The China Syndrome
The resilience – or otherwise – of China to the current economic slowdown is a favourite conundrum for asset managers. Commodity price inflation, stock market volatility and government restrictions on where managers can and can’t invest don’t make life easy for the investor hoping to capitalise on China’s economic expansion.
Dr Burton Malkiel, Professor of Economics at Princeton University, says that prospective investors should be prepared to look at an investment time horizon of five to 10 years for Chinese equities: “Brazil is usually the poster child for volatility but some of these Chinese markets make Brazil look stable.”
The last 12 months have been particularly troublesome. “In the first half of 2007 investors behaved reasonably, but in the summer, money flooded in through Hong Kong and forced up share prices, which created a bubble,” says Yang Liu, fund adviser to the Atlantis China Fund. “This is a liquidity driven problem. The question is whether China can provide sustainable growth with sound valuations.”
Jonathan Schiessl, manager of the Ashburton Chindia Equity Fund, believes that a lot of the earnings growth in the A-shares market – the one open to domestic investors – was reliant on companies playing the market themselves. The government became alarmed and tried to cool things down, fearing that retail investors would lose everything. “The domestic market is a very political market. All the listed companies are state-owned, and all the participants are state-owned, so it is very prone to sentiment coming from the leadership,” he says.
Volte-face
In the last few weeks, the government has performed a volte-face, deciding that the sell off has gone too far. It is now telling Chinese pension funds that they need to up their China equity weightings. Stamp duty has also been cut. This is tempting investors back into the market.
Liu believes China will be the first market to recover as it was sold off on other people’s mistakes – that is, the credit crunch in Western markets. “Investors will be looking for markets that can generate good returns over three to five years. We saw outflows in Q1 as people needed to cover the losses they were making elsewhere. China has been under-estimated.”
However, she stresses that fund managers need to ensure that companies are delivering good earnings because of all the liquidity sloshing around in the market. She tips Zhaojin Mining, the first 100 percent pure gold player listed in Hong Kong, as an interesting stock. This has a market cap of $2.5 billion, and trades at a P/E of 20x 2008 earnings. “It has been attacked by hedge funds short selling, so the share price fell substantially in March, but the company completed three acquisitions in 2007 which will boost its gold production and reserves,” she says.
William Fong, manager of the new onshore Baring China Growth Fund, also stresses the importance of verifying if the outlook for company earnings is sustainable. “We look at the valuation in comparison with its peers, and the historical trading range, and give more credit to those companies that have shown resilience to a slow down in previous years,” he explains.
Fong is pursuing a consumption growth theme in his new fund, focusing on banks, such as China Construction Bank and Shanghai Pudong Development Bank; real estate companies such as China Overseas Land; and own-brand retailers, which benefit from low-cost manufacturing in China, high profit margins, good growth potential and national distribution.
Difficult dilemma
However, other managers are sceptical about the opportunities in China as inflationary pressures build, social divisions widen, and the profit margins of certain companies come under pressure from regulations that do not allow price increases to offset higher raw material costs. “For example, energy companies like PetroChina and Sinopec haven’t been able to pass on increases in crude oil prices because refined product prices are capped,” points out Jonathan Bell, senior investment manager in the emerging markets group at Pictet.
The Chinese government faces a difficult dilemma – it needs to curb further excessive capacity expansion in overheating industries whilst encouraging the growth of private consumption. Liu suggests that continued rapid urbanisation and industrialisation will lead to further shortages in shops and an increased likelihood of confrontation. She expects to see more pricing interventions in energy and natural resources to protect the economy from commodity price rises and to maintain China’s competitiveness.
The government is already discouraging natural resources exports to keep as much in the country as possible: “The coal producers can’t send coal to Japan, and they are also looking at alternative energy supplies.”
In China’s favour, Schiessl believes that food price inflation will moderate in the coming months, following massive increases in pork and chicken prices in the first quarter. Pork prices rose because the pig population was infected by blue ear disease leading to a shortage of pigs getting to market. As a result, the February CPI figure climbed to 8.7 percent.
The government responded by offering tax breaks to farmers to encourage them to breed more pigs, so now China is awash with piglets, which will hit the market in a couple of months. “Food price inflation should moderate as the supplier response comes through,” says Schiessl. “Also, the winter storms replenished the low water table so the improvement in soil moisture levels should produce a bumper harvest, reducing the price of grains.”
Wild East
But other problems – like poor corporate governance and lack of transparency – remain. “It is difficult getting decent information,” says Schiessl. “The state is the largest investor so you have to look at how they treat foreign and minority interests, and whether they deliver what they say they will. The regulator says that it wants to improve disclosure and accounting standards over time but there is still a long way to go. China’s a bit like the Wild West – capitalism is a fairly new concept and you do still hear stories alarmingly regularly about CEOs disappearing with suitcases full of cash.” However, he stresses that the quality of management is better in the blue chip companies now.
