Rebalance the China Economy

16-Sep-2012

I like this.

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I posted my old research piece – rebalance the China economy, which was written in 2010.  When I read the report today, most of the points are still well held- China’s economy will transform from an investment-oriented towards a consumption-driven, while it will probable take  a decade, or even longer,  Banks return will deteriorate, Property market is a political call, etc.
 Some of the internet and health care stocks I recommended have significantly outperformed the market, while cyclical stocks such as Sany and China South Locomotive underperformed quite a lot.
The conclusion of the investment strategy I will revise as below:
While stock picking is our major alpha generation strategy, we will actively allocate our assets between cyclical and non-cyclical baskets, on the belief that China economy and stock market are very volatile and cyclical. Some style assets, even industry leaders like Zoomlion and COSCO, can significantly underperform the broad market in a long period during the recession cycle. They can easily gain market share, fully leverage up and, therefore, easily outperform the market in the up cycle.
One thing we should keep in mind: six out of ten best performed China A-share stocks in the last 12 years came from cyclical companies. If we bought them at the peak time in 2007, most of the stocks are still below the water today, while three of the four non cyclical top 10 performed stocks, namely, Moutai, Yunnan Baiyao, and Gree appliance, are way ahead their peak prices in 2007.  The only one out of four non cyclical stocks- Suning, is below its 2007 peak, because its business model has been challenged by on-line retailer like 360buy.

Rebalancing the China economy

–         Where are the investment opportunities?

Author: Richard Pan

MFC Global Investment

Tel:  + 86 186 1634 7428

Email: richardpan@vstone.com.cn

zhongning.pan@gmail.com

Date: July 18, 2010

 

1. What is the miracle of China’s economy? – The mechanisms behind China’s economic growth model

Traditional thinking tells us that China’s economy is mainly driven by societal trends of urbanization and industrialization and which will continue to be the primary economic drivers thru the next decade.  However, China’s economic model has two important mechanisms to generate very rapid growth in production and in employment by effectively taking money from the household sector and using that to subsidize rapid growth. Such mechanisms are:

a) Factor cost distortion – the markets for labor, capital, land and resources remain highly regulated, and the pricing and costs of these factors are also significantly distorted, while almost all the end-product sales are undertaken within free markets.

Labor cost

China’s wage growth, especially farmer labor wages, significantly lags behind productivity growth.  At least 150 million former farm workers are now working in urban centers, at one of the lowest wages globally, when taking into account an average of 50 hours overtime per month per worker.  Workers have very little bargain power, because a huge pool of unemployed rural labor moving to the cities and strict limitations on unionization, this has depressed wage growth, for both migrant rural laborers and the established urban workforce.

Capital cost

China’s deposit rate and lending rate are artificially set at a very low level. Professor Michael Pettis’ research shows that[1] in the past decade,China’s lending rate should have been at 10% of nominal rate, given its 12% nominal GDP growth per annum.  However, during the past 10 years, the lending rate was only 6%. This disparity has provided borrowers, which are SOEs, real-estate developers, infrastructure investors etc, an enormous subsidy from depositors.

In the last 10 years, because of low interest rates, 3-4% of GDP was transferred from the household sector to the banks and borrowers annually. This is a huge transfer of income.

Other costs

The cost of industrial use of lands, energy and environment are also set at very low levels.

According to Professor Huang Yiping’s research[2], cost distortions account for 10% of GDP in the last decade. Repressed costs of labor, capital, land and natural resources artificially raise profits of production, increase returns to investment, and improve international competitiveness of Chinese products. This is why economic growth is strong, but investment and exports are even stronger. These distortions also contribute to global imbalances by boosting China’s current account surplus and capital outflows in the form of foreign exchange reserves.

 

b) The booming property market

In 2009, total new home sales inChinareached 4.5 trillion Rmb (661bn USD).  If the direct cost (construction cost and some sales expenses) accounts for 50% of total sales, I estimate that more than 2 trillion Rmb, or 6% of GDP, has transferred from householders to property developers, property investors, local governments and the people along the value chain.

