Source: Smart investors.

Long-term investor and century-old asset management institution Baillie Gifford has recently focused on discussions about China in research reports and internal dialogues.

Global Alpha team investment manager Helen Xiong wrote a report in September titled 'Finding New Growth Points in China,' stating, "We expect China to continue to rise - not only in economic indicators, but also in technological strength and advanced manufacturing capabilities."

Helen mentioned that while investing in China brings complexities, as a global investor, you cannot ignore it.

She used a very interesting metaphor to describe it.

"To understand the potential of this country, you can look at natural phenomena. After bamboo sprouts, it may not show significant growth for many years because it is developing strong roots.

Subsequently, through the still mysterious biological mechanism, it can rapidly grow at a speed of over 1 meter per day, eventually exceeding the height of an adult by 15 times, with hardness even surpassing oak."

Helen Xiong was born in China, spent 10 years of her youth in South Africa, and then moved to Europe. She joined Baillie Gifford in 2008 and is now also a partner, involved in managing portfolios such as Global Alpha and Monks.

Her multicultural life experiences have enabled her to have a very open perspective.

Recently, in an internal dialogue, Helen discussed with colleagues the advanced manufacturing industry and overcapacity issues in china, as well as the broader discussion of why china is crucial to all long-term investors.

The firm stance of Baillie Gifford on investing in China at the end of last year has also received extensive attention from domestic investors.

Smart investors will translate and share the main content with everyone.

Without understanding China, you cannot understand the world.

Can you first briefly introduce yourself, especially the unique perspective you bring when looking for growth opportunities in China, LK?

Helen: I was born in China, both my parents are Chinese, but I only lived in China for the first six years of my life. When I was 6, I moved to South Africa, which was in the early 1990s, when South Africa was going through a historical transition from apartheid to democracy. I left South Africa at the age of 16 and have been living in Europe since then.

Regarding the perspective issue you asked about, I believe that if there are any advantages to being a person with a mixed background of Europe, Africa, and China, it's that I have a better understanding of cultural backgrounds.

When we look at things different from ourselves, we often use our own thinking patterns and frameworks, and we are not always aware of how these thinking patterns and frameworks are influenced by our cultural background, which sometimes carries certain biases.

I suspect I have biases like everyone else, but I may be more aware of these biases.

LK How would you view the investment opportunities in China after seeing a series of relatively weak economic data?

Helen There are many different perspectives to consider economic data, but we must be careful to distinguish between cyclical factors and structural factors.

From a cyclical perspective, China's economic recovery is not as strong as many Western economies. Real estate prices are one of the reasons.

70% of Chinese consumers' wealth is related to real estate, so when property prices fall by 10% or 20%, it does have an impact on people's perceptions and their wealth perception.

From a structural perspective, China is transitioning from a real estate-dominated economy to an advanced manufacturing economy, which is a carefully planned process.

They have been working on this for many years, but this kind of transformation will bring some impacts in the short term. Transitional transformations may not always be smooth, but they have experienced similar processes in the past.

In the 2010s, the economy relied more on housing and real estate construction. Now, they are trying to lay the foundation for advanced manufacturing.

Therefore, China is making efforts to move away from the low stock price real estate industry towards higher value and higher return industries.

LK, in your focus on Global Alpha and Monks at Baillie Gifford, Chinese stocks only account for a small part of the diversified investment portfolio you manage. Why the focus on China?

Helen, you are right. I manage a globally diversified investment portfolio with Chinese companies representing only a small portion. However, I believe we live in a world closely connected to China. Our global supply chain relies on China.

Without China, the transition to green energy is impossible.

Most of the Western companies we hold depend on China as one of their largest markets. China not only holds economic influence but also significant diplomatic influence, especially in Asia.

Additionally, China is home to some of the world's leading technology companies.

As a global investor, even if you choose not to directly invest in Chinese companies, you cannot ignore China. Without understanding China, you cannot comprehend the world.

Even if you only invest in companies outside of China, events in China can still affect them?

Helen Yes, even if you are just a US investor, you would still have a very strong interest in China.

How to view the overcapacity of electric vehicles

LK You recently published an article 'Looking for New Growth Points in China', in which you mentioned that the overcapacity of electric vehicles and other advanced manufacturing industries in China is a 'feature' rather than a 'defect'. Can you explain what you mean?

Helen Yes, I have discussed with many investors about some industrial sectors in China, and they are worried about overcapacity, so they often overlook these industries.

But I think this is largely due to some misunderstandings, especially the different time frames.

Those who are concerned about overcapacity only focus on the short term, but I believe that Chinese decision-makers do not only consider the short term; they are more concerned about the demand for this industry in the next five to ten years and plan accordingly.

The second point is that while overcapacity poses a risk for many mature industries, the situation is different for emerging industries like electric vehicles.

