As the world’s second largest economy gearing up for more financial openness, China is the market that any investors with global view cannot miss. Yet, its profound dynamics in economics and policy environment require on-the-ground knowledge. This monthly information - by our dual team in Shanghai and Frankfurt is an endeavor to illustrate our investment thoughts and prove digestible insights on China’s market and policy trends.
The Caixin manufacturing PMI, a widely used indictor to gauge factory activity, reported at 49.2 in August, the first time dropping below the 50-mark since April 2020, which indicates a contraction.
In our view, the above is significant in certain ways: 1) It could be a turning point of a relatively tight monetary policy since earlier this year. Private sector will likely see better liquidity, as the market expects a reduction in reserve ratio. Infrastructure expenses are likely to be raised too. 2) Regulatory policies against new economy is likely to moderate as we see this month compared with it was in August. The speech by Vice Premier Liu He reassured the supporting of the private economy in spite of the recent crackdown policies.
but looking at figures we think it can be contained. Evergrande’s chance of default has been somehow anticipated by the market for years, as its bond was once issuing at over 13% but also widely purchased by international investors including Allianz, Ashmore and BlackRock. Of Evergrande’s total debts, listed banks own less than 10%. Most of debts (30%) are in the hands of local government owned banks, as well as insurance and trust companies, 20% were issued overseas.
We see further short term impacts on property price and difficulties along the value chain. Yet financial institutions except trust companies are in very good capital position, therefore it is unlikely that it will cause a systemic breakdown. Debts issued by trust companies are on hands of individuals which may cause social problem in case of an outright default, yet most of its direct creditors are state-owned and they would consider the government’s top agenda which is social stability. For the same reason, we believe that the government will first make sure Evergrande will deliver projects on hand and avoid a sudden blackout.
In the past decade, liquidity has been pumping on an unpreceded rate, with the balance sheet of the US Fed expanded by 8 times since 2007, and more than doubled in the past year. It was similar for the other biggest central banks, namely BOJ, ECB and PBOC, such that the global money has been chasing for limited amid expanding assets. The world’s largest asset by market, namely, US equity and China property have seen higher valuation and lower expected return.
In general, the intrinsic return of most assets has decreased nowadays. As long term investor, we believe too much reliance on liquidity is fragile.
Instead of forecasting the liquidity, we look for assets with intrinsic return to build a portfolio with higher level of resistance against inflationary and liquidity risks.
China, hosting the world’s second largest capital market, is still having a good portion of stocks which are in reasonable valuation in our view. For instance, in the A share market there have been significantly higher proportion of companies trading at PE of less than 30x than 2016-2018. Whereas, they are upholding similar level of ROE and earnings growth across the period.
are namely Static value (dividend including repurchase), Value recreation (reinvest on retained earnings), and Revaluation (mean reversion of mispriced stocks, which often comes from changing growth or risk outlook by investors).
Dividend can be estimated objectively from corporate governance track record, operating cashflow and CAPEX forecast, etc. This is the first layer of intrinsic return. We are expecting 2-5% in most value position in China. While in some extreme cases it could be as high as 10%。
Or reinvest on retained earnings - basically ROE minus dividend payout. The ROE of A share in the past two year stood at 9.49% and 8.92% respectively, amid Sino-US trade conflicts and Covid-19 pandemic. The long term growth, after deducting certain dividend payouts, would still be a nice figure of 6-7%, which we consider is the underlying growth of share prices. Our strategy mostly focus on better quality companies, which means the value recreation part of the portfolio in china could generate at least 7% return.
The sum of the above two sources already provide a return of 9-12% in long term, had the fund manager avoid low valuation-creation inferior stock, it could be better.
With hindsight, the valuation revealed the underestimated policy risk for the reform of the pharma distribution which had been looming for long. If one held the stock for 10 years till 2020, the total return would be -30%. In other words, identifying the appropriate level of risk-pricing would avoid a misery return; and identifying those mispriced would give an astonishing long-term return
Having said that, we are intended to invest in a portfolio which will benefit from, but not solely rely on, China growth.
No one knows when the excess liquidity ends. Although when the time comes it will be painful, but can delay for a very long time, like such in the past 10 years.
As described earlier, the liquidity condition has led to a declining return of investment, and may blow further as excess liquidity subsides. Here is our take for long term capital: Insist on the primary principle of value investing, search for long-term intrinsic returns regardless of liquidity environment, and lift up resistance level for various risks.
Investors have heard about government interventions in the internet, education, video game, real estate and pharmaceutical sectors. For instance it has crackdown on private education and at the same time set stringent control on the time allowed for internet games by youngsters. These have brought tremendous impact to relevant share prices. New Oriental (9901.HK), a private educational services provider in China, has seen share price slashed since the policy unveiled in July. That has led to investors wondering which industry is next on the hit list.
Is the Chinese government being unpredictable? Has it become impossible for many investors to set an appropriate risk premium for buying company shares?
In a historical context, however, enforceable regulations are quite common in the Chinese economy. In 2004 and 2005, the authorities took action against small, poorly managed steel mills that were disrupting the market. In 2008, Chinese food companies were targeted after a series of quality scandals. In 2011, banks were required for a tighter capital standard as debt level ballooned after the 2008 global financial crisis. In 2013, the anti-corruption campaign has put moutai (Chinese white wine) consumption on alert. And from 2016 to 2017, pharmaceutical companies came under scrutiny following a string of deaths from counterfeit vaccines and drugs.
At the end, we know that a lot of stocks in those sector recovered and delivered mega returns to investors, such as Mengniu Dairy (2319.HK), Kweichow Moutai (600519.CH), Hengrui Medicine (600216.CH) and a lot more. We would like to highlight the investment approach as below:
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