China’s state-guided system excels at industrialising innovation. Relentless competition, manufacturing scale, supply-chain depth and affordability allow technologies to diffuse rapidly across the economy, creating world-class industrial ecosystems and globally competitive products.
Both systems have produced remarkable success.
Yet, investors do not own countries. They own claims on future cash flows of companies.
That distinction helps explain one of the most important investment stories of the past decade.
See also: Pivoting to US stocks that are the biggest beneficiaries of the current phase of AI revolution
Despite China’s extraordinary industrial achievements, US stocks have dramatically outperformed Chinese stocks, particularly since 2021. The divergence is visible not only in share prices (see Chart 1), but also in corporate earnings (see Chart 2).
The question is why. The answer lies not in which country innovates more, but which system captures more of the value created by innovation.
See also: To the stratosphere: The SpaceX IPO
Competition creates winners. Excessive competition creates consumers’ paradise
In America, successful companies often enjoy substantial pricing power. Whether it is Microsoft in enterprise software, Google in digital advertising, Nvidia in artificial intelligence (AI) accelerators or Apple in consumer electronics — market leaders can sustain high margins for lengthy periods.
This allows innovation to translate into profits, profits to translate into higher valuations and lower capital costs to fund further innovation.
China operates differently. Its greatest strength is also one reason Chinese equities have struggled. Competition is intense. Successful products are quickly replicated. Margins are competed away. Consumers benefit from better products at lower prices.
The result is that China may be one of the best places in the world to be a consumer, but not necessarily a shareholder.
We see this across industries. Ride-hailing, electric vehicles, smartphones, home appliances and, increasingly, AI services, have all become cheaper.
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Consumers win. Businesses often do not.
That distinction sits at the heart of the divergence between the American and Chinese equity markets.
The shareholder return machine
The numbers tell the story. Corporate America’s profitability has strengthened considerably in recent years. Initially supported by pandemic-era fiscal stimulus, it has since been reinforced by AI, rising capital expenditure and early productivity gains.
Net profit margins for the S&P 500 have risen from already elevated pre-pandemic levels to almost 15% today. Earnings growth remains robust, led by technology companies.
Importantly, these are not merely growth companies. They are highly profitable growth companies.
Many investors assume the US market trades at premium valuations simply because investors are willing to pay more. In reality, much of the premium reflects superior profitability, stronger shareholder returns, deeper capital markets and lower perceived risks.
The US benefits from scale, liquidity, institutional trust and reserve currency status, which lower both its risk-free rate and equity risk premium. Most investors simply do not understand this fact.
Investors pay more because they are buying more predictable future cash flows. This helps explain why American equities have consistently commanded higher valuation multiples than most other markets’, including China’s.
Chart 3 shows the higher PEG (forward price earnings relative to growth) multiples accorded the S&P 500 versus with MSCI China stocks in the past 20 years. It also underlines what we wrote earlier, that despite the S&P 500 rising to all-time record high prices, valuations relative to earnings growth have in fact been trending lower. And this is the reason for the Absolute Returns and AI portfolios’ latest pivot towards US stocks — specifically companies we believe are the biggest beneficiaries of the current phase of the AI revolution.
China’s challenge is competition more than regulation
Much has been written about Beijing’s regulatory interventions. The cancellation of Ant Group’s initial public offering (IPO), restrictions on private tutoring, investigations into technology platforms and property-sector deleveraging undoubtedly damaged investor confidence.
But regulation alone does not explain China’s weaker equity performance.
The deeper challenge is structural. China’s industrial ecosystem is extraordinarily effective in spreading innovation — and competition.
As technologies diffuse, competitors emerge, prices fall, margins compress and returns on capital decline. This benefits consumers and strengthens national competitiveness but limits the ability of individual firms to generate sustained excess profits.
For shareholders, that difference matters enormously. Ironically, many of the forces that make Chinese products globally competitive also suppress profitability.
The great divergence
Viewed through this lens, the divergence between US and Chinese equities become easier to understand.
America optimises for capital formation, profitability and shareholder returns. China optimises for industrial capacity, affordability and national competitiveness.
Neither system is inherently superior. They simply optimise for different outcomes.
Many investors assume industrial dominance automatically translates into stock market dominance. It does not.
What matters is not who is producing the most, but who captures the greatest share of the value created. That is why America has produced many of the world’s most valuable listed companies, while China has produced some of the world’s most competitive industries.
When would we buy China again?
The most dangerous words in investing are “this time is different”. Every economic system eventually encounters diminishing returns.
Corporate America today enjoys extraordinary profitability. Net margins are near historic highs, supported by pricing power, dominant market positions and the early benefits of AI.
Yet, such conditions rarely persist indefinitely.
As industries mature, growth slows, markets become saturated and competition intensifies. Marginal returns on new investment decline.
When revenue growth slows, companies already operating at exceptionally high margins have limited room for further expansion.
At some point, earnings growth must converge towards broader economic growth. Return on investments must converge towards market rates. It is simply market capitalism at work.
