Nathan Lim

“Four cities, five days, 14 companies: we made the most of our trip to China and it confirmed our concerns and reaffirmed our decision to downgrade our economic assessment for the country.

“We also picked up several key insights into China’s development,” said Nathan Lim who runs the international equities fund.

China has settled into a lower gear

We were able to conclude that the slowdown in China has already happened and it appears the economy has settled into a lower gear.  Amongst the weakest sectors right now are steel, coal and chemical refining. The strongest include automobile manufacturing, shipyards and the logistics sector. In a broader sense, the weaker companies are those with a mix of customers leaning more towards the government or construction. There is a general view that the second half of 2014 will be roughly flat or only modestly higher than the first half as there does not seem to be another major stimulus program on the horizon. A near term risk we see are reports of broad inventory destocking. Running warehouses so thinly can have a chilling effect on sentiment as it represents a lack of confidence. We worry that excessive pessimism could be a self-fulfilling prophecy.

Monolithic stimulus programs are a thing of the past

The Chinese government has recognised that its previous rounds of stimulus were excessive and lead to massive misallocations of capital that has resulted in excess capacity in numerous industries. As one local manager put it “China is no longer building ghost cities”. The lessons learned from these prior experiments means stimulus will be far more directed and, at this time, is going into rail, offshore drilling, renewable energy and anything to do with pollution abatement.

China is redefining its economic playbook to be less dependent on fixed asset investment. It is trying to transition to an economy that is more balanced between investments and domestic consumption while simultaneously dealing with the legacy of unproductive capacity and their attached loans. Balancing the need for short term growth while allowing the excesses to wash out of the system will take time and constant vigilance, but at this time the authorities seem to be doing a good job.

Lean manufacturing has arrived in China

In those meetings where we had a chance to visit the factory floor, it was insightful to see lean manufacturing being rolled out. China may have lost its low wage advantage but its move into advanced manufacturing will be a wake-up call for all European and US manufacturers and their workers. In some factories it was reported that the products being made in China exceeded the quality standards overseas and were amongst the most efficient factories anywhere (a US multinational with 100 manufacturing facilities globally said of the five that had achieved silver certification, three were in China!). The move to lean manufacturing is seeing a dramatic impact on productivity as Chinese divisions of multinationals are making the investment into advanced equipment and bringing even their most sophisticated components and products into the country. Granted that implementation had clearly achieved varying levels of success, it demonstrates yet again the competitive forces emerging from this country.

The corruption crackdown is real

The corruption crackdown is real and will have a long lasting impact on doing business in China. Everything from the way government tenders are awarded to ensuring pollution regulations are enforced has taken a massive step forward since the appointment of Premier Li Keqiang. In the short term, this has had a chilling impact on the economy as government related economic activity slowed down due to arrests and officials taking excessive care; however, as tendering activity has resumed we heard from two companies who won tenders despite not being the cheapest bid for the first time ever because their solution better matched the requirements. Merit based competition will favour foreign multinationals as they have a generational lead on salesmanship. The typical local competitor competes almost exclusively on price and when faced with annual national wage inflation of between 5-10%, they will struggle to maintain margins.

People are fed up with the pollution

It is no exaggeration that the pollution in China is bad. The air, soil and water is under such stress that we could finally be at that point the US and UK found themselves following the Cuyahoga River fires and London ‘pea soup’ disaster in the 1950s that a generation finally takes responsibility for the environment.

While pollution it is being addressed, a concern we have is the rate of improvement is insufficient to offset public unrest as even ‘clear’ days with PM readings in the low triple digits is still well above the World Health Organization’s recommended level of 25. Enforcement of industrial discharge standards and waste disposal is an area we hope will benefit from the government’s crackdown on corruption.

Conclusion – China looking more closely at itself and its peoples’ need

“Reflecting back on our trip, China continues to grow as an economic force but its new found focus on human capital.