By using these two mechanisms, China achieved more than 9.8% GDP growth with less than 2% inflation in the last decade. However, this high economic growth is unbalanced and unsustainable.  It results in the misallocation of wealth and resources between the private sector and public sector, householders and monopoly SOEs, depositors and bank loan borrowers, house buyers and property developers. This has caused some serious problems:

  • Low wages direct effect is low domestic consumption due to limited expendable income for the greater portion of the Chinese population.  This is the key reason why retail consumption in China has been difficult to transform into a major economic growth driver.
  • Most profitable companies in China come from regulated industries (banking, telecom and natural resources) or property developers. These monopoly companies account for less than 10% of the total GDP, but more than 60% of Net Profit in all the listed companies. They don’t create much economic value for the society while most dynamic SMEs are difficult to grow because of limited access to banking loans and other resources. This is the reason that those monopoly companies rank within the top 10 largest companies in their categories while in the de-regulated sectors, such as information technology, health care, consumer goods, and capital goods, Chinese companies are not competitive and can seldom enter top 100 global list. [3]

Chinahas to rebalance, and switch from an investment-driven, export-oriented economy to domestic consumption driven economy. It will take a long time, maybe 3-5 years or even longer to rebalance, and the stock market will respond accordingly.

 

2.  What will happen in the next five years?

Forecasting China’s future economic growth is very difficult given the fact that China is not a pure market economy.  State-owned enterprises can be called upon to prop up markets. Losses may be concealed or shuffled around like a shell game.  Some bad situations can be turned around to good investment stories. The best example of this isChina’s banking industry.

However, it is possible to figure out some long term trends if forecasting the short-term change seems too difficult:

a) Economy growth model will change

Wage increase is the key forChina’s economy to rebalance.

China’s labor has reached Lewis Turning Point, where industrial wages begin to rise quickly at the point when the supply of surplus labor from the countryside tapers off. This may appear detrimental for an export-oriented country like China, however, the rising labor cost will urge the government to re-consider the future of low value-added industry in China, and move upward in the industrial production value chain. Rising wages would generate greater purchasing power for the working population and further stimulate domestic consumption.

Rising labor costs may bring a lot of pain for pre-existing labor groups in the short term as the industrial complex shifts in focus. However, rising wages for higher skilled labor, along with other measures, like de-regulation of interest rates and resource price reform, is the key for China’s economy to rebalance

b) Exports will slow down but won’t drop significantly.

China maintains a strong competitive advantage over other developing countries because of its world-class infrastructure, well-trained labors, and entire supply chains.  These factors will offset reductions in exports fromChinadue to the global recession.

The export prices will increase due to rising labor costs and Rmb appreciation. However, this does not necessarily mean that labor intensive industry will be transferred from China to lower cost countries like Vietnam and Bangladesh. In fact, adjusted by the working hours, Chinese labor cost is in line with Vietnamese workers. Labor cost is not the primary consideration for manufacturers whose labor cost accounts for less than 10% of COGS.

China’s export surplus will not be eased out very soon. Even though China’s currency has appreciated 21% in the three years through mid-2008, with little impact on narrowing China’s trade surplus. Trade surplus with theUnited Stateshas continued to balloon in the three years following the initial de-pegging, at an average rate of 20.8% during 2005-08.  Rmb appreciation is more a politic issue than an economic issue.

c) Risks for banking industry are still controllable but banks return will come down.

Among the top 10 largest banks globally, at least four Chinese banks are included. The primary reason is that Chinese banks enjoy a wide spread between regulated deposit rates and lending rates.  As for the NPLs (non-performing loans), the government has made the decision to bail out Chinese banks once and will carve NPLs out from banks balance sheets again if the financial services industry situation again shows signs of deterioration[4], ultimately at the expense of the depositors.

In the meantime, I believe that current high ROE of Chinese banks cannot be sustained.  In 2010 banks will account for 40% of the total profit of all the Chinese listed companies. This uneven profit distribution will change sooner rather than later.  With interest rate deregulation, NIM will gradually go down and ROE will drop from current 20% to a 13-15% return in the long run.  It is my opinion that Chinese banks earnings will peak approximately in 2012, and the valuation of Chinese banks will then demonstrate a gradual decline.

d) Property market –  A political call

Reasonable residential property prices are in the interest of China – homeowners will have more disposable income for consumption when costs for housing are reduced, and the private sector would shift investment capital into R&D and innovative technology instead of speculation in the property market.  The tightening policy on the property market will not be rescinded until property prices drop and stabilize.

However, it is very difficult to make the call that the property price in China can be kept at a relatively reasonable level in the long run.  China’s government still regards the real estate market as one of the important economic drivers of growth in the PRC, and excess liquidity will be poured into the property market again if government loosens the monetary policy.  Additionally, local governments and agents have huge vested interests in the entire real estate value chain and they have a strong lobbying influence on the policy makers.

