with each page of history turning, that we find ourselves compelled by some of the most obvious economic indicators in world history. Accordingly, we cautiously initiated an investment position in the economy of China last month. And as we did so, at least a small part of us couldn’t help but wonder what it might take to get our nation to realize that spending money we don’t have, borrowing money we can’t repay, and spreading the costs associated with legal liability avoidance into every nook and cranny of our existence is the height of foolishness. That being said, we know what we get paid to do. Recalling what one very wise economist said just a few days ago, “We cannot dwell on what ought to be, we must focus on what is.” In initiating a position in China, we did what we thought we had to do.

Stay tuned. This is most certainly a developing situation. Thus, we intend to continue to increase our commitment to research of Chinese-based businesses while also keeping our fingers on the corporate pulse of what we hope are America’s finest companies.

Jim Spence, Registered Principal

The information contained herein is for informational purposes only without regard to any particular user’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors. To determine if investment in a Separately Managed Account with Spence Asset Management is an appropriate investment for you please call 1.800.230.1840.

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The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.