Looking to its people’s needs/abilities will surely be its most powerful move yet because just imagine what its populous will achieve when they do not have to fight through choking smog and corrupt officials to earn a living,” said Mr Lim.

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“Not having Asian investments in their portfolio could become a medium- to long-term impediment to savings growth for Australian investors,” Mr Bryant said. 

“Many investors are too complacent about this shortfall, misleading themselves that their portfolio structure and overall investment strategy make up for any lack of Asian investment. 

“They have simply accepted a number of myths about investing in Asia – such as if they are invested in Australian companies, or if they have an international component in their portfolio through US or European equities, then they have exposure to Asia as these are major trading partners of the region. 

“Acceptance of such myths betray a lack of understanding verging on complacency that, if not addressed, could prove costly to their portfolios.” 

Mr Bryant said that while it is generally accepted that this is the Asian century for trade and power, investors haven’t accepted the sense of investing in the region to participate in its inevitable growth. 

“It makes particular sense for Australians to invest in the region because of our growing relationship with Asian countries,” he said. 

“Australia’s four biggest export markets are China, Japan, South Korea and India which, when combined, account for over 53 percent of our exports. Yet only 8.5 percent of our total international investments go to the region [1]. 

“On the other hand, our traditional trading partners, the US and UK, the powerhouses of the nineteenth and twentieth centuries, now only take 9.5 percent of our exports, yet account for 51 percent of our investments [2]. 

“This indicates a blinkered approach that does not recognise time has moved on,” Mr Bryant said. 

He said that he had also heard anecdotal evidence from investors showing that they simply don’t understand the investment realities of Asia. 

“For example, investors seem to think that markets in Asia are less secure than in developed countries because of corruption and weak regulation. 

“In believing this they are overlooking the scandals in Wall Street, London and other western financial and economic centres – including Australia with Storm Financial, Trio and the Australian Wheat Board (AWB) among others. 

“While Asian governance varies enormously country by country, main investment centres such as Japan, Singapore, Hong Kong and Korea, are highly efficient and transparent. 

“Nor do we recognise and give credit to the strength of Asian economies – today Asian central banks collectively hold about half the world’s foreign exchange reserves [3]. 

“Virtually all forecasts and predictions suggest Asia will continue to grow dramatically and, by the middle of this century, experts believe it will account for over half of all global trade. 

“Such evidence means that it simply doesn’t make sense for Australians not to be investing in a region with such strong attributes and outlook,” Mr Bryant said.

[1]   Emerging markets to account for 80% of future global growth: ex-IMF chief, English.news.cn, June 2011

[2]   HSBC survey (Nov 2011)

[3]   ‘Why Invest in Asian Credit?’ PIMCO, May 2012 

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Today, Asia contributes more to world GDP growth than the US and the EU do combined. The fundamentals of Asia are strong no matter how you look at them – one of the healthiest financial sectors in the world, overall gearing is low and balance sheets are strong for private and government sectors. Asian companies are more prudent in how they operate and their financial positions are sounder when compared with the days of the Asian financial crisis in 1998.

Opportunities in the region
The main reason I am optimistic about Asian equities is that there are some powerful economic and demographic forces that are driving growth in Asia.

On the economic side, when countries are poor, their savings rates are high. However once GDP per capita rises into the range between US$3,000 to US$10,000 savings rates decline and consumption becomes a larger portion of GDP.

In the past decade, for example, we saw China’s GDP grow from US$1,000 to US$4,000, or expand four times over. Over the same period, we saw car sales in China grow from one million a year to 17 million vehicles a year or by 17 times.

Many Asian economies such as China, Indonesia and Thailand have entered into this sweet spot for strong growth in consumption while other countries like the Philippines and India are not too far behind. This means that Asia is seeing strong domestic-driven growth and is less reliant on exports to developed markets.

In terms of favourable demographics, Asian economies are seeing a record number of people entering their peak earning years. At the same time baby boomers in the developed world are moving towards retirement, so they will need to tap into their savings to live and will consume less.