We can relatively determine that with the growth of production, manufacturing costs will decrease, following a very predictable learning curve. Therefore, the risk of overcapacity is smaller, as demand growth can be foreseen. With increased production, cost reduction, and price decrease, demand will naturally rise.

In fact, this is more like an opportunity, because if you are the first company to expand production scale, you will gain all the benefits of the learning curve and intellectual property rights, which will help you build a competitive advantage.

LK Assumes that Chinese auto manufacturers can improve efficiency and reduce costs by expanding production, but this expansion clearly cannot continue indefinitely. Excess capacity will eventually have a time limit, right?

Helen Yes, ultimately, the market will be survival of the fittest.

China is one of the most competitive markets in the world. Initially, these new electric car companies will receive a lot of support, but eventually, companies with higher efficiency and stronger innovation capabilities will prevail, while poorly performing companies will be eliminated, and the market will begin to consolidate.

Ideal choice for extended-range electric vehicles, more cost and capital efficient than other methods

LK You invested in an automaker like this - Ideal Auto. This company is special because, as far as I know, only three electric car manufacturers globally are profitable, and it is one of them. How does it differ from its competitors?

Helen If you look back five years, the penetration rate of electric vehicles in China was very low, only about 5%. This was still a result of over a decade of very favorable supply-side policy support. And today, five years later, the penetration rate is almost 50%.

The growth is very rapid.

The reason for the low penetration rate five years ago was due to 'range anxiety' and price. At that time, many electric car manufacturers either did not solve this problem well, did not attempt to solve it, or solved it through battery replacement.

In other words, owners could drive to a station and change the battery in three minutes. The problem with the battery replacement solution is that it is very expensive. The battery is the most expensive part of the vehicle, and if more than one battery has to be equipped for each car sold, it will greatly increase the cost of the vehicle, leading to a very limited market size.

Li Auto Inc truly pioneered a new solution, the extended-range electric vehicle (EREV). They installed a small internal combustion engine in the vehicle, the sole purpose of which is to charge the battery.

By carrying a tank of gasoline, when the battery runs out, you can use fuel to charge the battery, thereby solving the range anxiety problem. At the same time, due to less battery usage, the vehicle's range has been greatly increased.

As a result, vehicle manufacturing costs have been reduced. In fact, you can get an electric car at the same price as an internal combustion engine vehicle.

Secondly, I think many emerging electric car companies have a software background and have not truly focused on cost efficiency and manufacturing, after all, this is an industry, and the profit margin in the manufacturing industry is usually low.

Li Xiang, the founder of Li Auto Inc, is not starting a business for the first time. In his first company (also a listed company), the business almost went bankrupt and had to be rescued. His shares were diluted, and he was almost forced out of the company. He does not want such a thing to happen again, so they raised very little funding and focused on cost efficiency.

By choosing an extended-range electric vehicle in their business model, they have achieved profitability on a smaller scale compared to other companies due to higher cost and capital efficiency.

LK, have you ever met Li Xiang in person? What kind of person is he?

Helen, I have met him. A notable characteristic of Li Xiang is his extreme attention to detail.

I believe this is one of the common traits shared by many excellent founders, as they can clearly explain why they made certain decisions, including the cost of each part in detail.

For example, they decided not to equip their cars with fast acceleration features, as this could save approximately 0.03 million RMB per vehicle. They understand that the majority of ideal consumers are household users, and fast acceleration is not crucial for them.

LK, it is around 3,500 British pounds. We do not have this type of car here, but I know you test drove one. Can you describe to us how it feels to drive them? It is said that sitting inside gives a rather high-end feeling, right?

Helen, it is indeed a high-end product, priced higher in China compared to Tesla Model Y.

It's very interesting. I have discussed with many electric car companies about their products, and now every electric car company in China is talking about the so-called 'iPhone moment'.

Their idea is that these cars will have a similar impact on the automotive industry as the iPhone had on the mobile phone industry.

I think I didn't fully understand this point until I personally sat in the car and test drove it once.

This is an indescribable experience, a moment of wonder. The entire vehicle is voice-controlled. If I ask the car to turn on the back massage, it can recognize the source of the sound and only open the back massage for my seat.

LK Wow!

Helen There are entertainment facilities in the rear seats. There is a large screen that can be lowered, and you can control it by voice or gesture. For example, you can wave your arm, open or close your fist to control it. In addition, there is a mini refrigerator in the back of the car.

Cars are gradually evolving from mere transportation to an entertainment and relaxation space.

The investment risks of trade barriers cannot be eliminated but can be managed.

LK Recently, the USA raised the import tariffs on Chinese electric vehicles to 100%, while the tariffs on the lithium-ion batteries they rely on increased to about 25%, which will clearly have a significant inhibitory effect on purchasing these cars. How do you incorporate this dynamic into your investment considerations?

