Carl Icahn Was Right

Carl Ichan Investor

As this blog is written, Carl Icahn announced that he sold his entire extensive position in Apple. He cited macro and political risks in China. In my opinion, he made the smart move.

For starters, this blog isn’t really about Apple. It’s about China. Let’s begin with the macro considerations. It’s fairly safe to say that China has been misallocating resources for years into commodities, real estate and infrastructure, that this misallocation has been financed by ever increasing debt and that the large state owned sector has been destroying capital.  And that this misallocation is continuing.

Beyond that who knows? Forecasts for the Chinese economy range from total collapse to soft landing with variations in between. Alarmist warnings about Chinese debt are everywhere. One observer, Gordon Chang, has been forecasting a China collapse for years. Many of the more detailed forecasts are made by people who neither read nor speak Chinese . A significant handicap since most of the official data coming out of China suffer from reliability anyway. How do these forecasters really know what’s happening in the country?

I don’t pretend to know any more than anyone else although I am skeptical about the more dire collapse scenarios. Chinese dynasties historically have lasted a long time. The prior Qing dynasty lasted from 1644 to 1911. The Communist “dynasty” began in 1948 and is still relatively young. It’s still on the “upswing” part of the Chinese historical cycle although near term a slowdown seems to be underway.

And I am reminded of similar forecasts for Japan. The Japanese economy with substantial state direction, protectionism, low birth rates and a strong Confucian tradition, has more in common with China’s than is generally realized. The Japanese yen and Japanese government bonds have been forecast to collapse for years. But basically they have not (at least not yet) as Japan just continues to pile on government debt and peacefully wallow in economic stagnation. The informed foreign investors so far have gotten it all wrong.

Ken Rogoff and Carmen Reinhart, in their once widely quoted book This Time Is Different and some related papers, tried to come up with upper limit debt levels for countries.  But their efforts, partly marred by some arithmetic errors, are no longer taken seriously.

But still the near term macro picture for China is relatively negative. The details may be unforecastable.  The debt may or may not be cause for a severe downturn. But the China macro picture, however murky, offers a significant headwind that in itself makes for a difficult near term investment story for companies that are heavily involved in China.

Foreign Social Media Companies Will Never Be Allowed  to Succeed in China

All foreign companies have to confront China’s protectionist policies and its insatiable desire to acquire their technologies. But social media companies and those companies whose product is intellectual content have to face a more difficult hurdle, i.e., the Chinese government does not want them in China at all. The new Chinese leader, Xi Jinping, in particular has pushed in a direction that places more restrictions on the free flow of information.

Google and Facebook are prohibited from operating in China. Anyone travelling in China and staying in one of the country’s new gorgeous five star hotels will have experienced the intermittent inconvenience of blocked Western news sites. Apple is hugely dependent on the Chinese market. So long as Apple is in the toy business (i.e. making ever cooler iPhones), it will be able to operate in China. The iPhone in itself does not pose a political threat. But analysts are now talking about Apple’s “ecosystem” of apps, iTunes, books and movies. This ecosystem be a good reason to own Apple’s business in the US but it carries high risk in China. I think Carl Icahn had figured this out.

As an example, recently both Apple and Disney had their on line movie distribution channels shut down in China because apparently the Comrades objected to the showing of a movie called Ten Years (Disney should stick to mice and ducks). Ten Years is a negative flick about the deterioration of life in Hong Kong under Beijing’s control. Expect more of restrictions like this.

China is hurting itself with these restrictions. In what seems like a miracle of rapid economic growth, it has reached the knowledge economy stage. It craves technology but progress in technology requires freedom of information flow which China does not welcome. This is the Great Tech Contradiction of modern China.  It is discouraging to see China’s intelligent and hard-working people restricted in this way. The contrast with India which allows so much more intellectual freedom but can’t seem to build toilets is striking. But investors in global companies operating in China need to be realists. The Apple ecosystem will have difficulties on Chinese soil. Google and Facebook would be worth so much more if they could operate in China’s gigantic market. But they can’t.

America’s Real Enemy Is America – Not China

Anyone who has spent considerable time outside the United States and who is interested in investing must eventually realize that the US should continue to be the center of technological innovation and that it is the US companies that will change the world.  But you wouldn’t know this if you believed all the negativism that is sweeping America. As I see it – and pardon the intrusion of a political view – America is now being given a choice between the ultimate protectionist anti-Reagan Republican and an unreconstructed, more-of- the-same big government intervention left wing crook. America should have a bright future but it is threatened by itself. Who knows? Maybe neither candidate really means what he or she says. We can hope.

But back to China. The country does not walk on water. Investors must understand this. A very interesting article has just appeared in May-June’s  Foreign Affairs entitled “The Once and Future Superpower, Why China Won’t Overtake the United States”.  Two quotes convey the message of this article.

“China’s true Achilles heel on the world stage is…it’s low level of technological expertise compared with the United States.”

“The distribution of highly influential articles in science and engineering …tells the same story with the United States accounting for almost half of these articles, more than eight times China’s share. So does the breakdown of Nobel Prizes in Physics, Chemistry, and Physiology and Medicine. Since 1990, 114 have gone to US-based researchers. China-based researchers have received two.”

In another version of the same theme, the Wall Street Journal has recently run articles reporting on how so many Chinese students are fleeing from the high memorization, anti-originality environment of Chinese universities to attend institutions of higher learning in the US.

Near term, China is not a positive in the global investment picture. When the macro climate is right, low tech companies like Starbucks carry lower risks than high tech companies. Doppio Espressos and tall Cappuccinos do not threaten the control of the Chinese Communist Party. (I know Starbucks really has lots of technology but it’s not of the threatening sort.)

Carl Icahn Was Right