Talk Your Book: Finding a Bottom in China

0:00Today's Animal Spirits Talk Your Book is brought to you by CraneShares. Go to CraneShares.com to learn more about their whole suite of investing in China. We got KWeb, we got Clip, we got KPro, KBuff, all these different options on investing in China, some that pay call option income, some that protect you to the downside. Learn more at craneshares.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management.

0:37This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:51Welcome to Animal Spurs with Michael and Ben. Rough couple of years for China, to put it lightly. Yes. I mean, I've always said that I'm not a big person on contrarian indicators. Everyone's always looking for the Shushan boy all the time now. Credit to you. You don't get involved in the nonsense and the riffraff. Because I feel like there's contrarian indicators all the time if you wanted to find them. But there have been way more conversations lately saying, OK, I'm fine with emerging markets, but China, I'm out. And it wasn't that long ago where everyone was saying, well, geez, China has all these big Internet companies just like we do.

1:27What if that's the next really big growth area? And they're in a massive drawdown now. what are we talking? 70 to 80 % for a lot of these names? You know, I'm a contrarian at these levels. I mean, although I'm so contrarian that I bought it and I sold it recently. I tried to catch up and I said, eh, too much hassle. But I might be back. Yeah. So my whole thinking is for the people who want to, I understand the fact that a lot of these emerging market countries just aren't like us in terms of how corporations are like this deity that we just worship and the stock market is everything, that they don't have that same mentality.

2:04But China is the second biggest economy in the world. There's a billion people there. I have a hard time not having any exposure to that size of an economy and that size of a consumer base. Yeah. They described the recent pain as their GFC. And if you look at a chart of K-Web, yeah, looks about right. Yeah. Long way from the top. Yeah. So anyway, interesting conversation. I've always been fascinated by China because I feel like I don't know. I don't understand anything about how the whole country operates. Well, you're a world traveler. You just got back from Milan. That's true. But doesn't it, I mean, doesn't it - Shanghai next?

2:39Doesn't it seem like they just kind of make up their economic growth and say, we were 3 % this time? I don't know. So anyway, we learned a lot here. We talked to Jonathan Schellen, who we've talked to before from CraneShares. So here's our talk with Jonathan. You're joined today once again by Jonathan Schellen. Jonathan is the chief operating officer at CraneShares. Jonathan, welcome to the show. Ben, thanks for having me. Okay. What about chopped liver? Oh, sorry, Michael. You two, of course. Jeez. Lots to get to on China, which is one of the main focus areas at CraneShares. Where do we even begin here?

3:13What is the—okay, I'll give you a softball. What's the most asked question you've gotten getting on China for the past 12 to 18 months? When is it going to start going up again? Okay. So what's your answer? Now. The answer is now. Look, it's interesting. When we talked about a year ago, we talked about a lot of the things that we were observing that were kind of in the red zone, turning green. And last year, China started to enact a number of policies, monetary policies, that were going to help it get past the overhang of the things that happened during COVID. And our expectation was that sometime last year that China would unveil a bazooka, right?

3:58There would be some kind of massive stimulus taking place. And it never came. And what we've come to learn is that China can't apply a bazooka like the U.S. did and spend 36 % of GDP to push the economy forward. They're going to use something like a grand sniper rifle, and they're going to address individual issues very carefully with fiscal policy. And we're starting to really see that come together right now. Wait, why can't China do the bazooka? I thought that they could just push a button and make things happen there. They can, but here's the challenge. China's consumer has almost$3 trillion in their bank account.

4:43What happens if you give somebody with$3 trillion a cash check? Like, what happens? What does that person do? Inflation. Well, inflation if they spend it, but they're not spending it. A lot of the Chinese consumers are still in bunker mentality from zero COVID. So you can't just give somebody a check. They've got plenty of money. They have to solve problems individually. And the two issues in China that have been plaguing China have been in real estate, which we could talk about, but also in unemployment, youth unemployment. So the Chinese consumer went the total opposite direction of America.

