China has been in the news a lot lately. There are many stories of concern, ranging from the currency devaluation, the economic slowdown and the stock market collapse.

When I was in Hong Kong last week and my friend asked me to join him for tea to speak to Mr M, I jumped at the chance.

Mr M is a well-connected man. He sits on six or more boards in China (when he was giving out his business card to me he pulled out a deck of them), one of which is a major bank and the other a major telecom provider. Needless to say he is very well connected and has an excellent vantage point from which to take the real pulse of China.

This is a summary of some of his thoughts with my commentary:

• China’s slowdown is real, broad and secular. Mr M immediately confirmed fears of a slowdown in China. In fact the large excessive leverage and redundant capacity that has ballooned over the past decade or so is now hurting corporate profits and GDP. This seems to coincide much better with the drop we saw of about 9 per cent in industrial profits in August despite China’s insistence on 7 per cent GDP growth.

He emphasised that the shift from fixed investment and infrastructure is ongoing and won’t necessarily be a smooth transition to a more consumption based model. This is not a one-time cyclical force. It will play out over a longer period of time. It also suggests that GDP is probably less than reported and will be much lower than future estimates now seen in the market.

Near term, however, Mr M did point to an increase in favourable housing incentives and government spending that may stabilise growth.

• Chinese banks are okay but not stellar. Mr M commented that risk management systems at many Chinese banks are not that sophisticated and nascent in nature. He noted, however, that about 50 per cent of these loans are from government entities which are highly unlikely to default. Plus the deposit base it simply stunning: with some banks having over 240 million in depositors (or more than eight times the population of Canada at one bank).

Credit growth is still in excess of GDP growth but it is slowing dramatically and will have a knock-on effect for overall growth. Non-performing loans will almost certainly rise over time, but Mr M suggests a lot of bad news and scepticism is priced into big banks that trade at mid-single digit price earnings ratios and less than book value.

• Consumption patterns are changing. Gone are the days of excess and luxury binging in China. Anti-corruption crackdowns and a more subdued nature of spending is shifting the balance to spending practically. Mr M still views various consumer spending areas attractive, even signalling out cosmetics and affirming in particular — Sa Sa International Holdings (Ticker: 178 HK) (please see disclosure below). What seems clear from our discussion is that luxury brands, and companies catering to the affluent (or politically connected) are likely to see considerable pressure while basic consumption will continue unabated.

• Deleveraging is beginning and is needed. Mr M mentioned that the sudden rise in the stock market in China was partially on the back of excessive margin debt lending. He is a bit concerned with the level of leverage in the system but again noted much of this is government or quasi-government. Regardless, with overall corporate credit of nearly 200 per cent of GDP and excess capacity in many industries, corporate earnings will likely continue to be pressured. One only has to look at China’s Producer Prices Index (a gauge of prices received by domestic producers for their outputs either on the domestic or foreign market) which has been negative year-over-year since the beginning of 2012.

• China big-tech looks attractive but commodities don’t. Mr M has a lot of respect for the larger tech companies in China, including Alibaba (Ticker: BABA) and Tencent (Ticker: 700 HK). He views the longer term secular future of this industry as very positive with a huge total addressable market. They are disrupting a lot of the more traditional and/or state run companies and he believes they will continue to dominate the commercial space in China.

Mr M sees no value in commodity/fixed investment type assets. He notes China’s increasing focus on the environment and social good and felt commodities or fixed investment mega-projects are not in the cards.

• Command and control economy issues. Mr M seemed slightly embarrassed when we began talking about government’s recent attempts to “control” the stock market. He admitted it was a bit amateurish and probably will raise risk premiums for investors in China. He suspects that lessons were learnt.

The bottom-line was that China’s growth composition is changing and what worked before in investing in China and its proxies probably won’t work going forward. Emerging markets and or companies that relied on infrastructure or fixed investment focused growth will be pressured while those involved in higher value-add or consumption and social aspects should see continued opportunity. Overall, it was a fascinating prospective and my green tea with jasmine was pretty tasty too.

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at nkowalski@anchor.bm. Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. Investment involves risks. Readers should consult their financial advisers prior to any investment decision.