Bye-bye China, hello Australia

The unknowingly prescient The Coming China Crash report was written four years ago. Since then, I've developed a geekish obsession with China, expressed through the over-consumption of analysis, statistics and opinions. Barely a week passes where I don't settle in to an hour or two of long form journalism describing the alien frontier of a vast, complex country industrialising on an unprecedented scale.

Last week it was James Palmer in Aeon, talking of the balinghou, a darker, more visceral, version of people of a certain vintage (mine) moaning about selfish Western millenials (my kids). This week it was The Economist, warning that the long term consequences of China's booming stockmarket would be far worse than the inevitable crash.

Pieces like these reach into the country's bewildering milieu and grasp at its heartland, promising something of its essence, either through mind-bending stats or fascinating anecdote. The Economist article, for example, says that stocks listed on the Shenzen exchange have an average PER of 64; that in just one week in April four million brokerage accounts were opened; and that 'two thirds of newcomers to the market left school before the age of 15'.

Having read hundreds of pieces like this I have landed on a central, irrefutable truth: no one really has a clue of what's really going on. China is infinitely byzantine and too culturally diverse and foreign for any laowai to pin something on it and expect it to hold. Those seeking numerical truth will be similarly disappointed. Chinese statistics are so rubbery they wouldn't look out of place in a Bob Jane T-mart.

Not much of this complexity reaches the commentariat, as the boilerplate repetition of the warning that Australia's economic fortunes are hitched to China's wagon suggests. Australians are particularly ill-quipped to find their way through the confusion. Only two Australian universities offer a dedicated course on the country's economy. The idea of the Asian century still hasn't really hit home.

Thus, at this challenging juncture, Australian investors are forced to rely on the unwittingly blind (the commentators, me included) to understand and interpret for them what cannot really be seen (the inner workings of Chinese society). If ever there was an existential problem in investing, this is it. What to do?

The only sensible thing is to understand what you can control and forget what you can't. You cannot control China's economy any more than Australia's. So, forget them both and focus instead on the degree of risk to which your portfolio is exposed to a China crash and a local recession.

That was the point of our China crash protection portfolio, published in the original special report and updated on 27 Sep 12. Much has changed since them, including an iron ore price crash, an oil price collapse and a local property boom that in Sydney and Melbourne at least looks very much like a bubble. An update is well overdue.

Table 1 shows the current status. Having delivered a total return of 51% since its formation four years ago, it has more than done its job. Successfully avoiding most resource stocks, the banks – a sector more exposed to a China crash than most investors believe – the portfolio instead focussed on local stocks not particularly exposed to an economic slowdown. Members that have followed along should feel pleased at the respectable returns and minimal risk taken to achieve them.

So, what now? Time has moved on and the China crash protection portfolio has been superseded. In April we published a Macro column titled Inflation, recession and deflation. Whether Australia suffers from any of these things, or none of them, dealing with these threats 'boils down to appropriate asset allocation and selecting stocks that can survive and prosper under both conditions'.

That was what part two of that story addressed, in which we introduced the recession-proof portfolio, including 11 locally-listed, high quality picks that offer the prospect of a quick recovery as the market wakes up to their defensive qualities. So, we're ceasing coverage of the China protection portfolio and bringing our focus closer to home through more regular coverage of the recession-proof portfolio.

Not only will the stocks in this portfolio be bigger and stronger businesses in 10 years' time, the fact that this portfolio actively confronts the vexed issue of cash holdings makes it more useful. The idea is to pick up really cheap stocks in a slowdown, which, as the original article states, 'is why you have nothing to fear from a recession and plenty to welcome'. The table below shows the portfolio's components, maximum portfolio weighting and current recommendation. Watch out for future updates.

Disclosure: Staff members, including the author, own shares in many of the companies mentioned.