5:25We decided we're just going to speculate on everything. We're going to spend money like there's no tomorrow. No one is holding back here. We're going crazy. They went the opposite way. They had like the Great Depression baby kind of thing where they had a really difficult period. And they said, no, we're keeping our cash way higher and we're being more conservative now. 100%. And think about this. Just think about even monetary policy. In the US, in April of 2020, our 10-year dropped to half a percent, 60 bps. China's 10-year dropped to 2.5%. They never took it. They never took their policy rates down to zero.

6:00And even now, only now, really, the 10-year in China has fallen below 2.5%. So only now is China's easing policy accommodative. But guess what? China also doesn't have any inflation. We created a bunch of inflation in the last couple of years. China doesn't have any. So now their job is to get the consumer to come out. And it is happening. It's certainly showing up in the earnings of some of the major consumer brands that have reported recently. So these Chinese internet stocks have been just an absolute nightmare. I'm looking at Alibaba. It's 78 % off of its high in 2000. I mean, not long ago, in 2020.

6:44Well, kind of long ago. 78 % off its high. I'm curious, are the businesses that bad? Or is it the stock price? And if it's just the stock, then what is causing these massive disconnects? Right. So the drawdowns in a lot of the major internet companies in China are down 50%, 60%, 70%, as you highlight, Michael. What's interesting is if you look at the valuations and the fundamentals of these companies, they're very strong. Earnings have been fairly stable. Right now, PEs in this sector, like for KWeb, for example, our PE on a forward basis is like a 14. And these companies are growing. They're growing, growing a lot.

7:24In fact, there's been a bunch of earnings. I'll take Tencent, for example, and this is really interesting. As some of these internet companies get larger and more mature, Tencent had revenue growth that was up 7%, which missed by about a percent. But its EPS growth was up 44%. So there's a ton of operating leverage in these companies, and Tencent doubled its buybacks. So they've got a ton of cash. They've got a lot of upside opportunity, not just on the top line, but they're really cranking out a lot of efficiency in the bottom line. So, you know, Tencent earnings up 44%. Meituan just reported it was up 70 % at BTA estimates.

8:07And I've got PDD, which is another top holding net income up 110%. So we're at that inflection point now where these companies are going to see top line growth and bottom line growth emerging in a way that we may not have seen in the last couple of years. But the market's not dumb. And there's a reason why these stocks are being severely punished. What are investors worried about? It's sentiment. There's negative sentiment in the US. But what's driving the negative sentiment? I mean, turn on the news. You listen to CNBC. You know, it's interesting. Even look at our political climate. There are very few things that Democrats and Republicans can agree upon.

8:52But the one thing they could agree on for sure is that China is bad. It doesn't matter who you're listening to left or right. There's a negative sentiment around China for different reasons. And so that's part of the issue too. People think, oh my God, China's terrible. It's our arch nemesis. It's become the boogeyman for America in some ways. So the trillion-dollar question is, what would change the narrative? Because these stocks need to be re-rated higher, and it's not going to happen because they're cheap. Right. Look, what has happened is that over the last two years, managers and allocators have been massively underweight China.

9:33China is in the indexes, but people are effectively not holding it because even last year, EMX China was up 10%. China was down. So this has been a source of alpha for investors for a couple of years now. What will get people to change their minds is when they start seeing China outperform and they'll be forced to buy because they're going to say, oh, geez, look how far I am behind the benchmark. Remember, China is 30 % to 40 % of broad EM. So if you miss it, you miss it. So do you think that China needs to see those homeland consumers become stock addicts like we are here, where the stock market is just such a big part of what we do?

10:11Or do you think it's just the rest of the world buying in? How long would that take to actually turn them into that more stock market mentality? I think you need a little bit of both. And we're starting to see a floor being placed under domestic stocks. And some of the larger banks and others are actually recommending the A-share market. The A-share market is the mainland market in China. So we're starting to see a recognition by the world that investing in A-shares is compelling. These are cheap companies. They're growing quickly. Their valuations are ridiculous. I'll give you an example. We did a study recently, and we published on it, that we wanted to say how many two-year periods have there been, and we'll talk about the significance of two years, but how many two-year periods have there been where K-Web was up over 100%.

