China's Hunger for Knowledge

By examining the key elements of China’s strategy, we will be in a better position to understand and anticipate its movements. This, in turn, will guide us in our long -term investment decisions. Today, Justice Litle looks at the transfer of knowledge and technology from multinational corporations…

For the big multinationals, investing in China is a schizophrenic enterprise. Dreams of huge profits are balanced against piracy nightmares, profit-crushing competition and razor-thin margins. This is exactly how China likes it. Foreign multinationals are prized for their technology and expertise: If they stay and succeed, Beijing leans on them to share the wealth with local partners. For those who leave with their tail between their legs, odds are good they were picked clean en route to the nearest exit. China has practically made an art form of bringing in outsiders to develop a market or industry, transferring said outsiders’ knowledge and technology to local imitators and then brutalizing profit margins with local competition once the transfer is complete. Most companies are offered a Faustian bargain: To gain access to the kingdom, you must partner up…we share our markets, you share your expertise. The bit about intellectual asset stripping is conveniently left out of the deal.

The typical turn of events goes something like this: The starry-eyed multinational, thinking of limitless profits to be made in the world’s fastest growing market, bears the brunt of the initial costs to set up shop. By the time the initial setup costs are recovered, the multinational discovers, with dismay, that copycats have crept in. The local partner, backed by Beijing, does not seem surprised; in a short while, profit margins have crumbled to dust. The multinational is then left with one of two less-than-pleasing prospects: soldier on near break even and hope that prospects eventually turn up, or pack the bags and go home…with strategic assets left behind.

Intellectual Property Rights in China: Imitate, Conquer and Dominate

The above may be a slight exaggeration, but not by much. Decent profit margins are hard to come by in China, and harder still to maintain for any significant period of time, due to the process just described. It has happened again and again, in everything from mobile handsets to microwaves to automobiles, as low-margin producers imitate, conquer and dominate. Optimists point out that Beijing is grudgingly moving toward general respect of intellectual property. Rampant piracy is recognized as a problem; China’s judicial wheels are turning against industrial counterfeiters, albeit in slow motion. The simple reality is that a lax attitude toward piracy and intellectual asset stripping is currently in China’s best interest (though it becomes steadily less so over time). Rather than reinvent the wheel, why not let a steady stream of naive wheel inventors who have already done the hard work come in and give away their secrets?

China will take a harder line on intellectual property rights when one of two things happens: Either multinationals will demand intellectual property enforcement and stop acting like sheep to be sheared, or China will build up enough proprietary knowledge and technical expertise of its own to warrant the standard legal protections.

On a more ominous note, China’s hunger for knowledge extends to military technology. At the moment, Beijing’s defense budget is less than 1/40th that of the United States ($20 billion versus more than $400 billion), but the gap will eventually close. Beijing will also have the advantage of leapfrogging the legacy systems and outdated programs that make up much of America’s military infrastructure, moving straight to the latest technology even as the United States sees domestic spending pressures increase.

Intellectual Property Rights in China: Lifting the Arms Embargo

It is here, where the stakes are highest, that a distracted America is finally sitting up and taking notice. Europe, in a move led by France and endorsed by Britain, plans to lift the China arms embargo in place since 1989. From Europe’s point of view, lifting the weapons ban is a natural and harmless move. Put in place as a result of the Tiananmen Square massacre, China is a new country with a new attitude. Europe and China both declare the move to be symbolic. China seeks acknowledgement as an upstanding member of the economic community, and claims to have no interest in the actual purchase of European weapons. As for Europe, it merely wants to smooth business relations with their second biggest trading partner and pave the way for future cooperation, by giving the Middle Kingdom a gesture of respect.

America, as usual, is stuck between a rock and a hard place. Protest seems pointless, but what other action can be taken? The true concerns of the United States are so grave they can hardly be voiced: potentially engaging China in a war over Taiwan in the South China Sea…and facing European military technology, bought for the express purpose of sinking American ships and killing American troops. How do you explain to your oldest allies that they are whistling past the graveyard when they breezily dismiss your concerns as paranoia? When the weapons ban is lifted – if America is unable to find some last-ditch effort to stop it – Europe will make all the right noises, all the right pronouncements. Promises will be made, peaceful intentions will be underlined, and all types of positive benefits will be sallied forth. The European Union says assuringly that a "code of conduct" will be put in place. For American hawks, the phrase might as well be "Peace in Our Time." Though the move may yet prove symbolic in the long run – China has multiple sources for military technology, at any rate – it is a harbinger of the dangerous game to come.

Who are the winners and losers in China’s quest for knowledge and technology? Naive multinationals who do not understand the Chinese way are clear losers; Chinese firms that get a leg up on their foreign partners are clear winners. Avoid investments in companies that view China as a typical market with typical rules; instead, look to companies that understand exactly what they are getting into and have means to protect their intellectual assets. Also consider exchange-listed Chinese firms that are in a good position to upgrade themselves with the help of "borrowed" multinational expertise. Once intellectual property rights start taking hold in China, look for new opportunities in standards-dependent industries that were previously unfeasible in a lawless environment. Watch closely as China transitions from basketballs and sneakers to pharmaceuticals and computer chips.

On the military front, watch the drama unfold between Europe, America and China. If the ban is lifted, expect America to consider an across-the-board withdrawal of cooperation with Europe on sensitive technology projects. Will the transatlantic alliance be placed in doubt?

It’s going to be an interesting century.

Regards,

Justice Litle
for The Daily Reckoning
March 08, 2005

Justice Litle is the editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between. Mr. Litle also acted as head trader for a private equity partnership, and has made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Reuters.