Bell agrees that more attention is now paid to minority interests, whilst Hong Kong-listed companies have to meet a higher standard of transparency and many use international auditors. “But there are still a lot of issues with private sector companies, such as transfer pricing, where the chairman of one company might be using his own private company as a supplier. Or sometimes with asset injections from the state or parent company it is hard to get a clear idea of the timing or pricing of those assets.”
Investing is made more frustrating by the multiplicity of markets, ring-fenced for one investor group or another. It is questionable how long this situation can continue. It seems certain that the B-share market will remain unloved as long as rumours circulate that it will be scrapped and merged with its racier cousin, the A-share market. “B-shares trade at a huge discount to the A-share market, and it is too illiquid and too expensive to deal in, so we avoid it,” says Schiessl.
Malkiel is also frustrated by the A-share market premium to the Hong Kong market – a factor of domestic investors’ inability to invest elsewhere. “Share prices for stocks like China Life can be 40 percent higher in the A-share market compared with the listing in Hong Kong or New York, because you can’t arbitrage between them,” he points out. “But the Chinese want to make Shanghai the major market in Asia and they won’t be able to do that if they insist on keeping foreign investors out.”
The Chinese are worried about loosening up too fast and fret about a run on the yuan, which Malkiel views as unlikely as it is so under-priced. “This government is a very cautious government, so I don’t expect change to happen overnight,” he says.
If you want to read more about how managers are trying to position themselves in China’s rollercoaster markets, please go to:
Battling Asian flu
Asian markets proved remarkably resilient last year, despite the problems in Western markets, ending 2007 up by around 30 pct. But in January, as a US recession loomed and panic spread, mass sell-offs saw the MSCI EM Asia fall just over 14 pct, as foreign investors sprinted for the exits.
“The fear is that if there is a recession in the US and Europe, Asian growth will be in trouble,” says Khiem Do, head of Asian multi-asset at Baring Asset Management, speaking at the time of the sell-offs. “This correction isn’t pleasant but this is the impact of the concern over the US recession. It is a nasty bug that is going around.” However, some markets, such as the China A-share market, Malaysia and Singapore, held up better than others through the turbulence.
Mike Hanbury-Williams, F&C’s head of Pacific equities, points out that although Asian stocks can experience volatility of 20 pct in one day, there is no real volume in these prices. “It’s often relatively small volumes that are sending prices downwards. When we buy in we see the stocks bounce back.”
Indeed, Asian markets have subsequently attempted to rally. “This suggests they may be able to withstand the cold winds of a US recession, if it is not too severe,” says Do. “Asian exports will fall but that won’t be disastrous as Asian exports to the US have fallen quite dramatically over the last 10 years, and intra-regional Asian trade has increased.”
Despite the argument that there will be few upside surprises to China this year, and the fear that it is getting a little toppy, Do said that it remained a good growth story and the valuations amongst the Hong Kong-listed China stocks were still cheaper than those in India. “But India is building a lot of infrastructure to modernise its industries and cities, and the growing middle classes are upgrading their homes. In China we can see the government trying to push the growth westwards, as Shanghai, Beijing and Guangdong are all in the east, and that requires a lot of spending on infrastructure.”
James Weir, investment analyst for the Atlantis Asian Recovery Fund, is more cautious, predicting a short-term pull back in India, in a longer bull market. “Things have gone quite far, quite fast in India, but it benefits from the requirement for infrastructure, which is gigantic. There are also a lot of power company IPOs coming up in the first quarter, and there will be a tremendous demand to build plants and for coal to fire these stations.”
He also thinks that China looks overbought in the short term: “It has had a tremendous run, and a correction is now underway. The fundamental story remains but the government has to balance out the flows, whilst inflation is still very strong, and interest rates need to increase. So it’s all about how well can they manage inflation in a market economy. If they manage it badly there’s an event risk to the equity market.”
Indeed, in India attempts have been made to clamp down on some of the hot money coming in, but China and Hong Kong have seen a massive run up in their markets driven by domestic retail investors. “The government is trying to manage the process of getting that liquidity from the A shares market into Hong Kong and other markets in Asia, but there’s a phenomenal amount of money in China waiting to come out,” says Weir.
The problem is that with currency controls in place, Chinese investors can’t just buy Hong Kong ‘H’ shares if they want them. A lot of the flows have been into mutual funds, but there are quotas on the amount of money that can come out of China, and the markets that it can go into. “No one wants an absolute tsunami of cash coming out of these markets in an uncontrolled fashion, but domestic Chinese investors will have an enormous impact on the Asian equity markets over the coming years,” Weir adds.