10:58You know, we've been running K-Web for over 10 years, and we found that there have been 67 two-year periods, like looking at daily entry points, where you would have earned more than 100 % in K-Web. And we asked ourselves, well, what have been the valuations at those points versus where we are now? And the valuations at kind of the average valuations over those points before K-Web rallied and doubled in value was actually higher on a PE basis, peg ratio basis, price to sales, you name it, than where we are today. So this is a very compelling entry point. And like I said, I think the reason people have ignored China is because it's performed poorly, the optics have been negative, and sentiment has been poor.

11:42But if you are actually a market observer, a professional investor, investor, you can no longer ignore the fundamentals, the valuations, and this deeply negative sentiment. It will turn. So the Chinese ETFs that US investors have access to, they bottomed in January. So you got to start somewhere. They stopped going down temporarily, at least. You spoke about maybe a floor under those stock prices. Eric Beltran has tweeted, The Chinese government has gone full BOJ, purchased$45 billion of ETFs in the past two months to pump up in the market, already owns a fifth of all equity ETFs. They moved to buying small caps because it moved stocks more.

12:26Purchases could reach$100 billion this year. So could they be the catalyst? Could they light the spark? And I guess if this doesn't work, then what? Right. So the national team definitely stepped in at the bottom. And the national team is really, you know, it's hard to know precisely who or what, but it's viewed as, you know, an organization or a network that is instructed to buy at different points in time. And they clearly had an impact. Now, just keep in mind, this isn't the BOJ. The BOJ owns meaningful percentages of the top companies in Japan. China owns a chunk of locally listed ETFs. So it's really a different dollar value, if you will.

13:15And we've seen, even with K-Web since that time, we've seen a 9%, 10 % rally off January bottoms. If you look at flows into and out of China, I mean, it's kind of wild how quickly people are thinking that China is becoming uninvestable, which the more you hear that, probably the more bullish you get, at least I'm guessing. But does China care about the stock prices? It seems like they were actively punishing these companies over the past couple of years. Yeah, I think that there was an acknowledgement. What's interesting about the way China thinks about its economy and the markets is it needs FDI, foreign direct investment.

13:52It needs robust capital markets. China has the second largest equity market in the world, the second largest bond market in the world. These are very deep capital markets, and it needs global participation. However, China's willing to take measures that will be pro its citizens versus pro companies. So for example, during COVID, when tutoring companies were charging a fortune for online tutoring, China stepped in and said, you can't do that. And they regulated that away. I'm not sure if we had a similar situation in the US, if our government would step in and do things like that. No way. Yeah.

14:31So that is probably the main difference that China will create regulation that acknowledges, look, we've got 1.4 billion citizens. We need to make sure that they feel happy and that they're growing and that their personal wealth is not impacted by something that's episodic. I mean, so being that that's the case, these stocks should trade at a discount based on fundamentals or whatever earnings. Like, if the government has the ability to do that, they're not going to get premium valuations. And emerging markets have always traded at a valuation discount, right? I was just going to say the exact same thing.

15:05EM on average trades at, you know, pick a number, 20%, lower valuations. But so relative to itself, it's cheap because that's what you should be looking at. Super cheap. We're at multi-year lows, no matter how you slice it. This has been the most extreme drawdown. I describe what we saw in K-Web as like our GFC. These are horrific drawdowns. We didn't have crane shares back in 2008. The company's been around for 10 years. So this has really been like our GFC in terms of China markets, which is also making it the opportunity. I'm always reminded by the fact, right? If you look over the last 12 years, the only thing that's worked is U.S.

15:46equities. It's outperformed everything. This notion of diversification is kind of irrelevant. In fact, you guys could remember the opposite was true back from 01 to 2012. Back then, everybody was like, increase international, increase EM, you get diversification, you get better returns. Bricks, that was the thing. That's it. And look, we ran the numbers from 2001 to 2012. EM outperformed the S &P by an average of 11 % a year with massive consistency. And then in the last 12 years, the reverse happened. The S &P outperformed EM by 11 % a year with massive consistency. The idea that that could happen right now on a go-forward basis is literally inconceivable.