It must be noted that in the short term, the earnings of property developers will not peak, given the fragmented nature of the real estate industry in China.  The largest developer, China Vanke, only accounts for 2-3% of total market share.  Leading developers can continue to gain market share in the long run.

e) Rural area reform – the key to succeed for China’s economy transition.

Rural area reform will be the next important step. The price of agricultural products will experience gradual appreciation, infrastructure and education will improve, and social welfare networks can be established in the rural areas of China. As a result, farmers will reduce their need to flood into mega cities seeking better wages. Instead, they will either remain in farm work or work for the factories located near their hometowns.  The quality of life in the rural areas and small towns will improve significantly after five years and retail level consumption in these rural areas will eventually pick up.

f) Productivity improvement and technology upgrade

In the long run, China’s economy will be driven by productivity improvement and technological advances.  In the last three decades, Chinese productivity increasing has played an important role in fueling economic growth.  In the future, productivity and technology will play an even more important role, in two aspects:

  • Chinese companies will upgrade technology and become more competitive globally.

Chinese companies have rapidly begun to move upward within the industrial value chain and can produce/assemble high value-added products ranging from consumer products, such as automobiles and consumer electronics, to industrials, such as VLCC vessels, refinery plants, high-speed rail trains, nuclear power stations, rockets and satellites. All at relatively cheaper price compared to the industrial complexes of global competitor nations.  This also explains why China can continue to win large-scale projects in the developing countries, especially Africa where China has proven its ability to install whole infrastructure networks at cheap prices.

  • Chinese society benefits from technology improvement (economy externality)

Chinese internet users have surpassed the amount of users in the US.  China has the largest number of cell phone users in the world. Yet, mobile phone penetration rate remains at 47% of the total population, according to the CIA World Factbook. Additionally, a Chinese mobile user’s cost is only 40% of that of a U.S. mobile user – Chinese users on average only pay $0.02 USD per minute for voice service while the US mobile user needs to pay $0.05 USD per minute.

Another excellent example of technological improvements benefitting Chinese society is infrastructure projects such as high-speed rail systems:  Taking Amtrak from Washington DC to New York, total 360km, will cost 90USD with 3.5 hours. Taking China High-speed rail from Wuhan to Guangzhou, total 1100km, will cost only 72USD with 3.5 hours.  The railway transportation cost in China is only ¼ of the US, even if we do not take into account the Chinese trains much faster speed.

 

3. What are the investment opportunities going forward?

Banks, telecoms, and oil & gas companies account for more than 60% of current profit of all the Chinese listed companies.  Many of these companies rank within the global top 10 in each industrial category. I do not expect that these companies will be able to generate sustained high level of growth during the next decade. Most of these companies will become utility stocks, providing social service, with very low bankrupt risk.

Where will the growth come from?  If we follow a simple logic that China will follow the path of the US market, we can easily find that China as a whole is in the same developing level of the US in 1980s. In the 1980s, consumer companies in the US had the best performance: stock price of Limited Brands increased by 58 times; Home depot increased by 50 times; Wal-mart increased by 40 times; Gap increased by times. During the last decade of 20 century, Information Technology companies took the lead: Stock price of Dell jumped 884 times, EMC increased by 775 times and CISCO increased by 692 times.  In the recent ten years, there are not many fantastic stories heard, but some consumer names such as Green Mountain Coffee and energy companies such as South Western Energy, increased by more than 40 times. [5]

Given China’s current situation, I believe that the growth will likely come from advanced manufacturing, Internet, health care, consumer and new energy sectors in the next decade.  Some of the strongest, best-positioned companies can have very exciting growth prospects. I believe that a bottom-up, fundamental-driven approach will be an effective strategy to generate excess return in the long term. The market becomes very volatile and valuations are not inexpensive comparing to four or five years ago.  Investors with either lower risk tolerance or a shorter time horizon are difficult to capture China’s secular growth in the next decade.

a) Advanced manufacturing

China has to develop high value-added products and climb along the value chain.  IHS Global Insight’s research suggests that China will overtake the United States as the world’s leading manufacturer earlier than previously anticipated. Measured in real value-added terms, China’s share in global manufacturing is projected to overtake that of the United States by 2012–13[6].

I expect to find China’s version of GE, Caterpillar and Emerson in the next decade.

Stock names:

– Sany A (600031): The largest construction machinery company in China.  It has a long term good track record and will also be listed in the Hong Kong market very soon.

