I spent four days in Shanghai and Hangzhou meeting companies and speaking with fellow investors. It’s now been two and a half years since the COVID lockdowns ended, and I still relish every opportunity to visit mainland China again. But make no mistake, this is a cutthroat place to do business, especially with deflation pressing down on everything.

CHINA’S GROWTH PARADOX

Many of my travelling companions were visiting China for the first time or had not been in many years. They marvelled at China’s economic miracle. It’s easy when you live here to forget that other countries do not (or cannot) prioritise economic growth to the same degree or for so long.

However, despite its growth, China Inc. has not historically delivered good returns in aggregate for minority shareholders in publicly listed companies. That disconnect has been on my mind recently and was a frequent topic of conversation among our group. Why the gap? A few thoughts:

Index construction is poor and does not include private firms or the wealth created pre-IPO.
Managers often prioritise capacity-building over near-term earnings.
内卷 (involution, a.k.a. intense competition) creates lean survivors but depresses industry profitability.
China has more asset-heavy businesses than elsewhere (manufacturing vs. software).
Companies may intentionally avoid showing profits to pre-empt regulation and deter rivals.

What Really Makes a Moat?

Examining the nature of competition and pricing power on the ground helps explain these interrelated forces.

Deflation is exposing which Chinese companies have pricing power and true economic moats. The answer, in my opinion, is not many.

A Swedish vertical market software company I spoke with recently described its software packages as “the heart and lungs of our clients’ businesses.” Their customers literally cannot operate without them. That’s a moat and one which conveys pricing power.

In contrast, many businesses in China execute extremely well and report high returns on capital, but face competition at every turn. This was tolerable while the economic pie was growing at breakneck speed. But competition has intensified as growth has slowed, making it significantly harder to underwrite long-term investments.

Investors used to come to China to ask, Where’s the most growth? Perhaps we are better off asking, Where’s the least competition?

Capital Allocation Matters More than Ever

Good capital allocation matters even more when growth slows.

Yum! China had one of the best slides on capital returns among the companies we met. I guess this is why its management team is so popular with investors.

Trip.com, on the other hand, grumbled that markets don’t value its minority stakes in other listed companies. But those stakes have sat fallow on its balance sheet for a decade, suppressing returns on capital. Why does an OTA need to own a 2% stake in an airline? There’s room for improvement there, despite Trip having one of the most secure market positions in any online vertical.

In the past, breakneck growth could paper over weak capital discipline. That’s no longer true. With the economic pie no longer expanding as fast, I suspect that capital allocation will become the main differentiator of long-term returns.

The good news is that more and more Chinese firms ‘get it’. The biggest shift has perhaps been among the state-owned enterprises, which will require investors to rethink their definition of ‘quality’ and where to hunt for superior returns. Already, the SOE-heavy, high-dividend-yield MSCI China Value Index has outperformed the broader MSCI China index by four percentage points per year for the last five years.

Fast Growth, Thin Margins

Of course, some of the companies we met are still growing fast.

Take J&T, for example. As if to prove my point, it entered China just five years ago and is already the nation’s fifth-largest third-party logistics firm. When market shares can change this quickly, is anyone safe?

J&T China broke even last year and may boast the thinnest margins I have ever seen, earning just 0.8 US cents of EBIT per parcel. Yes, that’s less than one cent of earnings a parcel - and that’s before interest and taxes! But when you move twenty billion parcels a year, extreme scale buys you some breathing room.

J&T was founded to serve the Indonesian market. It brought fast and modern logistics to that archipelagic nation’s 18,000 islands. Like many Chinese companies, it now has its sights set on growth in other emerging markets, especially Latin America. Will we see the same deflationary forces at work there? It would be a boon for consumers but a nightmare for high-cost incumbents.

the Power (and Trap) of Negative Working Capital

Leap Motor is also growing fast.

It is a homegrown EV OEM founded by ex-employees of Dahua Technology, China’s second-largest surveillance firm. Not a bad background for an era where cars are turning into smartphones on wheels. Since 2015, Leap has grown from a standing start to USD 4.4 billion in sales in 2024. It only recently turned gross margin positive (!) but runs free cash flow positive thanks to its negative working capital - that is, its payables exceed both receivables and inventory, meaning its suppliers finance its growth.

This kind of financing lets firms scale faster than they could otherwise afford, but it also traps them in a grow-or-die dynamic.

When I invested in BYD, I didn’t appreciate how it is far from the only Chinese OEM to enjoy negative working capital. This tells me the industry’s barriers to exit are higher than I’d thought, as unprofitable firms still enjoy positive cashflow. It also creates an imperative to keep growing. It’s double or bust!

OEMs have pushed their capital needs onto suppliers, who in turn borrow from the banks. The banks are happy to keep lending because demand for credit is so weak elsewhere. This is another distortion caused by deflation and ultra-low interest rates.