Helen, I believe that increasing trade barriers is inevitable, so you can't eliminate this risk, you can only manage it. Many people think that they can manage this risk by avoiding Chinese companies, but this is a misconception.

First, Europe exports a large number of luxury cars and luxury goods to China, and American companies also sell a large number of products to the Chinese market. So there is a risk of retaliation (i.e. China may also impose tariffs on luxury goods).

Next, many Chinese companies do not actually rely on selling products to Western markets. For example, the recently discussed Li Auto Inc mainly operates in the domestic market. Currently, in the field of electric vehicles, China holds around 60% of the global market share, making it the largest market.

Then, there are companies like Contemporary Amperex Technology, the world's largest battery manufacturer, with a 37% global market share. They do indeed sell to Europe, but also have production facilities in Europe. They are the largest European battery manufacturer with factories in Hungary and Germany, so many import restrictions do not apply to them.

However, ultimately, I believe the cost of production in Europe is higher. The cost of manufacturing a car in Europe is about 40% higher than in China.

As a society as a whole, there is indeed a need to decide whether to bear these costs and risks of delaying the transition to green energy, or to accept China's role in it.

LK, you mentioned the retaliation Western companies may face. Has this affected your investment decisions in any company or influenced your sell decisions? Do you have any examples of selling decisions?

Helen, it's not very convenient to give examples. But we can discuss the way we manage geopolitical and regulatory risks in our investment portfolio, there are two aspects.

First, we are reducing companies whose cross-border trade is a major investment driver. For example, we have reduced or sold companies like Estee Lauder, Adidas, and Pernod Ricard (a French company, the world's second-largest wine and spirit producer), and tend to choose companies that localize production.

Secondly, when investing in China, we tend to invest in industries that align with China's broader strategic priorities. Therefore, we pay more attention to advanced manufacturing industries such as batteries and electric vehicles, and invest less in sectors we believe face more regulatory risks, such as banks and real estate.

LK This is interesting because a few years ago we saw Chinese regulatory authorities imposing restrictions on some large internet companies. Do you think companies in advanced manufacturing industries are less likely to be subject to similar regulations?

Helen I wouldn't say there is no risk at all, but I think as long as companies in advanced manufacturing industries behave properly, comply with regulations, and contribute to society, the likelihood of being regulated is smaller.

We also need to remember that many internet companies are regulated because of their improper conduct. For example, regulations require them to protect consumer data and not enforce exclusive agreements with suppliers. I think these are good regulatory measures that any good government would take.

In China's stimulus policies, there is a focus on enhancing shareholder returns.

LK In recent weeks, China has announced extensive stimulus measures, from lowering interest rates, making it easier for companies to buy back stocks, to encouraging mergers and acquisitions, and there are rumors that more fiscal stimulus policies may be introduced. As a long-term investor, how do you think this will impact the companies in your investment portfolio and those you may consider buying in the future?

Helen Yes, I think everyone is excited about the fiscal stimulus and growth measures supporting the real estate sector, which also provide subsidies to consumers.

This is helpful for the market sentiment in China, with the stock prices of many Chinese companies rebounding strongly. However, these are all short-term and will not change the fundamentals of the companies.

I am more interested in some announcements buried in all the stimulus policies, especially measures encouraging mergers and acquisitions or encouraging companies to return more cash to shareholders.

LK In Japan, the goal of corporate governance reform is to make corporate management pay more attention to the interests of shareholders, right?

Helen In the past four years, Japan has carried out a series of corporate governance reforms. Historically, Japanese companies have held a large amount of cash on their balance sheets and have not paid much attention to shareholder returns.

And the focus of these corporate governance reforms is to raise standards, forcing them to pay more attention to shareholder returns. Therefore, the valuations of many Japanese companies have risen significantly.

LK If a similar situation occurs in China, as you have implied, it will be a very interesting observation. Before we finish, we'd like to ask our guests about the books they have recently read or can recommend. What book have you been reading lately?

Helen I am currently reading 'The Righteous Mind' by Jonathan Haidt, which is a book about moral psychology.

He believes that our moral judgments are based on intuition rather than rationality, with rationality only being used to explain intuitions.

He also pointed out that the differences in moral intuitions among different societies are very significant.

LK about the point that moral reasoning originates from intuition, even though we may not be aware of it. I'm wondering, do you think there is a similar situation in investment? Does intuition play a role when you decide which companies to research or buy?

Helen My rationality wants to say no, but this may just be my rationality defending my intuition.

I think there are many evolutionary reasons for intuition when it comes to moral judgments.

When analyzing companies, you always want to approach the issues with a beginner's mindset, and even question “why” on things that may seem obvious, never assume it is self-evident.

Over time, much of our work involves pattern recognition, and intuition does indeed play a role. I hope to believe that it is more of rationality at work, but I don't know if this is just me defending my intuition.

Editor/rice