EM equities: notes from the road in China



Stephen Deane, Portfolio Manager on the Janus Henderson Global Emerging Market (GEM) Equities Team, recently visited China. Within this article and video Stephen shares his observations on the companies he met, as well the broader opportunities, risks and culture he experienced on the trip.

There is a saying in China that, “the mountains are high, and the emperor is far away” which serves to remind us that viewing China as a single country is to miss the huge variations in everything from language to food to the cultures in the businesses that we meet.

The team visited China in early December travelling from Beijing, through Hangzhou, Shenzhen and finally Hong Kong, meeting companies the strategy either owns or we think might be of acceptable quality to own one day. What was striking is how mature many products, services and companies now are, something that stands in contrast with the high stock market valuations that appear to imply continued rapid growth.

We also observed that many Chinese companies that are gaining global market share already have market capitalisations greater than those of the multinationals they hope to replace. China’s leading white goods company, Midea, for example, has a US$55.5bn market capitalisation, which compares to US firm Whirlpool’s US$12.3bn market cap and US$10.0bn for Electrolux, the Swedish appliance manufacturer1.

1 Thomson Reuters Datastream as at 29 December 2017 in USD terms

Far from the watchful eyes of the Emperor

Traditionally, the further one travels from Beijing the less State control has been exerted. We noticed this in terms of restrictions on Internet access but also in terms of the kinds of companies we met. Many of the companies that have a dependence on the State located themselves closer to the seat of power in Beijing or will have originated from it. The more entrepreneurial companies typically situated themselves “far from the watchful eyes of the Emperor”.

What this system of government has achieved, however, is worth pausing to appreciate. China, since it began economic reforms in the late 1970s, has lifted hundreds of millions of people out of poverty in a country that other than labour lacks any significant resource advantages. India and China, often compared because of their large populations, have seen remarkably different fortunes since China began opening up. As of 1980, India had gross domestic product (GDP) per capita of US$263.8 and China US$194.8, adjusted for inflation2. By 2016, India’s GDP growth had grown to more than US$1,700 expanding by 6.5 times. In the same period China’s GDP had grown to more than US$8,000, a multiple of more than 40 times . Travelling in the two countries, the difference in infrastructure investments are stark and the huge build of roads and rail and a current wave of urban metro projects will likely pay dividends in China for decades to come.

As stock pickers, though, we are less interested in aggregate statistics and more concerned with whether the currently high valuations of many companies reflect inflated expectations. Our trip to China underlined the approaching maturity of the country and the opportunities that come with it. A number of product categories are approaching volumes per capita of more developed countries. Internet penetration is also high, and many categories have a larger percentage of online sales in China than they do in the US or Europe. Recently, Japan’s leading diaper/nappy company told us that in China’s wealthier cities already 85% to 90% of its products are sold online. This, combined with a forecast for population decline of around 3% between now and 20503, makes us wary of the high valuations for many of the companies we met on this trip.

China now faces several significant challenges including growing inequality, pollution, burgeoning debt and an ageing population that places a growing strain on the State. We are not thematic investors but understanding these challenges hopefully helps us minimise risk in the portfolios we manage. By way of an example, we were told of some polluting companies that were being shut down simply by having their electricity supply cut off.

2 The World Bank, GDP per capita in USD terms

3 United Nations, World Population Prosepects, 2017 Revision

The importance of alignment

We have long believed in carefully considering how we, as minority shareholders, are aligned with the interests of the owners of the companies in which we invest. China’s economy is also distinguished by the fact that in many instances State control is manifested not just through policies, laws or favourable incentives but through direct control of companies. Even when the State does not directly control a company, the government can easily compel it to do its bidding. This unusually makes companies that are large and cash rich more, not less, of a risk than we would see in other countries.

This is not to say that our interests and those of the government are never aligned. China’s well publicised effort to improve its dairy supply chain after an incident of melamine poisoning in 2008 has enabled State owned China Mengniu Dairy to build a strong consumer products franchise in partnership with multinationals Danone and Arla.

We met with two companies controlled by the China Resources group. China Resources (CR) was established in Hong Kong in 1938 to raise funds and purchase supplies for the People’s Liberation Army. Its function over time grew into a trading company for the People’s Republic and as the country has opened up for business this commercial spirit has been harnessed to run State-owned enterprises in everything from beer to cement.

