“Strength...Innovation...Value”

I would like to start with market commentary by Byron Wien from Blackstone Group. I found it to be insightful as it provides a look into how an influential group of very intelligent and very wealthy investors (including over 10 billionaires) and business executives view our world. They are representative of those who drive our economy, run large companies, make decisions, invest in the stock and bond market, hire people, and weigh heavily on who is elected. This summary covers a lot of things that keep me and you up at night. While we focus on China, what happens in the US market and the mindset of US investors have a lot to do with how Chinese stocks in the US trade, and that’s not going to change. Until investors regain confidence, small‐cap stocks will languish as they are the farthest out on the risk spectrum. What I hope you find interesting is this group’s views on China, which mirrors ours in that it will be the place to invest for the coming decade.

Despite stronger fundamentals for the vast majority of China‐based companies, the mounting short attacks and company follies have put multiples back where they were 2 years ago. It is not necessarily fair but in the stock market perception is reality. The good will survive, emerge stronger, and at some point get back to reasonable multiples. In the interim, while bonds continue to rally and money continues to flow out of equities, this bear market and bottoming phase will continue. With negativity at its highest point and the short interest in many of these
names rising precipitously, a rally seems close at hand.

The Roth Best Idea Fall Conference in beautiful Maui provided a brief and much needed respite from the recent market woes. With a view like this during meetings, every presentation sounded great. Since the first quarter when real gross domestic product expanded at a 3.7% rate, almost every measure of economic progress in the United States has
deteriorated. Unemployment has remained stuck at about 9.5%; the second quarter gross domestic product growth was
recently revised down to 1.6% from a preliminary estimate of 2.4%; home sales have retrenched after tax incentives
expired; retail sales are lacklustre and capital spending is uneven. Instead of gaining momentum the economy appears to be sputtering, and the mood of investors is
apprehensive at best.

In general, investors at Mr. Wien’s events were gloomy. They saw the United States in a longterm
slow growth environment with the near‐term risk of a double‐dip recession quite real. The Obama administration was viewed as hostile to business and its policies inhibiting both hiring and investment. Companies and entrepreneurs were reluctant to add workers because they didn’t know what their healthcare costs or taxes were going to be. Financial service firms were confused about how the rules emanating from the new financial service regulatory reform legislation would affect their businesses. Almost three‐quarters of Americans polled think the country is headed in the wrong direction and Obama’s approval rating is in the lamentable low 40’s. One participant said that the top 5% of the income ladder accounts for 30% of consumer spending and that is the group Obama seems to be attacking. The already high level of debt currently on the books of the federal government makes additional stimulus spending controversial and the political climate for more stimulus makes it unlikely that a major program could be passed. Finally, there are many who question the effectiveness of the first stimulus program.

State and local governmen ts are running hundreds of billions of deficits annually so they are more likely to be cutting back on expendituresadding to unemployment and slowing economic growth. Consumers are in the process of reducing the debt built up during the free‐spending era prior to 2008, so their role in contributing to growth (the consumer represents 70% of gross domestic product) is likely to be diminished. Current administration policies have not been effective in helping the middle class in America. Even if the Federal Reserve engages in a vigorous program of quantitative easing, the economy is unlikely to pick up much speed. There is a mismatch between the jobs that are
available and the people who have the skills needed to fill them. American labor costs are high and there are an increasing number of competitors around the world making products comparable to ours in quality at lower prices, so it is proving hard to expand our exports while our craving for foreign manufactured goods and oil keep our imports high.

Moreover, these are not problems that are likely to be solved any time soon; over the short term they may actually get worse. We seem tobe condemned to a long period of slow growth and high unemployment, and the current attitude of investors at the lunch and elsewhere seems to reflect those conditions. A substantial minority feared we were headed back into recession. Only a few investors thought the S&P 500 could reach 1200 in the next year.