Leap plans to grow exponentially for the foreseeable future. The problem is, so do its peers. How many EVs can they all sell before the price wars become truly ruinous?

Franchising Frenzy

Low interest rates have made franchising more attractive than ever, as evidenced by the rapid growth of chain hotel franchisors like Atour and H World. Franchisees hope to earn a higher return than what they’d get at the bank (currently just over one per cent), while franchisors can expand using other people’s money. When it works, it’s a win-win for both sides.

The economic logic is compelling too: chain hotels enjoy a ten to fifteen per cent uplift in revenue per average room night. But I wonder, will the last franchisee enjoy the same sparkling economics as the first? I doubt it. There’s only so much demand. And only so much premium real estate. Too much growth could hurt franchisees, which would ultimately curtail the franchisors’ ambitions.

After four decades in the market, even Yum! China is finally getting serious about franchising, just like QSR operators in other countries. Why now? Because they finally believe they can maintain food safety and consistent quality at scale. Also... there’s AI. With CCTV everywhere, it’s trivial to monitor franchisees’ compliance with operating protocols around the clock.

(Side note: is this a taste of what white-collar workers can expect when we start working for AI instead of with it?)

LOWER PRICES Broadens Markets

Deflation has forced companies to rethink their pricing and cost structures to retain thrifty customers and find new avenues of growth. Yum! China’s IR team were proud to tell us that Pizza Hut’s ¥6 menu (less than USD1) makes it an affordable luxury for even delivery riders, the unsung blue-collar heroes of urban China.

We budgeted ¥100 (USD14) each for lunch at Pizza Hut and could only eat half of what was served. A meal there feels cheaper than it was twenty years ago and the quality is better, too.

Lower prices make these goods and services available to people who couldn’t previously afford them. That’s good news for folks at the bottom of China’s economic pyramid.

So, How Much China?

One of our group enjoyed asking each management team: If you had to bet your child’s university tuition on one of your competitors, who would it be? Sometimes the answers came quickly. Sometimes they squirmed.

At Leap Motor, after an uncomfortably long pause and much dissembling, the manager admitted he wouldn’t invest in any EV company long-term because consumers have no brand loyalty. At least he was honest!

On our last night, someone turned the tables and asked our host: How much of a global portfolio should be allocated to China? It’s a great question, and one that deserves honest debate. Yes, there was some squirming, too.

President Trump’s Trade War brought long-overdue attention to the strengths of China Inc. The central government’s pre-emptive move to deflate the real estate bubble leaves the country on a stronger footing, even if its economy is weak today. Thanks to their deep internal supply chains and prodigious investment in R&D, Chinese businesses are now much better positioned to weather trade and technology sanctions than they were during the first Trump administration.

Above all, Chinese goods compete as much today on quality and sophistication as they do on price. This is not your grandfather’s exporter. As the chart below illustrates, China has become the dominant trading partner for much of the world. So, who needs whom the most?

Meanwhile, the Trade War showed that America Inc. is more vulnerable than its politicians believe. In fact, America Inc.’s high aggregate returns on capital are arguably the result of offshoring so much of its real economy to Asia, especially China. Everything is a trade-off, I guess. You can’t have your cake (world-beating equity returns) and eat it (enjoy economic security).

Curiously, tariffs and geopolitics barely came up during our meetings. That may be because Shanghai isn’t as export-dependent as southern provinces like Guangdong, and most companies we met were domestically focused. Or perhaps the silence reflected fatigue and caution. In a more politically sensitive climate, executives may have been reluctant to engage in off-the-cuff discussion about geopolitics, especially with foreign investors.

Either way, this hot topic abroad was noticeable here for its absence.

My Answer: Pick Your Spots

So, how much China?

My answer is that China deserves a meaningful allocation in a global portfolio. But you have to pick your spots carefully. As I’ve hinted at above, I am drawn to businesses that face less competition (like Tencent, Trip.com and Futu), or that can marshal overwhelming economies of scale to remain profitable even as they cut prices (like BYD).

Tencent enjoys entrenched network effects, Trip has little real competition, and Futu is taking market share from lethargic incumbents. Meanwhile, in the first quarter of 2025, BYD accounted for a quarter of Chinese automobile sales and two thirds of the industry’s profit.

As I argued in my most recent investor letter, China today reminds me of the U.S. in 2010 when it was emerging from the wreckage of the sub-prime crisis. Sentiment was fragile. Recession risk was real. The shadow of 2008 loomed large. But it was a wonderful time to buy American equities.

Of course, risks remain, from regulatory surprises to shifting global alignments. But valuations reflect much of that.

Final Word

A big thank you to my friends at Cederberg Capital for organising the trip and so kindly including me. Their planning was flawless and they were gracious hosts. They have built a wonderful investor base and I was delighted by the quality of conversations on the bus rides. I learned as much (if not more!) from my travelling companions as I did from the management teams we met.

So to them, too, thank you and bon voyage!

A Postcard from China