The Key to Electric Cars Is Batteries. One Chinese Firm Dominates the Industry.

I think CATL’s story follows the typical Asian development playbook. First, channel state support, resources, and finances to a key strategic sector:

Beijing rolled out a subsidy program starting in 2013 to encourage local and foreign auto makers to sell more EVs. China promoted EVs as part of a program to boost its capabilities in future industries, and as a way to combat pollution and reduce its dependency on foreign oil.

Secondly, support domestic players and shield them from foreign competition as they ramp up the learning curve:

As the market took off, in 2015, the government told auto makers they would only qualify for subsidies if they used batteries from a list of approved suppliers, which included dozens of Chinese firms but excluded foreign ones.

Later, once these companies are more mature and “ready to leave the nest,” implement export discipline. This exposes domestic companies to foreign competition and culls out the weaker players. The state will then have a better understanding of where to channel its resources to: the domestic players that are able to compete on a global platform:

Though inferior to top Korean and Japanese batteries by some measures, CATL batteries outperformed Chinese alternatives in output and stability, and were available at a scale few others could match, the former GM executive said. Many other local players struggled to stay afloat.

Slowly introducing greater competition allows the top domestic players to catch up to foreign competition:

In June [2019], Beijing announced plans to scrap its controversial restrictions on foreign EV batteries and reopen its market to the big Korean and Japanese players.

South Korea’s Samsung & Hyundai and Japan’s Toyota are a few examples of companies that have developed from this playbook. The result?

CATL in 2018 produced 27 gigawatt hours, according to Benchmark Minerals Intelligence, and plans to add about 20 gigawatt hours of production capacity every year for the next decade.

“What the government did was a good thing for China,” said Mr. Jiang, the former CATL project manager. “Without its restrictions, I don’t think CATL would ever have been successful.”

Record Slump in China’s Auto Market Continues in September

The large boom of China’s automobile market has likely neared a top in this cycle. This chart is revealing:

The automobile industry is still critical to the health of an economy given its position in the supply chain. Automakers have a long supply chain to source parts and materials, ranging from value-added parts such as engines and electronic chips to raw materials such as steel, aluminum, and chemicals. The sector is a large employer, not only for manufacturing cars themselves, but also in sales, delivery, after-market repair, and maintenance.

Other sectors that are directly or indirectly involved in the automobile industry: financing and leasing of new and used cars, technology platforms for car sales (e.g. Autohome, Bitauto), insurance, trucking (delivery of new and used cars), downstream oil & gas (i.e. gas stations), etc etc.

Nevertheless, the Chinese automobile market is still considered under-penetrated. China has 179 motor vehicles per capita – USA has 838, Canada has 685, and UK has 471.

There will be bumps along the way – we are in midst of one of them – but I’m highly confident that, in the long-term, we will see greater automobile adoption.

Who Willed the Electric Car? China, and Here’s Why

The energy markets also have a significant influence in the automobile market:

China produces less than 5% of the world’s oil—used in combustion engines—but about 45% of the globe’s coal, used in electricity production for EVs. In much the way that the U.S. is the world’s largest user of homegrown crops for motor fuel despite widespread criticism of ethanol subsidies as costly and environmentally damaging, China will spend money and endure a dirty industry to be energy independent as well.

More than that, though, Beijing wants to dominate tomorrow’s car industry. China’s opening to the West came too late for it to be a major exporter of internal combustion engine vehicles, but it has made aggressive moves to dominate battery production, including securing sources of key metals. Through lavish subsidies it already has by far the world’s largest domestic EV market.

From reading a swath of energy-related books and being more involved with the industry over the last year, I’ve become more cognizant of the importance of energy independence to a nation’s stability. The Arab oil embargo is a typical example of this:

This is largely why China is investing so heavily in electrical vehicles, renewable energy, and battery storage. It’s also why some developed nations still rely on coal for power (e.g. Poland). For another example of the importance of energy independence seeping into sectors…

South Korea targets hydrogen economy, from cars to cities

South Korea has almost no natural fossil fuel resources – it is a huge importer of thermal coal, coking coal, and oil. This is also true for Japan. Is it any wonder that those two countries are pushing for a hydrogen economy?

China enjoys bumper demand for euro-denominated bonds

Speaking of independence…

The Ministry of Finance was expected to follow up the launch with further deals, as often as once a year, according to one banker involved in the deal.

Beijing is seeking to encourage diversification away from dollar-denominated bonds, both in terms of its own debt and for corporate China, according to analysts.

Recently, I’ve been reading a lot about the US Dollar’s dominance in finance and trade settlements – it’s “exorbitant privilege”. It is quite clear that many nations are arguing for a shift away from this dollar-dominated system. To me, the light bulb went off when Mark Carney called for a shift from the current monetary system:

Mark Carney, the Bank of England governor, has said that the world’s reliance on the US dollar “won’t hold” and needs to be replaced by a new international monetary and financial system based on many more global currencies.

In a speech at the annual Jackson Hole gathering of central bankers in the US, he called for the IMF to take charge of a new system of currencies, insuring emerging economies from destructive capital outflows in dollars and removing their need to hoard US currency. In the longer term the IMF could “chang[e] the game” by building a multipolar system, he said.

It will take some time, but it seems like we are moving from a unipolar to multipolar currency system. That might alleviate the massive stress point on the current regime of relying solely on US dollar, but it may also add unwanted/unforeseen pressure points in other parts of the global FX system. We may also see some massive dislocations as we move from a unipolar to multipolar system.

