Forward-thinking needed to capture China’s shifting focus

China, which last year surpassed Japan as the world’s second largest economy with a GDP of nearly $6,000bn (€4,204bn), could overtake the US if it maintains annual growth of 8 per cent over the next 20 years, according to the World Bank.

Even though China achieved an important milestone, the government itself was quick to point out its economy is still at a developing stage: China remains a rich country with poor people, as the per capita GDP is only around $4,000 per year.

This underlies the Chinese leadership’s determination to diversify the country’s economic structure, to tame inflation, reduce income disparity and improve social safety nets. These objectives are reflected in the 12th Five-Year plan, which officially started in March this year, where China’s previous emphasis on exports and investments is shifted towards consumption and from urban and coastal growth towards rural and inland development.

“As more pro-consumption policies are introduced in the coming years, the intensity of the economy, represented by consumption/GDP ratio, should rise significantly,” believes Raymond Ma, manager of the Fidelity China Consumer Fund. “As a proxy of China’s economic model, we expect the weighting of consumer-related sectors in the MSCI China index to growth substantially.”

Over the next five years, China’s consumer-related sectors are likely to outperform the broader market and double or even triple their market capitalisation, says Mr Ma.

With its 1.3bn population, China’s consumption boom is now spreading from the top affluent groups to the middle class, and is expected to move towards lower income group over the next five to 10 years. Strong income growth and a rise in the affluent middle class population have driven an increase in higher-end discretionary spending, as people become increasingly aware of quality, brands and fashion.

By investing in consumer-related sectors, investors can gain exposure to the emerging middle classes and their “consumption upgrade”, says Mr Ma.

Making money

However, it is important to correct the misconception that all sectors benefiting from government policies will outperform, emphasises Yonghao Pu, head of wealth management research Asia-Pacific at UBS. “To follow blindly the policy initiative is not necessarily a good investment decision. Government policies do not necessarily translate into companies’ profits,” he says.

The Chinese government stimulus package in 2009, for example, was particularly supportive of the infrastructure sector but because of low pricing conditions, companies did not generate a lot of profits. “You need to look at the cost and the pricing power issues,” says Mr Pu.

Chinese companies require much higher levels of due diligence than European firms, he states. It is important to understand the language, to monitor local press and reports, and to be able to have regular dialogue with management about how they price products and manage inflation.

Having a good brand is also important, as is the company’s ability to bring innovation. The Chinese government strongly supports firms that are able to innovate, giving them freedom in pricing their goods, which can be translated into profits, claims Mr Pu.

As nominal salaries have increased 15-20 per cent over the last two years, companies to favour are those that are not labour intensive, that can increase productivity and add intellectual value. Also they should not be raw material intensive, as the increasing cost of commodities can eat into margins. Industry automation and upgrading is an important investment theme going forward, says Mr Pu.

“Government policies impact investment decisions quite a lot these days,” says Samantha Ho, investment director of Invesco Hong Kong and portfolio manager of the Invesco China Fund. For example, companies with exposure to western rural areas will benefit greatly from the “Go West” policy launched by the government to develop China’s Western region, which still lags behind more developed coastal areas.

Many companies borrowed for expansion recently and may be particularly affected by interest rate increases and monetary tightening. Administrative measures to fight inflation include price controls, which can squeeze margins of companies selling these products. So it is important to carry out a Swot (strengths, weaknesses, opportunities and threats) analysis of each company, says Ms Ho.

Understanding the motives behind government action can be vital. Normally, the government will look at the numbers before they make any decision, she says. For example, if statistical indicators show the economy overheating or slowing, the authorities will start to calm or stimulate the market.

“In China, there is just one political party, so you don’t have to worry about them fighting all the time to please voters,” she says. “You know the major concern for them is social stability.”

Last year’s policy initiative to boost blue-collar wages, combined with the plan to develop inland and western areas of China, particularly for technology manufacturing, is putting a strain on salaries. People are staying close to home in western China, and companies will have to raise salaries even more to attract people, further hitting margins.

Although Chinese productivity has increased, it has not completely matched wage increases. This has led some manufacturing companies to shift production to countries with lower labour costs, such as Bangladesh or Vietnam, in order to remain competitive in their exports.

The government accepts some of these companies will not survive, but is allowing them time to improve manufacturing quality, so they can move up the ladder and produce higher value added products, states Ms Ho. “The Chinese government doesn’t want to suddenly, overnight, have 10,000 companies going bust and lots of people unemployed in the streets.”

