Andrew Sleeman, a portfolio manager with Franklin Templeton Investments who co-pilots the Mutual International Fund, a multi-cap international portfolio, says there’s a lot to like about investing in China right now. After all, it’s the world’s second largest economy, and the largest car maker (since 2010), and this year took the title of world’s largest oil importer. It has a booming middle class who have moved beyond the desire for better food and medicine to a desire for cars, gaming and entertainment.
But when asked, “Would you want to be in charge of a dedicated China fund right now?” Sleeman turns a bit more sheepish. “I don’t have much hair and I’d probably have less,” he says.
Getting burned has turned into a hobby for China investors in the past few years—as the country has become the world’s unloved child. Its 30-year awakening to capitalism, its rapid urbanization and its almost 10% annual topline GDP growth rate since 1978 were once a great cause for excitement. But lately, that GDP growth has stalled (to about 7.5%), and the stocks have been moribund. Just this year, the Shanghai Stock Exchange Index plunged by almost 20% from February to the end of June, when it hit a four-year low, placing almost where it was at the depths of the recession. The summer carnage was exacerbated by the Chinese government’s effort to tamp down on interbank lending—the central bank let the rates rise at a critical time of cash need, says Richard Gao, a portfolio manager at Matthews Asia in San Francisco. The subsequent freeze led to a selloff that wreaked havoc on the markets.
“There’s a disconnect between the Chinese stock market and Chinese economic growth,” says Clem Miller, an investment strategist at Wilmington Trust Investment Advisors in Baltimore. Among other things, he says, the reason for this is that the country is simply suffering growing pains.
“Think about the fact that when you have too fast growth, ports get clogged, highways get clogged, the railroads get clogged,” Miller says. “You can’t have a just-in-time delivery system because you’ve got such clogged infrastructure systems. You’ve got water and air constraints. If you’re trying to set up a semi-conductor factory you need the cleanest possible water. It’s going to be hard to do in an environment that is not terribly environmentally pure.” Think of things like 10-day-long traffic jams. Those things sap growth eventually, he says.
Business owners face different problems amid rapid growth, he says, namely the risk of overinvesting or underinvesting in their own inventories and capital improvements, possibly making poor borrowing decisions in the meantime. “Essentially, too fast a growth in China is just as bad as too slow a growth in China,” Miller says.
Meanwhile, he says, 40% of the net worth of Chinese companies is held by the state, so not as many dividends are flowing to investors. In other words, “that economic growth has not translated into stock market returns.” Chinese investors largely eschew the stock market and put their money in property, looking upon second and third houses kind of like CDs.
Lou Stanasolovich, who heads Legend Financial Advisors in Pittsburgh, says it’s all been too much for him and his firm, and they are right now sitting out China for the most part, mostly investing through emerging markets funds for a small percentage of Legend’s most aggressive portfolios. Before 2008 he says the firm had a lot more exposure to China, including a 5% country exposure in its ultra-speculative portfolio.
“As go commodities, so goes China—when you look at the amazing numbers that China has in terms of bringing in commodities and now construction of automobiles and things like that,” Stanasolovich says. “But they also have a lot of problems that are going to choke off their growth at some point, and maybe to a degree [have] already done that. [This is] predominantly clean drinking water and the amount of pollution. So we’re not overly optimistic.”
The interbank lending freeze, say observers, was a warning shot across the bow to local banks and the “shadow” banking system that had up until the summer been promiscuously lending money, largely to unsustainable businesses, and creating fears of asset bubbles.
“What the central bank is doing,” Miller adds, “is trying to make sure there is not too much lending by the banks and especially by the so-called ‘wealth management products,’ which is a fancy term for saying off-balance-sheet lending. At the same time, they don’t want to disrupt the broader economy. They’re trying to remove what they would call excesses.”
As the Chinese government now focuses more on the “quality” of growth to get its house in order, not just topline growth, says Gao, the short-term volatility has meant pain for exports, manufacturing and corporate earnings. This is not for the squeamish, and many investors have taken a powder (Bloomberg News reported that China funds lost $558 million in net withdrawals in one week in mid-June.)
How To Play?
However, “there’s still a good opportunity to invest in China, you just need to be selective,” says Gao. Sleeman adds that Franklin Templeton, a value investor, has recently seen more opportunities to buy than it has in the last few years. And Joseph Tang, the investment director at Invesco China, adds that despite the slowdown, there have been signs the Chinese economy is becoming more stable and valuations more attractive.
“On price-to-earnings terms, MSCI China is now trading at 8.7x 2013 p/e, versus its 20-year historical average of 12.4x,” Tang writes in an e-mail. “As measured by (P/B) metrics, the region is equally supportive, trading at 1.4x trailing P/B versus [a] 20-year average of 1.9x.”
Also, despite its recent doldrums, China is now the world’s second-largest economy, and to investors it’s too bright a target to resist. Its people have an increasing amount of money to spend, both at home and overseas. Ignoring it is like ignoring the sun, even if some people are worried about their wings melting.
“You’ve got 20 million people per year coming in from the countryside into the cities,” says Miller. “So they have to build a lot of buildings, they have to build a lot of bridges, they have to build a lot of electrical systems. That can take a lot of cement, concrete, steel, iron and copper. Not to mention crude oil for gasoline.”
China for years has been trying to develop a self-sustaining middle class consumer society to become less reliant on exports to other parts of the world. Many investors have played that theme by grabbing stakes of companies selling into the country—cigarette makers, brewers and soda bottlers, for instance. But that has a downside. Take Yum! Brands, for example, the owner of the Pizza Hut, Taco Bell and KFC chains. The company’s China revenue now doubles that of its United States’ businesses. When two emergencies struck last year—an outbreak of avian flu and questions about the company’s poultry supply chain integrity—the company’s same-store sales in China plunged and the stock swooned.