Put these two demographic shifts together and the world is about to see a massive shift in demand from the developed world to emerging markets especially those in Asia. On top of the demographic changes, there is the economic impetus of healthy salary increases coming through in Asia. This is leading to the emergence of a growing middle class in Asia – it’s expected to almost double to over a billion people in the next five years. China is expected to report the biggest absolute increase, while India and Indonesia will have strongest percentage growth.

Overall, Asia’s healthy financial system, robust domestic demand, low debt levels, high savings rates and the emergence of China as a global economic powerhouse will support a multi-year growth story for the region. It is for these reasons that I believe Asian markets have greater upside when global markets improve.
 
How are you playing Asia’s promising consumption theme?
In some cases I am investing in malls and department stores. In other cases, I look for brands that can take advantage of rising consumption. These can be local brands such as companies making shoes or fashion or those that own jewellery stores. There are some global brand names available too. Prada, for example, is now listed in Hong Kong and has got a healthy growth profile into China.

India is presenting attractive opportunities in this area. The country tends to be overshadowed by China, but it’s still expected to grow about 7% a year in coming years. While it’s not the 8%-plus of China, India is likely to soon surpass China in population. It’s a young market as far as the demographics go. The emerging middle class in India is something that will be of great interest to many companies in coming years. We are seeing demand changing already. Motorbikes were the prime mode of transport but you’re now seeing some of the new wealthy switch to cars and so on.

There are some fantastic management teams in charge of local companies that are taking advantage of the opportunities presented there. Housing Development Finance, for example, is a bank there that I’ve looked at for more than a decade and every year, it grows 20%. The bank provides mortgages and you can just imagine how the demand for better housing will rise as incomes increase. The bank is expanding with the market, delivering very consistent returns. It’s an efficient bank – it probably has the lowest costs in financial services on the planet.

What type of companies do you look for?
My objective is to invest in good quality companies at an attractive price. Typically, these companies have strong management teams and a well-defined growth profile within the region. I keep a lookout for companies that have the potential not only to be successful within their own country but also on a global scale. Some businesses have already managed to do that.

The Koreans in particular have been successful in developing global brands. Samsung Electronics is already the world’s number one producer of flat-panel TVs and smartphones and makes consumer products such as fridges and washing machines for Asian consumers. Similarly companies such as Hyundai Motor that have strong market share in emerging markets and growing market share in developed markets have the potential to deliver strong earnings growth even as Europe enters recession.

Korean cosmetics companies such as Amore Pacific and LG Household & Health Care are doing well in China. Korean brands are respected in China and they are likely to build on this achievement over the next five years.

How is Asia faring in its battle with inflation?
Except for China and India, both of which saw positive inflation surprises driven by food in March, inflation momentum for most in the region remains relatively benign. Recent slides in commodity prices, especially oil, provide a welcome relief. Moreover, headline inflation readings are now well below most central banks’ inflation targets. Lowering inflationary pressure should prompt further easing of monetary policy in Asia.

Are deep structural problems festering in China such as a property bubble?
It is a risk that all investors spend time analysing. One of the things that we take comfort in is that China’s been through a similar growth phase in the past decade and that there were times when office buildings were in oversupply and now they’re not. The risks that some of these issues will hamper the Chinese economy are low.

In China, houses are usually 100%-paid-for two years in advance – and with cash and not borrowed money – so the ripple effects of a collapse in property values are not that bad to the rest of the economy, nor the banking sector.

Does that mean investors should avoid property developers or banks that are lending into those sectors?
Prima facie that would be the case. And for most of last year I didn’t investing in Chinese banks or property developers. But the prices became so attractive that I’m have recently. Evergrande, a developer in China, was recently trading at a 76% discount to its net asset value and only four times earnings. That was too good to pass up as the company is doing projects that are pretty much 100% pre-sold. It’s just got to build these developments and as soon as it’s finished them the cash of buyers that’s been sitting there becomes income.

4 June 2012
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