How is corporate China evolving?
No Shortage of capital
With over 20 years managing money in China I have seen significant changes both in the corporate and investment environment. One of the biggest shifts that has occurred is the fact that China is not short of investment capital. A couple of decades ago attending an IPO presentation was a major event with companies keen to impress investors. Now, these events are mainstream and very heavily attended, confirming no shortage of investor interest.
A further relatively recent development has been the increasing adoption by Chinese companies of ever higher standards, particularly in relation to environmental protection and employment practices.
Common Prosperity policy driving up standards
Another major change has been the government’s focus on the lower-middle income section of the population. Under the banner of “common prosperity”, this policy has driven higher regulatory standards for corporates specifically in terms of worker protection, environmental standards and overall levels of corporate governance. I see this particularly within the manufacturing and e-commerce sectors.
While greater workers’ rights/protections may be laudable for Chinese society, it clearly impacts companies through higher costs. However, I actually think this has a silver lining – it makes the difference between good and poor companies more apparent. My belief is that quality always prevails.
Avoiding the “tall poppy” syndrome
The Chinese government is communist and believes in central control. Ideally, we prefer companies that are not overly dominant in their field and therefore an obvious target for government attention. In fact, paradoxically we always try to persuade companies to pay more tax as it makes them less vulnerable to government scrutiny. My experience tends to show that when a company gets too big in China, often that is a good sign to sell.
What should investors focus on?
Earnings drive performance
It may seem self-evident, but it is sometimes easy to forget that share prices follow earnings over the long run. Market participants get distracted by macro factors such as GDP growth, regulation, the property market etc. But, plotting the performance of the Hang Seng Index relative to 12-month earnings forecasts over the last 20 years, the correlation would be exceptionally high.
A similar example can be seen in China Merchants Bank. For a number of years after it listed in Hong Kong in 2006, the share price went nowhere. First there was the Global Financial Crisis (GFC) and then investors worried about the true level of non-performing loans (NPLs) it had. More recently, the share price has been weighed down by the property slowdown as well as management changes.
But we have always liked this company. Even though it is a state-owned enterprise (SOE), China Merchants Bank has performed better than most other Chinese banks over the long term. Over the last 15 years, despite the uncertainties and cyclical concerns, China Merchants Bank’s earnings have risen steadily.
Secondly, our investment approach has always been to buy quality companies and hold for the long term. As a team we don’t play policy-driven factors, rather we focus on investing in companies where we think profits will be consistently higher over the next 5-10 years. I am not saying policy issues are not important, simply that they are not the most important. Higher regulation increases entry barriers, which is actually positive for better quality businesses.
For example, we believe that an attractive pharmaceutical company to own in China is Jiangsu Hengrui; a wellregarded automation company in China is Shenzhen Inovance; and a high quality medical equipment company in China is Shenzhen Mindray. There are fundamental reasons why we like these companies and it has nothing to do with government policies, property measures, interest rates, the state of the economy, or GDP growth. Our research and analysis suggests that these companies have the potential to grow much bigger in the future — which makes us less concerned about short-term market noise.
The Chinese property sector?
A bubble, but not a threat
With Evergrande front of mind, it’s easy to lose perspective on the wider measures the Chinese government have been taking over many years to normalise the property sector. They have been taking measures for more than four years — they didn’t wait for Evergrande to occur. Their dilemma is how to control property prices when there is a clear correlation between higher residential property prices and consumption. Too sharp a price correction could have a very negative impact on domestic spending, the overall Chinese economy and political stability.
I also think it is important to realise there is a difference between property prices, which are certainly a bubble, and the critical issue of leverage. Both at the householder and lender level, leverage in China is far lower than in many Western countries. Residential property repayments represent a lower % of household income in China than in the West. Among the lenders, when many banks initially listed, mortgages as % of loan books were around 4-5%. Today that has fallen to around 25%. By comparison, in the UK that number is closer to 50-60% of total loan book.
We do own one property company in our China portfolios. China Resources Land (CR Land) is the 10th largest property developer in China, but it focuses more on highend shopping malls (around 40% of the net asset value). It has a strong balance sheet and its shopping malls have benefitted from the consumption upgrade trend in China. We believe this should continue to be a strong growth driver for the company and took the opportunity to add to our holdings as the valuation became more reasonable.
Investment strategy response
FSSA portfolios tend to do well in bear markets so are actually holding up relatively well at the moment. This is due to the fact we have never been traders of stocks, rather we are long-term holders of high-quality businesses. We have also never been tempted to invest in companies that are not currently profitable, or have a business model we cannot readily understand or do not find attractive. As a result, we are prepared not to get involved in fashionable, high-profile sectors that we consider overvalued e.g. electric vehicles.
Our consistent approach is also greatly aided by the profile of the team. Many of us have now worked together for over 20 years.
Avoiding the losers vs picking the winners
Attribution analysis shows our team have added more value over the years avoiding the blow-ups as opposed to cherry-picking the winners. Analysis also shows the merits of our buy-and-hold strategy — a large amount of value has been added simply buying our 5-6 favourite stocks and holding them for 10-20 years. Average portfolio turnover is only 15-20% — a very low level compared to many competitors.
Within FSSA portfolios there are many stocks which we have owned for more than 10 years. We have added to and trimmed our positions over the years depending on valuations, but on the whole we believe these companies are fundamentally highquality companies with strong management teams, leading franchises and good growth potential.
Learning the lessons
The Chinese government still maintains its zero-Covid policy, but my view is that the government will start to loosen restrictions. We are already seeing this in Hong Kong. Overall, I don’t view Covid as a multi-year negative factor for the market — it has happened and it will eventually become less of an issue.
When Covid first emerged over two years ago, FSSA undertook a stress-analysis of all our portfolio investments (e.g., no revenue for six months). Our primary focus was on balance sheet strength — and if they had enough capital to weather the storm. More left-field, we also looked at how companies were actually using their Covid experiences to improve their operations. The best quality companies are always able to make continuous improvements, regardless of circumstances.
Some companies, such as Shenzhen Inovance, were even able to gain significant market share during Covid. During the height of Covid, China was still relatively intact while global supply chains were disrupted. When multinationals were not able to fulfil their customers’ needs as everyone was working from home, Inovance came in and swept up market share.
We believe that their improved market share should last beyond Covid. Since the early days, the management has been extremely focused on research and development (R&D). Over the years, they have evolved from elevators into programmable logic circuit (PLC) programs, which are like the brains of automation equipment and controllers for electric vehicles. We like the kind of progressive management who are always looking to improve things, and their people are really quite driven.
Has China lost its low-cost producer status?
Moving up the value chain
It may no longer be the lowest cost producer, but it is still low cost. This is important in China as social cohesion is vital for the government, particularly in keeping unemployment levels low. Strategically however, the ambition is clearly to migrate upwards from low-cost manufacturing towards higher-end manufacturing and eventually up to services. What hampers the rate of transition is the continuing difficulty in hiring good quality people. Ultimately however, I believe the government would happy to see other countries pick up the mantle of being the world’s lowest cost producer.
Portfolio impact from higher input prices?
Over the short term (3-6 months), I don’t think many companies will be able to pass on higher input prices with an inevitable negative impact on Q1 earnings. Not helping of course is that higher costs overall (e.g., energy, commodity prices etc.) may weaken global economic growth and demand — not an easy backdrop within which to pass on price increases. How do you pass on the impact of an oil price which has doubled in a month?
But, to reiterate our view, we believe that quality companies with strong market share should eventually be capable of passing on these higher costs. For example, home appliances companies like Gree Electric and Midea Group suffered from rising copper and plastic prices last year. These companies are the top two players in the air-conditioning sector in China and they both have strong market positions. Together they control around 70% of the market, so they should be able to pass through the cost pressure to their customers although it will take a few quarters to do so. The secret is to identify companies that are able to move up the value chain.
What have you been doing across your wider Asian portfolios?
Adjusting country exposures
When we have a high conviction, we are prepared to be contrarian. Often the most profitable time to add exposure is when everyone else is negative. We have also been reducing our India exposure, currently around 20%, due to high valuations.
One of our most favoured regions is Southeast Asia where we believe the demographics are extremely positive with a very young population. This region is around 15% of current Asian portfolios. Other important weightings would be Taiwan (12%) and Japan (7%).
How supportive are current valuations?
Attractive, but not distressed
Prime valuation metrics we look at for China would lead us to believe that valuations in China are currently attractive. price-to-book and price-to-sales. However, this does come with the caveat that the composition of the main index has changed a lot over the years. Valuations are not ‘distressed’, but certainly attractive.
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Source: Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet, Lipper and Bloomberg. As at 31 May 2022 or otherwise noted.
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