Justice Litle has been cooking up something big – a new report on crude oil supply…and a connection between two countries that may surprise you. We’ll have more information soon, so keep your eyes peeled, you’re not going to want to miss this one…

Martha Stewart is out of the can, but not exactly on the loose.

Like so many things in America in the 21st century, what seems to matter is the collateral, not the pertinent. Martha’s "crime" was insignificant…she sold a stock she thought was going down. But no one seems a bit concerned that an ambitious prosecutor railroaded her. She might as well of been shut up in Guantanamo or sent off to Syria, where torturers could have beat a confession out of her. The news shows would still only want to know if her weight went down…or if her stock went up. Martha’s a genuine celebrity now. And thanks largely to celebrity coverage of her stint in the Big House down in Pennsylvania, stock in the House of Stewart in New York rose from $10 to over $37, increasing Martha’s personal holdings by $600 million. As far as we know, no one ever made more money while scrubbing toilets in the pen.

Who would buy stock in a money-losing media company, whose chief personality is doing a prison term? The same rubes who bought tech stocks in ’99…and who now speculate in houses – mom and pop lumpeninvestors without a clue or a prayer…who have no business being in the stock market in the first place.

But while the public was bullish on Martha Stewart Living Omnimedia, private investors who knew what they were doing, have been dumping it for months. Barron’s reports that insiders at the company sold 10 shares for every one they bought, while their honcho labored on heads.

Meanwhile, our Pittsburgh correspondent, Byron King, reports on Bernie Ebbers’ efforts to stay out of the hoosegow:

"At his trial on Feb. 28 in New York, former Worldcom CEO,
Bernie Ebbers, took the stand in his own defense. He denied that he knew anything about Worldcom’s profits, revenues or other pertinent financial information. He delegated that to others, he testified. He denied that he knew about, let alone condoned, the financial fraud that is now apparent in Worldcom’s business records. He was misled by his employees…

"Ebbers’s attorney, Reid Weingarten, questioned Ebbers about his background. Ebbers testified that he had dropped out of two colleges before getting a degree in physical education. Then, he worked as a milkman, delivery driver and basketball coach. Finally, Ebbers said, he found work in the telecommunications industry, although he claims that he never understood the essentials of the business.

"When asked to reconcile his limited background and admitted lack of understanding of the inner workings of a complicated corporate business, Ebbers testified, ‘I know what I don’t know.'(Well, maybe he doesn’t.)

"Ebbers testified, ‘I don’t know accounting…I am not up to date on technology…I was not technically competent to lead Worldcom for the indefinite future.’"

Ebbers’ defense, in other words, is that he couldn’t have intentionally misled anyone about the facts of Worldcom; he had no idea what the facts were!

But so what if he was ignorant of the telecom business?

We recall another telecom executive – Gary Winnick – head of Global Crossing. All the man knew about his business was what he had learned from watching a 30-minute video, describing how undersea cables were laid. Yet, his stock rose too – until the company was worth more than $50 billion.

The public loved Global Crossing as the stock reached more than $60 a share. But the insiders – notably, Winnick himself – knew when it was time to sell. He sold $735 million worth…just before the company went belly-up.

At least Winnick knew what business he was really in – stock promotion. But poor Bernie Ebbers seemed out of his league altogether. He forgot to sell.

More news, from our team at The Rude Awakening…

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Eric Fry, reporting from Manhattan:

"We have been called ‘rich Americans’ for so many decades that we have come to assume this state of affairs as a kind of birthright. But the world we have known may be changing…and if so, the financial world that global investors have known may also be changing…"

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Bill Bonner, back in London…

*** We welcome Justice Litle, Outstanding Investments’ new editor, to these pages. He’s a global commodity expert. As global commodity experts are wont to do, he thinks about China…

"China can legitimately claim to have forgotten more than much of the world has ever known," Justice reminds us. "Gunpowder, the plow and the printing press were discovered by China ages before Europe rediscovered them. China was once a far-flung empire rivaling the status of Rome. Before the birth of the West, before the birth of Christ, the Middle Kingdom was great. The Chinese remember their greatness, and it drives them."

More from Justice, below…

*** We are still thinking about real estate. A bubble has expanded the prices of houses all over the world. Someday, the bubble will pop. But two kinds of property may at least outperform other real estate investments: brands and beaches.

*** Is there really a property bubble in America?

"No," says colleague James Ferguson in London. If you want to see a real estate bubble, you have to look at Britain. House prices in the United States have risen almost 50% in the last five years, he notes. In England, they’ve gone up twice as fast. And in America the house price-to-income ratio is at a record high of 3.35. But in the United Kingdom, the ratio is over six.

What’s more, James points out, "typical mortgage repayments; (interests and principal) adjusted for average income, have fallen by more than a third…this means that should Treasury yields (and thus mortgage rates) rise in the near future, U.S home-buyers would not necessarily have to flee the market."

In the United Kingdom, meanwhile, the debt service burden has remained almost constant at 10%. "Now that rates are rising, the debt service burden is approaching record high levels. It would appear we have no option now but to cut back on debt – and that spells lower house prices."

*** Chris Mayer reminds us that when it comes to debt, Americans are no slouches either…

"The U.S. consumer is like a man who, seeing a noose, can’t resist sticking his fat head through it and giving the thing a tug.

"In today’s Wall Street Journal, I read a story about how U.S. consumer debt increased to an all-time high of $2.1 trillion. According to the report, consumers are borrowing more on credit cards, as well as taking out new car loans. On the same page, I see a story titled ‘Bankruptcy Bill Builds Momentum,’ about a new piece of legislation that will make it harder for people to walk away from their debts.

"It is by connecting these small pieces in the grand jigsaw puzzle of finance that the next great bust will inevitably be revealed."