While China is often seen as a monolithic one party state, it houses a tremendous number of interest groups, such as big state owned enterprises, exporters and regional and provincial authorities. “The leadership very much works by consensus among those different groups,” says Jonathan Fenby, co-founder and head of China research at consultancy Trusted Sources. “They work out policies which everybody will be reasonably happy with.”

Chinese mindset

Studying the aims of the communist party leadership – to preserve ultimate power, while maintaining social stability and encouraging trade with the rest of the world – is also vital to understanding China. “Some analysis that looks at China purely in Western economic terms doesn’t necessarily work in terms of China itself,” believes Mr Fenby.

China’s strong drive and ability to leapfrog technological development has often taken by surprise foreign companies that derived large percentage of their revenues from the country. Firms such Siemens, Alstom and Kawasaki were all heavily involved in providing technology for Chinese high speed trains. But China today is producing its own equipment for high speed trains and exports it to other countries such as Turkey, Saudi Arabia and South America.

“You have to move on and you have got to be looking at which companies are going to have what China is still going to need in four years time,” states Mr Fenby.

For example, the country plans to have its own 200-seat airline flying in four years’ time. The foreign suppliers of aircraft to China are going to face internal competition, and it will be those who can make aircraft engines who will benefit, because China will not be able to make fuel-efficient engines.

China’s aggressive plan to build major skyscrapers or high-speed train stations in the next five years is clearly beneficial to global manufacturers such as Kone or Otis, which produce elevators and escalators. But it may well be that in five years’ time, the Chinese will make their own elevators, reflects Mr Fenby.

Real vs paper investments

Chak Wong, ex-trader and investment banker turned professor of Finance Practice at the Chinese University of Hong Kong, has a split view on China as an investment case. “I am very bullish on real investments in China but a little bit bearish on paper assets,” he says, explaining that he invests in shopping mall-based restaurants in second tier cities.

These real investments are driven by economic growth. Just 50 per cent of the Chinese population live in urban areas, the other 50 per cent live in rural areas and 18 per cent of people are farmers. The rural/urban income ration is about 1:5, and this high income inequality is further worsened by inflation, which was reported as 5.5 per cent in May. In addition to having raised the banks’ reserve ratio several times and increased interest rates, the government backing rapid urbanisation, aiming to raise urbanisation rates from the current 50 to 70 per cent over the next few years. This translates to about 250m people moving to cities.

The government, which is trying to dampen speculative demand and contain property price inflation, has also unveiled the most aggressive programme of building affordable housing anywhere in the world, planning to build 36m low-cost units between 2011 and 2015.

“We are talking about building cities that will house another European Union. That requires a lot of development,” says Mr Wong. “There is no question that the real economic activity is going to be very high in the coming 10 years.”

Sectors like entertainment, education, construction, logistics and the service industry will all benefit in real terms. Differences between wage growth rates in various sectors reveal the underlying development. Wages in the IT sector, construction, scientific research and education are all rising above the national average, while the manufacturing sector falls below it.

Mr Wong is concerned about risks of contagion from the European financial crisis, which can have a negative impact on the global and specifically the Chinese economy – currently, 20 per cent of Chinese exports go to Europe – as well as on investors’ appetite for risk. “I don’t think all these uncertainties have been priced into the market. The Hang Seng index is still double its low in 2008, which is a way too bullish estimate,” he says.

“I like investing in China but I would wait for the right moment,” which could be after the full resolution of the European crisis.

The best way to access Chinese investments is through exchange traded funds (ETFs), says Mr Wong, with mutual funds too costly and generally failing to add value. He also mentions gaining exposure through investing in onshore currency accounts, with the RMB expected to appreciate.

But there is by no means a consensus about use of ETFs for access to Chinese companies. Mr Pu at UBS says the main benchmarks today are heavily dominated by a few large cap names in telecoms, banking and energy, and are significantly exposed to State-owned enterprises.

At the moment, he says, Chinese stocks offer attractive valuations, after recent corrections due to inflation risk and tightening of monetary policy.

“The next two months will be interesting to start to increase China exposure,” believes Mr Pu. “But it also depends on your investment horizon: if you invest for the next five years, it is a good entry point, but if you are just looking at the next three months, you need to be careful, because the market could be very volatile.”