China may be approaching the opposite side of this cycle. For years, Chinese companies have sacrificed profitability for scale. Intense competition and capacity expansion have compressed margins but also created perhaps the deepest manufacturing ecosystem ever assembled, with world-leading production costs and scale.
The common assumption is that Chinese companies must eventually achieve American-style margins before their stocks can outperform. That assumption is flawed economics, bad mathematics and poor finance.
They may never achieve American margins — and do not need to.
Once fixed costs are absorbed and marginal costs continue falling, profits can rise dramatically even if margins remain modest. This is what should keep the rest of the world awake at night.
A company earning a 5% margin on US$1 trillion of sales is more profitable than one earning 20% margin on US$200 billion sales.
What matters is total profits.
China’s system appears increasingly geared towards maximising scale. Lower costs enable lower prices, which drive market share, volumes and further cost reductions.
This dynamic has already unfolded across solar panels, batteries, electric vehicles, consumer electronics and, increasingly, AI.
At some stage, China’s industrial ecosystem may become so large that even modest margins generate extraordinary profits. When that happens, investors may value Chinese companies very differently.
The question is not whether China can build world-class industries — it already has.
The question is whether industrial dominance eventually translates into shareholder profits rather than primarily consumer benefits. If that transition occurs, the investment case could change dramatically. And as we articulated in the past weeks, its export momentum is precisely aimed at this objective.
In that world, investors may find themselves doing the opposite of what we are doing today: buying Chinese equities and selling American ones.
Successful investing is not about loyalty to countries or systems. It is about identifying where future profits will accrue.
Why we have rotated towards America
This framework explains our recent portfolio decisions. We have reduced our exposure to Chinese equities while increasing our allocation to select US companies that we believe are among the largest beneficiaries of the current AI investment cycle.
This is not a judgement on China’s future. The republic remains one of the world’s most dynamic economies and continues to produce globally competitive companies.
Rather, it reflects our view that the economics currently favour American firms when it comes to converting innovation into shareholder returns.
The companies we have added to the Absolute Returns Portfolio — Alphabet Inc, Microsoft Corp, Nvidia Corp and Talen Energy Corp — provide exposure to different layers of the AI value chain.
Together, they reflect our belief that the next phase of AI value creation will increasingly be captured by the infrastructure, software and energy providers enabling deployment at scale.
The portfolio changes in both the Absolute Returns and AI portfolios should therefore be viewed through this broader lens.
Every technological revolution encounters a physical constraint
Every major technological revolution eventually runs into a bottleneck. For railways, it was steel. For automobiles, it was oil. For electrification, it was copper. For AI, it is increasingly becoming energy.
This is why Talen Energy deserves inclusion alongside technology names. As AI data centres proliferate, electricity becomes a critical input. The beneficiaries are not only chipmakers and software companies, but also those controlling scarce power generation assets.
What could prove us wrong?
The greatest risk to our thesis is that AI becomes increasingly commoditised. If models become interchangeable, competition intensifies and pricing power collapses, AI could begin to resemble many of the industries that China dominates today.
In that scenario, extraordinary innovation may not translate into extraordinary profits.
Likewise, valuation matters. Even the greatest companies can become poor investments if purchased at unrealistic prices.
Markets are forward-looking and already discount substantial future growth.
The key question is no longer whether AI will transform the economy. The question is who ultimately captures the profits.
That is why we continue to monitor developments in China closely. The future winners are not where the profits are today, but where they will be tomorrow.
The economics of investing
The lesson is not that America is superior to China. Nor is it that China is destined to fail.
Rather, the two systems are optimised for different objectives. China’s system maximises competition, industrial capacity and consumer welfare. America’s system maximises profitability, capital formation and shareholder returns.
Today, the economics favour America. Tomorrow, they may favour China.
Our job as investors and analysts is not to choose sides. It is to recognise when the economics have changed.
In the end, stock markets do not reward the country that produces the most. They reward the system that captures the greatest share of economic value.
And wherever those economics lead, that is where we will invest.
Next week we will complete this four-part series with our final article, “The great misreading of China: Why exports are a consequence, not a strategy”.
Portfolio commentary
The Malaysian portfolio rose 1.4% for the week ended June 10, outperforming the benchmark FBM KLCI, which gained 0.4%. The biggest winners for the week were United Plantations (+7.2%), Kim Loong Resources (+5.9%) and Maybank (+2.5%). The only loser in that same period was Hong Leong Industries (-3.5%). Total portfolio returns now stand at 219.6% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 8.2% over the same period, by a long, long way.
The Absolute Returns Portfolio, meanwhile, fell 4.2% last week on the back of the broader selloff in US and global equity markets. Total portfolio returns now stand at 25.8% since inception. The sole gainer was Berkshire Hathaway (+1.7%) while the top losers were Talen Energy (-11.3%), Alibaba (-10.3%) and Schneider Electric (-9.4%).
The AI Portfolio was down 12.9% with sharp losses almost across the board. Last week’s loss pared total portfolio returns to 22.9% since inception. The only gainer was Naura Technology (+0.8%) while the biggest losers were Broadcom (-22.4%), Unusual Machines (-20.8%) and Akamai (-19.0%).
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