16:33I can't imagine a single way, and I guess I would speak for probably most investors here, it's inconceivable to think that EM could outperform the S &P 500 over the next 10 years to that extent. Right. Right. And look, the other thing to keep in mind is over that period, currency returns were 30 % of it. That's the problem. The dollar has been a headwind for international stocks too. 3 % a year, strong dollar in the plus side over the last 11, 12 years. minus 3%. So the other side of it was, so a lot of symmetry in this EM, S &P type trade. And if you think about the conditions now, they, I'm not saying they're exact, but there's definitely some rhyming with what we saw in prior periods.

17:18So we would say, we crane would say, look, you need to own EM. You need to diversify. You need to have this exposure. And if you consider China's role within EM at 30%, 40%, 50%, depending on how you're slicing up the pie, you've got to have China exposure too. It is funny from, you mentioned the diversification thing, and people are totally ready to abandon that and just say, OK, it's the S &P 500 or the NASDAQ. But even with EM, people are now saying, well, geez, China's been so bad. I'm going to get rid of China exposure from my emerging markets, which just anything in history, anytime you have a huge period of overperformance or underperformance, if you go headlong into that and the either extremes, it's usually not a great idea.

17:59So from your perspective, so we've talked about KWeb before. Last time you were on, we talked about K-Lip. We've settled on K-Lip, not Clip. Animal Spirit settled on K-Lip. No, no. Crainchairs does not. Yeah, no, we've decided to do something that Michael does not support. We call KWeb K-Web, but we call Clip Clip. That's right. Okay, that makes sense. Then you also have these new buffer ETFs, which you're offering different ways to find exposure on this. So these buffer ETFs, So it's K-Pro and K-Buff, where you're offering 190 % buffered downside. Michael and I have talked about these buffered ETFs before.

18:32Maybe you can tell us how yours works in terms of the timing. How long are these contracts for? What's the downside protection? How does the upside work? Sure. So one thing that's important to note, which is kind of remarkable. So I mentioned that K-Web's been around for 10 years. And over this period of time, a really meaningful options market has developed around K-Web. In fact, KWEB is a$5,$6 billion ETF, so it's meaningful in size. Call it top decile in AUM. But the options market for KWEB, it is a top 10 optionable ETF. Out of all 3 ,400 US ETFs, KWEB is top 10 in open interest. So it is a massive options market that's developed around KWEB.

19:14And that's because there's a lot of institutional money. There's a lot of smart investing and speculative investing around calls and puts in KWEB. Hey, this is a dumb question. Does the options activity show up in the total assets or management for KWeb, or is it a separate thing? No, no. And that's what's so unique. The options ecosystem arises adjacent to the ETF, and we don't have anything to do with it. We can benefit from it as we are in building new strategies, but we don't facilitate it other than having the ETF itself. So the market makers are the ones that are making money. There is no direct monetary benefit.

19:54Oh, interesting. No, they may use K-Web to hedge, right? Like if I was an options market maker, I'd definitely participate with K-Web to help hedge positions. But we don't benefit from it financially directly. So what's interesting is, so we launched CLIP as kind of one bookend of what we are calling now our volatility suite. So we have K-Web as 100 % growth. We have CLIP as 100 % income in this context as an at-the-money covered call strategy. But as I'd mentioned right away, the question we keep getting is, geez, I love what you're saying about valuations and fundamentals. And I know the potential, but I don't want to lose money.

20:33Yeah, I'm not all the way there. I like the idea, but yeah. And the other thing is, look, the optics, right? If you're a financial advisor and you have a China line item, you don't want to have to answer the question to your client, is this going to lose me money? So we developed K-Pro and K-Buff for a couple of reasons. One, making sure that we have something in our volatility suite that protects on the downside. But two, also seeing that there is a lot of success with defined outcome strategies and structured products. And a lot of the banks, quite frankly, have built structured products on K-Web and sell them to their clients.

