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TIANJIN – The scale of China’s construction boom is off the charts.

The country used more cement between 2011 and 2013 than the U.S. did during the entire 20th century, and its voracious hunger for Aussie iron has rained cash on our country.

It’s hard to capture with words the enormity of projects here, so I thought it would be useful to count cranes while on the bullet train between Tianjin and Shanghai. I gave up after spotting 53 cranes in 2 minutes.

Unfortunately, as I’m about to explain, China’s building boom has gotten ahead of itself. And those 53 cranes? Every single one was idle.

China devours 2/3 of the world’s seaborn iron ore. So goes its appetite, so goes the price of iron ore.

You can’t get a read on how China is faring by focusing on government-published numbers, though. It’s the worst-kept secret in finance that no one trusts those numbers.

Instead, you’ve got to do your own homework, get on the ground, and find independent sources to get a directional health of the economy’s health. For example, inventories and accounts receivable are growing faster than sales at the Chinese consumer companies we’re following — a classic red flag of low-quality growth.

And then there’s construction, which matters most to Australians. Once again, independent sources paint a darker tale. Chinese steel demand fell 3.4% in 2014, per the China Iron & Steel Association – the first drop in 14 years. Also, Caterpillar expects the Chinese market to shrink in 2015. Neither surprises us given the vast multitude of idle projects (and Cats) that we spotted.

Not surprised that Caterpillar sees Chinese construction shrinking in 2015.

Not surprised that Caterpillar sees Chinese construction shrinking in 2015.

The country has overbuilt. A well-regarded contact in Beijing told us that another study revealed 28% of the homes in Beijing had not used electricity for six months. In New York, he reckons that number might be more like 4%. Meanwhile, researchers at China’s Southwestern University of Finance and Economics found that 49 million (22%) of Chinese apartments sold in 2013 were vacant.

In theory, those homes will fill up as Chinese move from the country to the city. In reality, there are enough empty apartments in China to house 6 years’ worth of urban migration. That’s more than an entire year’s worth of global iron ore demand going up in smoke.

The local market seems to have finally realised its predicament. Home prices in China have declined for four straight months, and this from the government’s own data. Not helping confidence among lenders is the recent default by Shenzhen developer Kaisa Group on a $52USD million interest payment, which Anne Stevenson-Yang of J Capital Group pointed out to us was only about 1/10th of the net cash the group supposedly had in the bank.

Combine that lost confidence with the lack of long-term financing for projects in China (typical of most emerging economies) and it’s easy to see how the wheels of construction can so quickly grind to a halt.

All that’s troubling enough as is, but iron ore supply is also growing. UBS forecasts that iron ore’s oversupply will 6X from 35 million this year to more than 200 million by 2018. The major miners are fixated on gaining market share, and they will, but at the expense of crushing the iron ore price for years to come.

Some analysts think higher-cost supply will come offline in response to lower prices. Again, in theory, that’s true. In reality, miners have many motivations — faith, hedges, survival, and politics — that will inspire them to keep producing at a loss, ruining the party for everyone. And, speaking of oversupply, now is a good time to zoom out and recall that the iron ore price has spent most of the past 15 years at much lower prices than today:

Source: Index Mundi

Source: Index Mundi

Growing supply and falling demand is a bad combination. It’s not crippling if you’re a large, low-cost producer like Rio Tinto Limited (ASX:RIO) or BHP Billiton Limited (ASX:BHP), but it is life threatening for producers with high costs, think Mount Gibson Iron Limited (ASX:MGX), or debt-heavy balance sheets, think Fortescue Metals Group Limited (ASX:FMG). Even Rio and BHP will find this price environment a bumpy road (just because you’re the lowest-cost producers doesn’t mean your profits can’t fall). And mining services companies? They’re not only in the same boat — they’re tied to the anchor.

That’s why, even though almost every miner is drowning near multi-year lows, we just can’t get behind them today at Motley Fool Pro.

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Navigating Tough Times

A major slowdown in mining will have knock-on effects for the rest of the Australian economy. Higher unemployment, lower capital expenditures, and more sour loans are all on the cards.

Take it from a guy who got a big call right but still took a loss. Back in the middle of the past decade, I correctly spotted the U.S. housing bubble and avoided direct hits with banks and home builders…but still took losses during the GFC when the ripple effects of housing’ implosion washed over the rest of the economy.

It was a painful but valuable lesson, and one I’m very mindful of with the ASX 200 sitting near a 6-year high today and selling for a meaty 17 times earnings. With a valuation like that, you’d think we’d be growing above-trend. But we’re not.

The good news is that you don’t have to blindly invest in an index, and despite iron ore’s headwinds we still see ways for Foolish investors to profit.

It starts with smart diversification. We at Motley Fool Pro recommend Aussie investors invest in 20 to 30 stocks – enough to provide balance but not so much that your returns cocktail gets watered down.

The “smart” part comes into play thanks to a focus on multi-faceted diversification. If your portfolio looks anything like the ASX 200 with its 48% in financial services, you are not diversified.

Smart diversification spans across not just industries but currencies, business models, and risk profiles. It makes use of exchange-traded funds (ETFs) to get access to industries and markets that can’t be tapped on your home exchange.

That’s why we own the iShares Global Consumer Staples ETF (ASX:IXI) here at Pro. Not only does the fund give us access to top-flight businesses that don’t trade on the ASX, but the value of the ETF rises in Aussie dollar terms when the Aussie dollar weakens. It’s an extra way for us to win and has helped us at Motley Fool Pro to profit from the Aussie dollar’s fall. And given the multi-year headwinds facing iron ore and other China-centric commodities, we think having upside on a weak Aussie dollar is very good business.

Next, focus on recurring revenue. Companies with subscription and membership models do well in good times and bad. They also have thick margins, which make for thick dividends and rest-easy balance sheets.

75% of our portfolio at Pro is with companies powered by recurring revenue. We’re also very focused on strong balance sheets today. Companies with cash-rich, debt-free balance sheets can play offence during tough times, while debt-laden businesses go the way of the dodo.

Finally, we’re focused today on big, growing dividends. No, interest rates won’t stay this low forever, but they will in Australia until growth reignites.

Meantime, we’re enjoying the superior yields on our shares and getting paid to wait while our investment cases play out.

To find out more about Motley Fool Pro, and to ensure you receive a “priority invitation” to join Motley Fool Pro, including qualifying for a special “early bird” discount, please click here now. It’s totally FREE to register your interest, and there is no obligation whatsoever.

What’s Next?

We’re in Shanghai for the home stretch of our trip – 9 meetings in 5 days.

What a city.

What a city.

Look for more coverage in the coming days. Meantime, catch up with my first dispatch from Beijing — 1.2 Billion Reasons to Follow China.

Foolish Best,

sig_JoeMagyer_sm

Joe Magyer

Joe does not own shares of any companies mentioned in this article. The Motley Fool owns shares of the iShares Global Consumer Staples ETF. The Motley Fool has a disclosure policy.