China Embraces Bankruptcy, U.S.-Style, to Cushion a Slowing Economy

Now this is new:

China’s system differs significantly in at least one respect: Bankruptcy courts here sometimes are inclined to protect shareholders over debtholders—with the aim of averting social unrest.

Last year more than a thousand people, including judges, bankers, home buyers and employees packed into a university auditorium here in China’s northwest to hear how a court-appointed law firm would sort through more than 7.5 billion yuan ($1.07 billion) in claims against a failed real-estate company. Hundreds of police officers and security personnel stood watch because of fears that grievances would turn to violence.

In some cases involving publicly listed companies, courts give priority to small investors who have suffered losses to keep them from stirring social unrest, at the expense of debtholders and other creditors that rank higher in repayment priority, said Xu Defeng, a law professor at Peking University.

On balance, I think China is harming itself with this type of system instead of a more market-driven approach embraced by the US and Canada.

One of the bankruptcy process’ aim is the remove the debt overhang issue. Debt overhang usually occurs when a company is so underwater that even the most senior creditors would see only partial recovery on their claims in liquidation. However, most companies typically have a higher value as a going-concern instead of being liquidated. But senior debtholders may balk at putting forth more capital when their initial claim is already underwater. And junior stakeholders, such as equity holders, will be unwilling to inject capital, as any capital they inject will go straight into the debt holder’s pockets. The bankruptcy process solves this issue, but nevertheless, equity holders are usually wiped out (as they should be!).

If this distortion in China’s bankruptcy system is not corrected, it will most likely harm capital formation in the long-term. Debt has a asymmetric payout: limited upside, unlimited downside. That’s an unattractive payout profile! Creditors usually demand some protection, such as a first claim to assets in liquidation, in order to be comfortable lending. If that protection is removed, the cost of debt will likely go higher.

On the other hand, shareholders also conventionally have an asymmetric payout: limited downside, unlimited upside. The current bankruptcy system provides shareholders with an even more limited downside. While the cost of equity may lower, it will likely not be able to offset the increase in the cost of debt. Although who knows…

I’m probably making a bigger deal out of this than is warranted. It seems like favoring shareholders were limited to a few select cases. Nevertheless, will be an interesting development to watch..

Exclusive: ASML chip tool delivery to China delayed amid US ire

The semi-conductor industry in China is another one I will keep a closer eye on. For now, just a snippet:

China’s biggest maker of computer chips, Semiconductor Manufacturing International Corp., placed the order with ASML in April last year for its cutting-edge machine, which is needed to produce the latest, most powerful chips. But that shipment is now “pending later notice,” three people close to the situation said.

ASML also made clear that its near-unique EUV machine is subject to the so-called Wassenaar Arrangement — a multinational export control protocol designed to stop the spread of advanced technologies that can be used for military ends — but that it had an exemption from the Dutch and European authorities to sell the machine to Chinese customers. The permit appears to have now expired.

Permits take eight weeks to approve or reject, according to Dutch regulations.

Other Readings

DSV’s 2018 Annual Report

Grubhub Q3 2019 Shareholder Letter

Americold Equity Research & Investor Reports

Equinix Equity Research & Investor Reports

Autohome Q3 2019 Earnings

Books

Exorbitant Privilege

Other Media

Gold: The “Third Rail” of Capital Allocation

Long Shorts – Finding Asymmetric Upside

• The thing is, most people instinctively want to short. That’s just the natural reaction. The problem is with government intervention, extreme fiscal and monetary intervention, shorting probably isn’t the way to do it. I’m short – it’s not really working.
• Note: from my discussions with hedge fund folks in Canada, this is a consistent theme I’m hearing – shorting is simply not working.
• Another one of my long/short themes is for profit education, because what we saw last cycle as well is that when people lose their jobs, the first thing they do is go back to school. They try to improve their careers and their education and make themselves more hirable. There was a huge boom and demand for for-profit schools the last cycle, I think that’s going to repeat this cycle. Additionally, there’s been a huge winnowing out as unemployment at historic lows.
• Names mentioned: UTI, ASPU
• When I look at shipping, I see a sector that’s at a major inflection point. If you go back to what I talked about previously, with trade wars and tariffs and global disruption, shipping is really a way to play geopolitical instability, and the easiest way you can think about it. Basically, a cargo goes from one place to another place, you have set trade routes that are historic and repeatable. Then suddenly, someone changes those routes, a politician, and instead of going to the most efficient way to move cargoes, you go somewhere less efficient.
• We’re entering this period of geopolitical instability at a time when this historic lows in terms of total supply of new tonnage coming, it’s been a 10-year bear market. Anyone who’s bought a vessel for the last 10 years lost money, and so they stopped ordering finally.
• Names mentioned: Scorpio
• We’re seeing this in all the other sectors where one of the Ponzi sector stalwarts is going to fail and someone in the old economy that’s been struggling for many years against them is going to prosper.
• I think rather than trying to guess when one of these Ponzi frauds dies, you should look at who the competition is and figure out who’s going to win when the uneconomic competitor disappears.

Inflation Risk Amid a Scramble for Yield

Thoughts

• Are we in a duration bubble? Growth going up, quality going up, real estate, defensives, 100-year bonds, perpetual bonds, etc.