Cie. Financiere Richemont, a Swiss maker of luxury goods like watches, jewelry and pens sold under tony brand names like Cartier, Montblanc and Piaget, has also been a popular play, but it also endured a dip in stock price after its former good fortune selling to China’s emerging upper classes. Partly, this was because of economic slowdown, but a government crackdown on bribes with luxury goods also hurt sales, reportedly.
There are investments that take advantage of China’s changing dietary habits, too, including its increasing desire for protein; investors have been seeking out companies selling farming equipment for instance (think Caterpillar and John Deere).
In the health care industries, Miller says the more interesting plays to watch out for are medical devices and pharmaceuticals. “One of the issues involved in these emerging markets is the fact that people are eating more and they are getting heavier. And issues such as diabetes are coming up more frequently and so companies that sell diabetes drugs can be expected to do well off of other people’s misfortune, unfortunately.
“And if you have heart problems, you need to have diagnostic equipment.”
Stanasolovich says that oil and automobiles are “natural plays” in China. “Why? Simply because there are simply more people that can afford cars, and if you look at the demographics, you really don’t start buying a car until you get to $3,000 a year in income.” Also, as a result of increasing incomes, he says the banking industry will do well also, and companies like MasterCard and Visa will start cashing in there.
Gao says industries like health care, IT services, food services, clothing and education will stand out, and classic China plays like infrastructure will take more of a back seat.
In health care, Gao likes companies such as Mindray Medical International, a medical device manufacturer headquartered in Shenzhen that offers patient monitoring systems and has strong distribution networks to Chinese hospitals. “They’ve been penetrating to hospitals in the second-tier, third-tier cities in China. The health-care spending in China has been growing at around 15% to 18% per annum. We’re expecting that growth rate will continue in the next five to 10 years.” That means more hospitals and more opportunities for equipment companies like this one. (Not in hospitals themselves, which are largely government run.)
Telecom, on the other hand, though it’s still growing in the high-single digits, is experiencing maturing growth, Gao says. “The penetration rate in China for cell phone users is quite high,” he says. “We’re more excited by value-added service providers taking advantage of the growth in the cell phone users.” He points to a company called Tencent Holdings—an Internet, media and advertising company whose “QQ” instant messaging service offers chat rooms and gaming with a “sticky” community of more than 782 million users. The company’s revenues went up more than 50% in 2012.
Gao says that his fund looks for exposure in companies with good coverage in smaller cities where incomes are rising faster. And he thinks the best way to play these themes is by focusing both on companies listed in Hong Kong and U.S. ADRs, which he says are purer China plays and take advantage of the growth directly. Going through multi-nationals is less efficient, he thinks.
Tang, the investment director for Invesco Hong Kong, also likes gaming, health care, automobiles, alternative energy/environmental protection companies, and media and technology related sectors.
“These sectors offered superior trend growth and were ‘domestically driven’ that were generally sheltered from the external uncertainties,” he writes. “We believed many of these sectors were beneficiaries from the ‘trading-up’ trend for Chinese consumers.” He says his firm has steered clear of sectors or cyclical plays kicked around by Chinese volatility: energy, commodities, shipping and airlines. The top 10 holdings of the Invesco PRC Equity Fund include a smattering of banks and consumer discretionary names such as China Mengniu Dairy; Galaxy Entertainment; resort developer Sands China; and Chongqing Changan Automobile, a builder of passenger cars and microvans.
Sleeman says about 10 of the 100 companies in his fund are in China, mostly Hong Kong-listed companies. One is SinoMedia Holding, an advertising company with robust first-half numbers, he says.
He’s not currently in telecom companies, which he doesn’t think have been great custodians of capital, nor in banks, which he says still need to possibly shake out bad loans.
“The banks have really been to a large extent funding vehicles for state-owned enterprises. It’s been quite difficult for an individual or an entrepreneur to get a loan in China. But it’s these very low-interest-rate SOE loans that are the real concern. They weren’t priced properly. There was no consideration as to the economic viability of the businesses to which they were lending. … And many of these businesses have been closed down by the government.” These include a lot of construction-related industries like cement and glass, he says.
“The other one that we like a lot, on the auto side, not so much the auto manufacturers as the auto dealers,” says Sleeman. “Everyone has been looking at the auto dealers in China because they sell a lot of cars. But the margin they get for selling a car is less than 5%. But the gross profit margin they generate from servicing that car is close to 50%. … We care about how many cars they sell only insofar as they are building their installed base of customers.”
Robert Lloyd George, the investment chairman of his own namesake subsidiary at BMO Global Asset Management (advising China funds in the U.S. and Canada, including a fund for Eaton Vance), also says that foreign investors don’t want to be heavily exposed to state-owned enterprises since the government might be cracking down on them after a series of accounting scandals.
“I think that we would look at the consumer sector rather than the construction or energy sectors or mining,” he says. He mentions apparel retailers like Hong Kong company Giordano, which has a large number of stores in China (as well as around the world). “We like to invest alongside a family because dividends are well supported and the cash flow is strong. … We can’t say that about the state-owned enterprises. We don’t feel that China Inc., or the Communist Party, as a major shareholder, is a good fellow shareholder to have.”
He feels that the credit crisis in China has been a bit overblown; however, like Gao, he believes investing in China requires patience for stock analysis and selection case by case.
“I don’t think that one wants to buy an ETF of China,” he says. “If you do that, you’ve got 70% to 80% in oil, telecom, banks and those state-owned companies.”