If you want to read more on which markets are expected to do well in Asia this year, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=&storycode=35200
Forever Blowing Bubbles
June 11, 2008 at 3:17 pm (Asia equity markets, Commodities, Macroeconomic commentary, UK equity markets) (bubbles, buy to let, China, Commodities, contrarianism, dotcom, miners, SVG, UK, value investing)
This time it’s different – the plangent refrain of the investor suffocating in a bubble. Ah, what bliss it is to recall the golden days of the dotcom era, when we thought the mini-scooter-driven party would never end. We would all be commuting to work via the internet and downloading our memories into cyberspace in a kind of Neuromancer-meets-Facebook “mash up”.
Now we look back and scoff at the delusions of our younger selves. What on earth were we thinking? Boy, we were really stupid 10 years ago! We forgot to ask important questions like: What does this company do? And: How will it make money? Thank goodness the commodities super-cycle is nothing like that.
And just why is it so different? Because China and India are industrialising like crazy, of course! Who could pass up that opportunity? Hmm, well let’s just run a slide rule over that shall we?
Tony Dalwood, head of public equities at SVG Investment Managers, believes that mining stocks and other natural resources plays, which have run up on the back of the commodities boom, are heading for a fall. “Value investing has underperformed because commodity stocks like the miners have got ahead,” he says. “The market is focusing on cyclical peak earnings, but miners are heading for a problem when returns normalise.”
Panic and crisis
Adam Steiner, head of research, public equities, at SVG adds: “The investment time horizon of hedge funds and traders is microscopic compared to pension funds, and the markets are now very momentum driven. In moments of panic and crisis no one is using valuation to pick stocks – they just churn their portfolios to try and keep up to date. They don’t want to be underperforming the market at the end of the quarter.”
He argues that resources companies are “grotesquely overvalued” – mining is a cyclical industry and is generating the highest returns it ever has, but as costs go up and more capacity comes on stream this won’t continue. “Whenever you have a bubble there is always an argument that this time it is different,” he says. “People are pointing to the impact of China, but the increase in the oil price is not completely accounted for by that. To pretend the demand for resources is in no way influenced by the global economic cycle is crazy. If oil goes to $200 a barrel then the average US driver has to spend 10 to 20 percent of their income on petrol. So you have to ask – if everyone in China owns a car, how will they afford to drive it around? High commodity prices in themselves slow global growth.”
He adds that the population of China is only three and a half times that of the US, and the majority are peasants in the north and west. So the Chinese economy will only become two or three times bigger than that of the US and it will take a long time to get there. “You also have to keep in mind that a lot of China’s growth has been financed by US debt.” That is, consumers withdrawing equity against their homes to keep spending – something they are unlikely to be doing much of in the foreseeable future.
The commodity gurus argue that prices are supported by years of under-investment, which has created a pinch point – miners can’t get the stuff out of the ground fast enough, so prices keep increasing. But when new capacities come on stream, shouldn’t prices correct to more realistic levels, especially if the US is in the doldrums? So investors have to ask themselves: How far do we want to ride this boom? You can bet the chartists are hunkered down over their models right now trying to call the peak.
Buy-to-let blow up
Steiner is also worried about the horrors that may lie ahead for the UK, especially if the buy-to-let boom turns out to be the UK’s very own sub-prime meltdown. “The banks have only written down their lending impacted by the US so far, not their UK lending losses,” he argues. “That will come if we have a nasty house price plunge. For the last few years there has been a very strong tailwind that has helped retailers, banks and property, but that has now gone into reverse, and it is likely to be a headwind for another three to five years. The issue will become – how are banks going to make money now? The ratings will recover but the earnings won’t.”
SVG takes a contrarian approach and is focused on companies not at the peak of the cycle – particularly, telecoms, pharmaceuticals, software and media companies. Steiner says that pharma stocks are interesting as they are “off the scale cheap” – some 40 percent below their 20 year average. “All the arguments for pharma – such as the ageing demographics – remain intact, but they have been hit by the FDA tightening up its approvals process and the market is fretting over near-term fears.”
He adds that media is “mind-blowingly cheap” because of fears that if the economy does turn down, media will do badly. SVG is focusing on business-to-business companies such as DMGT and the WPP agency, which is more diversified, and therefore less cyclical than people seem to think. “This is the exact inverse of 1998 to 2001,” he argues.
It’s an interesting idea – that TMT will ride again after a speculative bubble in commodities goes pop. M&A activity in the small and mid-cap telecoms and software sectors has been brisk in the last couple of years, with strong private equity interest. “A lot of small and mid-cap deals are happening and they have raised a decent amount of money,” says Steiner. Telecoms has now re-rated a little, but SVG believes there is further to go. Perhaps it’s time to dust off that mini-scooter and drive back into the TMT market again.
If you want to read more about developments in the TMT sector, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42257
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