21:10And so we thought, geez, isn't a defined outcome ETF similar to a structured product on K-Web? And if we have CLIP, can't we do protection? And what's really interesting is that the volatility of K-Web and the implied volatility in K-Web options allow us to do things and deliver outcomes that would be very hard with an S &P or a NASDAQ or others. So we can produce very attractive terms. And I'm happy to talk about this. So you can get like bigger downside protection probably because there's so much volatility implied in the options. Right. Because remember, the way that these work is that you buy puts.

21:51So you buy explicit downside protection, but you sell calls out of the money. So you sell upside after a certain point. So just to take KBuff, for example, when we launched KBuff, that offers a 10 % downside buffer. So it's called a 90 % buffer, but what it means is you could lose up to 10%, but the upside is 41.2%. So you lose nothing past 10%. So you can go down 10, anything past 10, you're protected. Right. And the way these work also, it's important to note, is that it's effectively a two-year period, right? So all of our, both K-Pro and K-Buff, they mature essentially on January 16, 2026.

22:37So you really need to hold them for the outcome period to achieve the outcome. They are mark-to-market. There's a daily NAV, so you could buy them and sell them anytime you want. But that outcome isn't delivered until the end. You need to hold the ETF. So what happens at the end? So at the end, and the way that we've structured these funds is that we just re-up. You could obviously liquidate your position if you choose to do so, but we're going to reset or restrike, as they say, the call and the put. We're going to offer for KBUFF the same 10 % downside protection, but we're going to have a new upside cap, participation cap, based on whatever the market conditions are at that time.

23:20And that's what's interesting about these. You could have a different upside depending on what the market conditions are. Is volatility high or low? are interest rates high and low? And the level of interest rates are the things that have allowed a lot of these defined outcome strategies to work right now. And when you say interest rates, that's US interest rates, and obviously the other component is the volatility. So talk about how that actually works. Correct. So implied in option pricing, and I don't want to sound like a math geek here, but if you think about like the Black-Scholes pricing model, interest rates, The risk-free rate is an important component of it.

23:58Implied volatility is an important component, as is time horizon. So those are really central inputs into determining the value of an option, the price of an option. And the simplest way to think about it is if you have a two-year time horizon in an option and the risk-free rate is somewhere between 4 % and 5%, you only have to set aside, you know, 90 to 92 cents today to deliver a dollar in two years. And that's whereas if rates were zero, you know, how much would you have to set aside today to deliver a dollar in two years, something closer to a dollar? So right now, the ability to provide less expensive protection is quite good because of where rates are.

24:42There's obviously no free luncheon investing. When you talk about KPRO with 100 % downside protection. What is the trade-off? Because again, you're not getting this for free. So what are you not getting in exchange for this? Sure. So K-Pro has a two-year cap of 22.69%. So if some of the scenarios I talked about where K-Web doubles, you're not getting a doubling. If K-Web goes up 100 % over the next two years, you're getting 22.69%. In fact, if you think about the historical distribution of KWeb returns, what KPro is giving you is essentially a 25 % band. You're getting only 25 % of the outcomes that we've experienced in KWeb overall.

25:26We've cut out 75 % of the distribution. But again, it's at maturity. So let's just say that there's some sort of announcement or whatever, there's a catalyst and KWeb doubles in six months, you're not getting your 22 % over that six-month period, right? You have to wait for the full two years. Absolutely not. Because remember, along the way, the option dynamics affect the NAV of the fund. And we have a great case study already. I mean, we launched the strategies last month. And what you'll find is that even though K-Web has been up 9 % since we launched, and I knew this was going to happen. I said, the moment that we launch these strategies, that's going to be the bottom of K-Web.

26:06Well, it's got to be. I mean, it's poetic, right? Yeah, of course. People want protection. They want to dip their toes after an 80 % drawdown, but they don't want risk. It's like, well, come on. It's not to say that there's not risk. Of course, there's always risk in investing, but after an 80 % drawdown, it's been at least slightly de-risked. Right, right. So let's say that you come into one of these strategies later because it doesn't end until... Is there an easy way for people to understand where is this on the range of outcomes? 100%. And so best practice for defined outcomes, and we follow this, is on our website.