 

– China South Locomotive (1766): One of the two high speed train producers in China.

– CSR times (3898): Key component supplier for high speed train.

– China high precision automation (591): A small automation company which is gaining market share from NMCs, high growth can be achieved due to low base.

 

             b) Internet

Chinese internet companies have two advantages: largest user base in the world and young generation who have strong tendency to do on-line gaming and shopping.

In the long term, platform companies will dominate the market.

Stock names:

– Tencent (700): The largest on-line community company, with strong user addiction, tens of millions of users log in at the same time.

– Baidu (BIDU):  The largest search engine in China, with 70% market share

– Taobao: The largest on-line auction and payment website, eBay China version, not listed yet.

In the near term, Ctrip, the leading travel agency, can continue to gain market share in the travel industry.

 

c) Health Care

With the population aging, rising disposable income, and awareness of personal health, the spending on health care has increased at CAGR 20+%.  Although the high-end market is still dominated by MNCs, Chinese local pharmaceutical companies are moving from low-end generic medicine producers to patent drugs producers.

Stock names:

– Hengrui Medicine A (600276): One of the largest providers of antineoplastic drugs, drugs for the treatment of cardiovascular disease, drugs for surgery and drugs for the treatment of endocrine,  dozens of new products in the pipeline

– Yunan Baiyao A (000538):  One of the largest traditional Chinese medicines with special function

– Shandong Weigao (8199):  has a range of products, which includes consumables (infusion set, syringes, medical needle, blood bags, dental and anesthetic consumables, pre-filled syringes, blood sampling products, and other consumables); orthopedic materials; blood purification consumables, and stent.

 

             d) Consumer discretionary and consumer staple

– Belle (1880): Largest Chinese consumer stock, with more than 20 footwear brands in its portfolio, four of its brands are in the top 10 women’s footwear brands, high-teen SSS growth

– CRE (291): Have the largest volume of single brand beer in the world, have largest hyper market in China

– Midea A (000527): Largest white goods company in China, is entering global market, experiencing the path that LG Electric did ten years ago

 

5) New energy

– Longyuan Power (916): Largest wind power generator in China with more than 15 years track record, the capacity will grow by 4-5 times in the next 10 years.

 

4. CONCLUSIONS

China’s economy has to rebalance in the next 5 years.  Investment and export driven model will be replaced by domestic consumption driven economy. In the meanwhile, Chinese companies will move up along the value chain and produce high value-added products instead of simply assembling business like Foxconn is doing today.

The companies which had good performance in the last booming cycle, such as banks, oil & gas, telecom and materials, have difficulties to perform in the new era – They are too big to outperform.  Instead, some of the innovative companies such as advanced manufacturers, internet companies, branding consumer names, and clean energies, will emerge into global leaders in the next one or two decade.  Equity investors can have tremendous return by investing in such companies, if they have enough patience to tolerate short term volatility.

As far as the investment approach, I believe, bottom-up, fundamental research will become an effective way to generate alpha.  The entire China market return might not be satisfied as the market will have some structural changes in the next decade – some established leading companies might not achieve high growth as they did in the last decade, while some niche market leaders will develop into major players in the global market.  Traditional top-down approach probably cannot work very well in this transition period.

 

 

Appendix -1

Top 10 Banks in the world by market cap

 

 

Top 10 Telecom operators in the world by market cap

 

 

Top 10 Oil & Gas companies in the world by market cap

 

 

Top 10 healthcare companies in the world by market cap, and the largest Chinese firms

 

 

Top 10 industrial goods companies in the world by market cap, and the largest Chinese firms

 

 

 

 

 

 

Top 10 consumer goods companies in the world by market cap, and the largest Chinese firms

 

 

Top 10 consumer services companies in the world by market cap, and the largest Chinese firms

 

Source: Bloomberg, date: March 2010

 

 

 

Appendix – 2

The best performed US stocks in the last three decades (market cap > 1 bn USD)

 

 

 

 


[1] Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor atPekingUniversity.

[2] Dissecting the China Puzzle: Asymmetric liberalization and cost distortion.  Author: Huang yiping, Beijing University,China Center for Economic Research, No. E2020003

[3] See Appendix 1

[4] It is widely estimated that 8 trillion rmb loan went to the LGFP (Local government finance platform) in the recent two years and the risk is difficult to assess.

[5] See appendix 2

[6] Forecast by IHS Global Insight


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