We met with CR Phoenix, a hospital operator, and CR Pharma, a drug developer and distributor. The cost of an ageing population is a challenge for the government and CR has been enlisted to help drive down cost and improve transparency in healthcare. This work is only just beginning as most hospitals are still directly controlled by the state, giving CR Phoenix an estimated 0.2% of the total market. CR Pharma is one of three companies consolidating drug distribution in the country with a combined market share of around one third versus more than 90% in the US4. As investors, the key question for us is what level of return the government will permit CR to earn from these services?

4 Company estimates

All that glitters…

One thing that struck us as we moved from city to city were collections of rental bicycles from companies like Ofo and Mobike, scattered everywhere we travelled, sometimes literally in large piles at the side of the road. Anyone with a smartphone can rent these from one of several companies all competing to own a part of the ‘sharing economy’. The huge investment required to achieve this kind of ubiquity (more than 10 million bicycles globally in Ofo’s case) is only possible because of the deep pockets of their backers, which include Tencent and Alibaba.

The presence of these two Internet giants was difficult to avoid on our trip, to the point that in several outlets we were unable to pay with anything except Alipay or WeChat. The two companies have spread their reach across the economy from films to department stores, using the prodigious cash flows from their core businesses to invest elsewhere in search of growth. It was hard for us to see in some of these business models how they would ever generate an acceptable return but perhaps this is how companies in the Internet space have to deal with the constant threat of disruption? If this is true then the cash surplus these companies appear to generate may never find its way back to minority shareholders.

Another risk is that their core businesses may be starting to mature. Several people we met mentioned that most e-commerce growth was now in cities (tier three and below) where large retailers had yet to develop a physical presence. In wealthier places, good quality and well positioned shopping malls are having a resurgence and it seems likely that a balance will develop between shopping on- and offline. According to McKinsey, the global management consultant, in tier one and tier two cities more than 80% of those aged 13 and older are already online and nearly 90% of those are already shopping online. There are more people still living outside of these cities in China but the exponential growth cannot continue indefinitely.

Aside from these concerns, we also worry about some of the conflicts of interest that exist in such tightly controlled companies with complicated corporate structures. There often seems to be a grey area between the company’s money and the founder’s money. By way of an example, Hundsun is a financial services software provider (fintech) that we met in Hangzhou. Its largest shareholder is a company controlled by Alibaba Group Chairman Jack Ma.

In 2014, one of the same group of owners personally acquired a stake in Hundsun, the fintech business we met on our trip, to become its largest shareholder. In June the following year Reuters reported that this stake was acquired by Ant Financial, which is an affiliate company of the Chinese Alibaba Group. This mix of personal and corporate investing is something that makes us nervous of how well protected minority investors are, given the apparent conflicts of interest

Trip takeaways

Reflecting on the trip, we feel there is a lot to interest stock pickers such as ourselves in China’s local ‘A’ share stock market. The young Chinese people we met were full of optimism for the future, a less common occurrence in the more developed world. More companies than we expected have fully left their state-owned roots behind and become what look like genuinely private enterprises. For example Foshan Haitian, the 300-year old soy sauce maker, believed it could become China’s Unilever. This positive trend could well continue in industries the government views as non-strategic.

We still have a number of concerns. These include the level of confidence most people seem to have that the Chinese government can successfully reign in obvious excesses in the finance and property markets. Similarly, the high prices for many of the companies that are investable imply growth in excess of the level of maturity of many of the industries. Investing in China is not straightforward due to restrictions on foreign ownership in certain industries and more generally investing in the local ‘A’ share stock market. Where there are other ways to access the market such as US or Hong Kong listings many of the corporate structures are designed to limit minority shareholders protection, such as variable interest entities (VIEs) which we have written on previously.

Another way to invest is via companies with successful products and franchises in China, such as our strategy holdings in Heineken (Dutch brewer), LG Household & Healthcare (Korean cosmetics) and Uni-President (Taiwanese food and beverage). These more reasonably valued companies offer investors, in our view, a better way to gain exposure to Chinese consumers and benefit from management teams with proven ability to navigate the challenges in this exciting market.

Note: The above stock examples are intended for illustrative purposes only and are not indicative of the historical or future performance of the strategy or the chances of success of any particular strategy. Janus Henderson Investors, one of its affiliated advisors, or its employees, may have a position in the securities mentioned in the report. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.

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