Jun 16, 2013

China - China has its problems but should not be written off

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The demographic differences are still relevant but the market may now be overpricing the growth of Asean and taking too gloomy a view of investing in China, meaning opportunities for those of a patient investing disposition.

Last year, China’s growth seemed to be slowing and the Association of Southeast Asian Nations countries were offering better prospects.

It is 10 years since I first visited China with a view to investment. At my previous firm I participated in the early flotations of large financial companies: Bank of Communications, PICC, Bank of China, ICBC.

International investors fell into opposing camps at the time. Broadly speaking, they have remained entrenched ever since.

The state had taken over large chunks of bad loans, arguing they were for social projects and had injected fresh capital into the banks ahead of flotation. Some believed these bad loans had just come from bad lending disciplines.

Two views became established: one that believes nothing and waits for the apocalypse and the other that applies normal investment criteria, with appropriate adjustments applicable to any emerging market.

Investing in China remains challenging but profitable.

The Shanghai market fell as much as most other global markets in 2008. This was due to overexuberant ratings in 2007: banks on 5x book etc.

It is a shame that the fall from ‘bubble valuations’ eliminated the diversification benefit that investing in this economy should have brought that year. Looking at the price to book ratio of Bank of Communication during the past 10 years, the smart investor would have bought at IPO and sold in 2007 when it reached 4.5x. Today that ratio is close to 1x.

Those waiting for the apocalypse overlooked this inconvenient evidence of resilience and pointed at the housing market as a time bomb. China has indeed seen speculative development funded by off-balance sheet funding. Those who have spent time in Hong Kong are generally aware that the Chinese like a punt; and if there isn’t a horse running, property will do.

The authorities’ clampdown on speculation seems well advised and there should be more tales of speculative property schemes delivering losses in the pipeline. If the US Fed had acted similarly in 2006, perhaps a lot of the subsequent mess would have been avoided.

There is also a lack of confidence in China’s official statistics and financial reporting. Having anticipated the more modest GDP growth last year, the numbers that came through were not too upsetting.

Alternative measures of economic activity, such as electricity usage, acted as a good leading indicator. Emerging market investing is often aided by such data.

China is huge and gathering national data is not easy. It must be remembered that UK national statistics are often revised dramatically in the year after publication – and our country is the size of one of China’s smaller provinces.

The largest accounting and governance issues seem to have been with entrepreneurial businesses, often quoted on overseas stock exchanges. In these cases shareholders do not own the Chinese firm but merely have rights over its economic rent.State-owned enterprises generally have provided enough data for us to do our diligence and while the banks use local definitions of what is or is not a nonperforming loan, the trend data we observe seems to have fitted the facts over time.

Such structures are unusually open to abuse and so we have preferred to miss out rather than take the governance risk. Many US-based investors have taken the opposite view and avoid investing in the state-owned entities and Hong Kong-listed stocks we prefer.

I would go further and claim that Beijing has behaved rather well as a shareholder. When China Unicom and China Netcom merged, Beijing did not vote its majority stakes in both companies, preferring that minority shareholders vote through the terms.

I cannot think of an equivalent example when a western government owns a stake: do any EADS shareholders think their vote would count?

All this said, there are issues that should not be ignored. Capital does not move freely in China and the economy is prone to areas of oversupply and scarcity.

Meeting growth in demand for electricity alongside increased car ownership has led to appalling pollution, especially in Beijing. The ageing population combined with the one-child policy gives the country a rapidly rising dependency ratio. Eliminating corruption has been prioritised by the new politbureau.

But measuring and comparing this issue with other countries, including developed ones, is no easy matter. We shake our heads at territorial disputes with neighbours but try not to take sides. However, the economy is still growing rapidly, if only around 7 per cent rather than 10 per cent, and inflation is currently subdued.

Our approach has been to invest as if China were a fairly developed country. The country’s success in raising GDP per head over the past decade has reduced China’s attractiveness as a cheap place to offshore lower value manufacturing.

Looking at specific stocks, China Mobile, with nearly 800 million subscribers, should see much higher revenues as they start using smartphones for internet access, inside the Chinese firewall, rather than just for voice calls.

We recently invested in China’s biggest jewellery chain, Chow Tai Fook, and hold a Singapore-listed Reit, CapitaMalls Asia, which owns shopping malls above railway stations in Chinese suburbs.

For the more cautious, we recently returned to Hutchison Whampoa as an investment. Li Ka Shing has moderated the risks in his holding company after it over-invested in European mobile phones (Three mobile in the UK) in the TMT years. The company has also cut its exposure to ports through a Singapore flotation.

The biggest assets now are a global utilities business, Cheung Kong Infrastructure, which snapped up Northumbrian Water and Southern Electricity after the banking crisis, and Asia’s biggest chain of beauticians and pharmacies. With a wealthy ageing population this seems a fine investment for the future.

As Hutchison is an unfashionable conglomerate it trades at a discount of more than 25 per cent to the sum of its parts. More conventionally, it trades on 14x earnings and yields about 2.5 per cent. This seems a high-quality investment giving long-term exposure to this large and still fast-growing economy.

Overall, our fund’s exposure to China has risen to 6 per cent of assets, using some of our profits from last year’s investments in the Philippines and Laos. Clearly, this is not a large exposure compared with our exposure to the US or Japan.

Simon Edelsten

Business & Investment Opportunities Saigon Business Corporation Pte Ltd (SBC) is incorporated in Singapore since 1994. As Your Business Companion, we propose a range of services in Strategy, Investment and Management, focusing Health care and Life Science with expertise in ASEAN 's area. We are currently changing the platform of www.yourvietnamexpert.com, if any request, please, contact directly Dr Christian SIODMAK, business strategist, owner and CEO of SBC at christian.siodmak@gmail.com. Many thanks.

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