New investment themes

China may be the world’s largest polluter but it is also the largest investor in renewable energies, with plans to spend almost $800bn in the next decade to develop cleaner ways of fuelling its economy.

China is the world’s biggest manufacturer of solar panels and wind turbines but only an estimated five per cent of them are actually used in China, the rest is exported, estimates Mr Fenby at Trusted Sources. “In China there was great excitement about renewable sources of energy 18 months ago, but so far progress has been quite slow. Today, renewables are an export story rather than an energy story.”

Although clean energy, such as solar or wind, is still playing a marginal role in the economy, in the future, with the government support is going to gain importance, says Mr Pu at UBS.

China is facing a real energy problem, which was fuelled, amongst other factors, by the increased demand for household electrical equipment, particularly in the rural areas of China. A couple of years ago, the government launched a programme aimed at incentivising use of household electrical equipment in rural areas, with the result that the electricity system is having difficulties in keeping the industry supplied. The water theme is also interesting, because of increasing water shortages, and companies involved in water purification or preservation will grow in weight, believes Mr Pu.

One industry that has received far less attention in the Western world is the logistics industry, which is in a bad state in China, believes Mr Wong. In China, logistics account for 20 per cent cost of GDP, compared to 10 per cent in the US. This means that for every 10-dollar production, two dollars go to logistics. Most of the logistic companies in China are small or medium sized and not very efficient.

The service sector is expected to grow exponentially, as the country modernizes and urbanises. University education has expanded by seven times in the span of 10 years from 1m to 7m student places. “All this creates opportunities for people who go and do real business in China,” says Mr Wong, mentioning the success that Disney English is having with its English schools, as well as luxury goods and brands such as Ferragamo or Gucci.

“I buy Canali or Zegna suits but only in Italy, because they are much cheaper than in China,” he says. “In China, the percentage of US dollar millionaires is very low, but their absolute number is very high.”

Hedge fund investing

Speaking at the recent Bloomberg China conference in London Tony Morrongiello, head of hedge fund research at Caliburn Capital Partners brought evidence in favour of active and hedge fund investing in China. The peer group of 120 hedge fund managers that Caliburn monitors, which has doubled in number since 2006, have generated double the returns of the benchmarks over the past few years. These managers run equity long-short or equity absolute return type funds, operate mainly out of Hong Kong and have significant research operations in mainland China.

“Before you even start doing any selection work, it appears this group of managers, locally based, have actually added a lot of value. Whereas if you look at developed market equities, you are hardly getting paid for the fees you are paying,” he says.

However, only 20 per cent of these fund managers are actually managing more than $200m. “Size is a problem for international investors that want to come and invest big digits with big managers, but size of assets is clearly very detrimental to returns in China, you have to be nimble,” says Mr Morrongiello.

“If you want managers to run proper short books, we think that $500m as is pretty much the maximum that you can run in a proper hedged equity strategy.”

The sweet spot is between $100m and $300m, he adds, because as long as the managers are small they have the ability to vary exposures and protect the downside.

Before investors even ask themselves the question whether it is worth investing in hedge funds, they should really ask themselves whether the active approach is the best one to access China, he says.

“When you look at the Chinese economic reality and particularly the implications of the 12th five year plan, which is all about balancing the economy towards the consumer, away from fixed asset investments and away from State owned enterprises - assuming that the government achieves its objectives, which it generally does - it means that the markets are going to be fundamentally restructured in terms of composition of underlying equities,” he says

There are going to be massive winners and losers from these economic readjustments. “But benchmarks today are overweight structural losers, they are heavily concentrated in a few large cap names, very heavily exposed to State-owned enterprises and are heavily exposed to high consumers of energy, inefficient producers and banking. It is potentially a very good environment going forward for active investments.”

The driving rationale for investing in China today is not so much the pure GDP argument, as equities are not always the best ways of accessing GDP growth, but it is valuations and dispersion of equity returns, says Mr Morrongiello.

“Valuations have been massively compressed in China over the last 3 years and there is an opportunity here to buy cheap equities and to be able to extract a lot of alpha.” However, it is a fact that superior earnings growth will resolve in better returns. “You are buying cheap earnings growth and that will serve you better as an investor in a growing economy than in developed markets which suffer headwinds.

“Through hedge funds we can capture 70 per cent of the (long only) equity returns with a third of volatility over three to five years,” he says.

Yonghao Pu, UBS