I asked the group if there was a bullish case to be made since periods of profoundly negative sentiment usually created major investment opportunities. Several pointed out that money supply was likely to expand, which was generally good for stocks. Both interest rates and price earnings ratios were low and usually those two don’t go together; multiples could rise. Corporate earnings are terrific, corporate balance sheets are in great shape with plenty of cash available for investment or acquisitions. Currently depreciation is running higher than investment, which shows a lack of confidence in the future, but that could change. Merger activity is picking up, reflecting business confidence in strategic deals.

Boards of directors are pushing managements to do something constructive with their cash. The public is selling stock mutual funds and buying bond funds, reflecting their disenchantment with equities, and almost invariably they make this shift at the wrong time. Young investors got burned in the technology bubble and older investors are shifting their portfolios into conservative assets, resulting in a paucity of equity buyers. You can buy high‐quality stocks providing reasonable yields, which means the market is not devoid of opportunity. Larger
companies are especially attractive. Nobody has made money investing in the indexes for 12 years. A quarter of the stocks in the Standard & Poor’s 500 yield more that the 10‐year U.S. Treasury. There are plenty of companies out there with a lot of cash waiting for someone to bid for them. You can buy companies with reasonable growth prospects at 12 times earnings while Treasuries with no growth prospects are selling at 40 times the coupon.

The problems we are facing have been coming for a long time and they will not be solved quickly because so many of them are structural. Our political system is broken, our education system is falling behind and slow to respond to constructive ideas, and our infrastructure is pathetic. The teachers unions stand in the way of educational reforms; the Republicans only care about getting control of Congress and the White House and they lack a convincing program likely to turn the economy around. Tax cuts alone won’t do it. Not enough good people are going into government and those who want to are daunted by the screening process and the exposure. Negative campaigns are showing up everywhere and they seem to work, which is discouraging. The infrastructure in Europe and Asia is better than ours and we’re slow to make improvements here and lack the serious money to do it.

We debated whether the Chinese miracle would continue. Most believed the government there has proven its ability to regenerate itself with competent leaders and was very effective in both producing growth when it slowed too much and restraining growth when it reached a level likely to produce inflation. The usual concerns about demographic problems, pollution, human rights, the legal system and corruption were mentioned but were not yet considered troubling enough to slow China down. Recent data showing growth at only 7% was not viewed as indicative of a prolonged downtrend. There was a feeling that the air pollution problems and the lack of safe drinking water were likely to become serious issues in the future.

China is doing more about its environment than most countries, but it is starting from a very low base. The Chinese are major manufacturers of wind turbines and solar panels but that is primarily for export. China passed Japan this year as the second largest economy in the world and it appears likely to continue to grow in economic importance. Somewhere in the future it will surely run into difficulties but the bubble that everyone has been expecting in real estate doesn’t seem to be about to burst. There are excesses at the high end, but they don’t appear to be system threatening. A healthy crop of new engineers is coming out of its universities every year and we can expect to see examples of Chinese technological innovation in addition to the production of quality manufactured goods at attractive prices. A country with this much economic power is likely to want more of a role in geopolitics and this will be a challenge to the established countries in the West.

Overall there was a feeling that to bring about the profound changes that are needed a major crisis would have to occur. Another recession could create severe problems in commercial real estate as well as residential mortgages and the banking system, and that might bring on serious reforms. In terms of where to invest if the current slow growth economy continued, vacant office buildings and farmland looked good to some. Few were enthusiastic on gold. Many liked Brazil and some favored India. Nobody had anything good to say about Japan. In reaction to the current craze of the banks and others to borrow short term and invest in longer‐term bonds of various quality, one participant asked plaintively, “Has there ever been a carry trade that hasn’t ended badly?”

As always we welcome your feedback and support.
Regards,
Matthew Hayden
Feng Peng
Ted Haberfield
John Mattio
Scott Powell
Mark Flather
Johnny Lai
Ling Zhang
Jennifer Heady
Mark Henshaw