China:To what extent is a slowdown priced in?

01 June 2012 - Suhail Suleman

To what extent is a slowdown priced in?

By Suhail Suleman, analyst
June 2012

Since abandoning Marxist economic ideology and embracing a more liberal model of state-directed market development in 1979, China has achieved uninterrupted economic growth for over three decades. The rate of growth over this period is unprecedented in recorded human history, and the country has been transformed from a rural backwater to the second largest economy in the world in the space of a single generation. Although it remains firmly a middle-income country when measured by income per head, this development has had a profound effect on the world economy. China’s factories have churned out goods at a cost that has benefited consumers greatly throughout the world, but has decimated the lower-end manufacturing sectors of several countries that could not compete with Chinese scale and labour costs.

Perhaps the single biggest indicator of China’s importance to the global economy has been the impact the country’s growth has had on commodity prices and volumes. Over the past decade, the sheer size of its economy coupled with close to double-digit rates of growth combined to raise the prices of most commodities to record levels, following decades in the doldrums. China is the largest consumer of iron ore and cement, the biggest producer of steel and burns more coal than the US and India (the second and third largest users) combined. Everywhere, from South America to Australia, mining companies have invested heavily to extract the minerals and metals required to meet Chinese demand and a large number of countries now find their economic outlook completely intertwined with China’s fortunes.

In recent months there has been much debate about whether China’s period of super growth has come to an end. This fear stems primarily from evidence that suggests that heavy investment in infrastructure and construction has resulted in a property bubble. Property bubbles tend to be very problematic when they unwind, as they are typically associated with erosion in the credit quality of borrowers (as the value of the collateral declines) and the financial stability of lenders as they face large-scale defaults.
There is definitely evidence of an investment binge in China that has resulted in elevated property prices. A big culprit was the stimulus spending provided by the central government in the aftermath of the global financial crisis. There is, however, one big difference between China’s property bubble and those of the US, Spain, Ireland and other countries that fell prey to the bursting of the credit bubble in 2007/8; China’s property boom has been financed primarily by household savings. The spectre of widespread bankruptcies sending China into a recession and dragging the world economy down with it is therefore an unlikely outcome.

When people talk of a China slowdown, context is very important. After years of 8% – 10% growth, 6% – 7% will seem lethargic in comparison, but in absolute terms the country’s current $7.3 trillion output will increase annually by more than the entire output of countries like South Africa, Argentina or Norway. While other countries are struggling to grow real incomes for their people, China will be slowly bringing millions of people out of poverty every year, with a large number even migrating to the middle class. For many years China has been synonymous with heavy fixed investment in infrastructure and construction. Going forward, the makeup of growth will be far more focused on the consumer sector. This is partly because the government is actively trying to rebalance the economy away from investment, but mostly because a large urban middle class has emerged over the last two decades and their consumption power remains broadly untapped by any objective standard. It is for this reason that we remain very positive on the Chinese shares that we own in our funds, all of which are consumer-facing businesses. China makes up 25% of our portfolios and we discuss the
investment case for some of the individual positions in brief below.

Our largest Chinese exposure is now Daphne International Holdings (4.7% of fund), a retailer of mid-level and entry-level shoes. We have written extensively about Daphne in a previous publication (see Corospondent January 2012), however, in recent months our conviction on the business has increased and so we bought into share price weakness to get to this large position. Members of the team recently spent some time with the company’s chief financial officer in Shanghai and visited a few of the Daphne and Shoebox- branded retail stores, as well as several competitors’ stores and concession stands in department stores. The value proposition for both of Daphne’s shoe brands remains compelling and the company’s payback period on some stores is within a year of opening. They currently have 5 000 stores which they believe they can double without any cannibalisation as they are present in less than half of the hundreds of small cities across China. Despite this compell-ing growth profile and history of executing its expansion plan, Daphne trades at 10 times this year’s earnings and pays a healthy 3% dividend yield.

Great Wall Motors (4.5% of fund) is another holding that we believe the market does not reward despite consistent delivery of production and earnings growth over time. The company has grown earnings at north of 30% per year over the last five years, a period covering the global financial crisis and heavy overcapacity in the world’s car industry. It has successfully diversified away from pickup trucks into (first) SUVs and now passenger vehicles, developing a reputation for quality that is unparalleled amongst Chinese car brands. A few of its models are licensed for sale in some of the jurisdictions with the strictest safety and emission standards in the world, yet they are sold in China at similar prices to other local brands that have inferior technical specifications, less safety features and shorter warranties. Great Wall trades on 8.5 times this year’s earnings and pays a 2.6% dividend yield. In addition to Great Wall, the fund also owns Brilliance China Automotive (1.8% of fund), a joint venture between BMW of Germany and a local state-owned partner. Brilliance trades on 10 times this year’s earnings despite the very low penetration of luxury car brands in China and the very high branding power of BMW. We continue to hold Lianhua supermarkets (3.5% of fund), an operator of hypermarkets, supermarkets and convenience stores that originated in Shanghai but is now present in much of the east coast of China. When the market was in a frenzy for Chinese consumer exposure in early 2011, the company’s shares traded as high as HK$22. Today the share price has fallen by two-thirds despite moderate growth in earnings of the core business. The company has opened many stores in
recent years and also acquired a supermarket chain, both of which will take time to mature and fully integrate. In our view this means the current earnings base is well below normal. In addition, Lianhua has a valuable stake in a joint venture with French retailer Carrefour, the no.3 hypermarket chain in China. Adjusting for its joint-venture stake and the large amount of free cash on its balance sheet, Lianhua trades at less than five times its historic (depressed) earnings.

As a final note, it is worth looking at one of our few remaining exposures to China’s internet sector, (1.6% of fund). The company can best be described as the ‘Google’ of China, particularly since Google left China due to censorship restrictions (searches with Google now take place via their Hong Kong server). With more than three quarters of search traffic and an even larger proportion of search revenue, Baidu is the undisputed leader in this market. The company should benefit from migration of advertising away from traditional sources to the online sphere, particularly as broadband access continues to increase over time. In addition to the large and established market leaders, Baidu has cultivated relationships with almost 500 000 SMEs in China with whom it works closely to best understand how to maximise value for money when they pay for keywords and ad placement. The company generates an incredible amount of cash and is constantly investing in new revenue streams to reduce reliance on the core search business over time. Although appearing expensive on shortterm metrics, the infancy of the market means Baidu has the potential to grow earnings at well above market rates for many years, which brings longer-term multiples down very fast.

SUHAIL SULEMAN joined Coronation’s Emerging Markets team in 2007, initially covering the consumer and industrial industries. He currently co-manages the range of Global Emerging Markets funds. Suhail has 10 years’ investment experience.

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Notes to the editor:
Coronation Fund Managers Limited is one of southern Africa’s most successful third party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange.