15 July 2019
By David Palmer, Co-Fund Manager HC Verbatim Portfolio 5 Income Fund
China is a land of opportunity – and limitations.
It has over 5,000 listed companies with a market capitalisation of $11 trillion.
That’s just under its $12 trillion GDP. By comparison, US equity markets are valued at around US$30 trillion – or 1.4 times GDP.
The opportunities for our fund managers, and other leading global investors, ought to be plentiful.
But Chinese opportunity is leavened with limitations. Government constraints, high debt levels and other factors mean the best opportunities lie in a few portions of the economy – or in global companies doing business in China.
The first limitation is because the country has a dual track corporate sector: some companies are private while others are government run.
Private companies, often referred to as SMEs, or small and medium sized enterprises, have been the lifeblood of a more vibrant economy since former leader Deng Xiaoping signalled the start of ‘reform and opening up’ in 1978.
SMEs are reputed to represent 90% of total exports, 80% of urban employment, 70% of patenting activity, 60% of GDP and 50% of tax revenue. The sector in aggregate earns an 8.5% return on assets, and has spawned investment opportunities such as Alibaba and Tencent.
On the other hand, centrally-controlled state owned enterprises (SOEs) have played an important role in China’s recent development. But they typically earn a lowly 2% return on assets, are highly indebted, frequently loss making, low growth businesses, badly in need of reform. They have not been good investments.
State control doesn’t end there. Government policy has a significant impact on the fortune of companies – to an extent we’re not accustomed to in the West – and it currently favours SOEs.
It’s tempting to believe China’s rulers have the tools and ability to effectively manage their economy. But in truth, the system is complex, policy errors occur and frequent course correction needed.
Investing in Chinese equities
China also needs more international capital because it has less of its own.
Once around 10% of GDP, its current account position is being pushed down by a range of factors towards zero. This is why the country has taken steps to improve access to its domestic equity market.
While progress will probably be slow, over time the $11 trillion Chinese equity market will become increasingly accessible to our portfolios.
But that’s in the future. Today, opportunities are limited.
We’re looking more at global companies, listed outside of China and Hong Kong, providing attractive goods and services into China.
They have good standards of disclosure and accounting and are willing to engage with shareholders.
Until Chinese capital markets mature and governance standards improve, this is likely to be our preferred channel into Chinese growth.
China now represents more than 30% of the global market in luxury goods, cars, consumer appliances, mobile phones, and spirits. Branded consumer companies in luxury goods and staples have a high proportion of their potential sales in China and some durable competitive advantages. For example, European luxury brands, with hundreds of years of heritage, are impossible for the Chinese to replicate domestically.
Education, personal care, food away from home and travel are all areas of consumer spend supported by strong thematic drivers.
Healthcare is a large and growing market for innovative Western companies. Chinese healthcare is around 5% of GDP, substantially lagging the 8% spent in Europe or 16% in the US. As the population ages rapidly this will increase.
Beyond the broad consumer opportunity, there are also select industrial companies that can benefit from China’s development.
The penetration of automation and robotics in China still lags that of Japan or South Korea, despite 10 years of rapid growth. In crucial niche markets, such as analogue semi-conductors, US companies such as Texas Instruments retain a leadership that will be difficult to displace.
Moreover, deepening Chinese financial markets provide an opportunity to financial services firms such as Allianz, UBS or Prudential that have recently been allowed greater access to the domestic market.
China’s a uniquely interesting and challenging market in which to do business and to invest. Our investment process is rigorous, selective and vigilant of the risks.
Some of these are political: aside from the China / US trade war, the former’s emphasis on ‘military-civil fusion’ raises national security issues for the latter.
But it’s undoubtedly an exciting source of good investment ideas – especially because of its growing marketplace for international companies.
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.