Julien Moulin – An Investment Journey to China
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By Julien Moulin and Frederic Durr
While working in London for two of the world’s largest asset management companies, we couldn’t help but hear a lot of talk about China. The funny thing was that people from our investment teams kept talking about China as the “place to be”, but no one had actually found a good way to invest directly in the country and make money out of it. Our previous trips to Asia and China had indeed encouraged us to keep a close eye on the development of the country, and in early 2004 we decided to take the plunge and be part of China’s rebirth. We took Dr Faber’s advice: “If I were 26 again, I would move to Shanghai, Ho Chi Minh, Yangon, or Ulan Bator. I would learn the local language to perfection, live with seven concubines, and start a business.”
We have now been living in Shanghai for more than a year, have started to manage money for foreign investors, are slowly learning the language, and are still struggling to find the seven concubines…. Nevertheless, the past year has been an incredible adventure. We have learned a lot about the capitalist soul of the Chinese and the importance of negotiation, whether one buys an insignificant object or makes an important business transaction. We have got to know of their short-term mentality, which is quite understandable given their history over the past 50 years (ask 100 Chinese people whether they prefer to get $100 now or $1,000 tomorrow, and you are likely to get only one answer … $100!), and we were shocked to learn the surname Shanghai girls give to foreign guys: “Fei ji piao” (plane ticket). We have also travelled extensively throughout the country, from east to west and north to south, visiting factories, production sites, warehouses, government officials, ski resorts, tea plantations and, indeed, karaoke clubs (called “KTV” in China) — informal places where you can sometimes get the most valuable business information. In the past few months, we have put our thoughts and what we have learned and experienced together, and started investing in this market and making money out of it.
It is common knowledge that China is the fastest-growing major economy in the world. It has been growing at more than 9% per annum this past decade. (However, looking at electricity consumption, the GDP growth seems higher than this.) On a PPP basis, China is already the second-largest economy in the world and is responsible for about a third of global growth. We are convinced that the country will regain its place as the largest economy in the world, whether it takes 20, 30, or 50 years. However, we believe that China’s ascension to the status of the world’s biggest economy won’t happen in a straight line. Most of the growth has been due to fixed asset investments, which stand at a record-high 50% of GDP. Therefore, on the one hand, China has the second-biggest road network in the world behind the US. Roads and airports are of top quality, even in such remote areas as Yunnan and Inner Mongolia. And these infrastructure investments will continue, even if they are in slightly different forms. For instance, the metro in Shanghai, which is far better than the London Underground for 1/15th of the price, currently runs on three lines and will have 11 lines by 2010. On the other hand, this investment- and export-led growth isn’t sustainable, as shown in Table 3 (courtesy of CSFB).
Almost the entire infrastructure has been financed by complacent banks, resulting in a very weak banking system crippled with bad loans.
We feel that another risk is the lack, and rising cost, of commodities that China needs in order to fuel its growth — particularly energy, where the country has to compete with its Asian neighbours, Japan, and now India. This is likely to result in geopolitical tensions in the future.
Finally, wealth inequalities between the 900 million rural dwellers and the 400 million urban residents are growing. As clever as Chinese statesmen may be, managing such a rise is extremely difficult and there will be some setbacks along the way, similar to what has happened in major economies such as the UK and the US. The ageing population, the growing trade deficit, and the significant unemployment rate in the countryside will also probably at some point weigh on the development of China.
On the Renminbi issue, a recent Big Mac survey in The Economist shows the RMB undervalued by 59% against the US dollar. We don’t know when, and by how much more, the RMB will be revalued. It’s not our job to speculate, as investment banks do on a weekly basis, on what day this will occur; however, we believe that the US insistence is counter- productive, as China will never want to appear to bow to foreign pressure, particularly from the US. And even if China were to revalue by 50%, it would still be competitive against the US and the trade deficit would be even bigger, as the man responsible for the weak US dollar, Alan Greenspan, explained recently to US senators. However, we believe that allowing currencies to float and focusing on domestic consumption are compulsory steps if China and Asia wish to rise to prosperity and decouple from the US.
On a sector basis, we feel that some manufacturing industries are already non-profitable, mainly because of wild investments and intense price competition. This is especially true in businesses where companies don’t have any pricing power, where labour costs are small as a proportion of total costs, and where raw materials over which companies have very little influence represent the bulk of these costs. We expect soon to start seeing companies going out of business. (Fertiliser companies are one example.)
Real estate, especially in a few specific locations, is another sector where we are seeing significant price pressure at the moment. In Shanghai, prices have risen dramatically. In central Shanghai, top-end lane houses can go for as much as RMB40,000 to RMB50,000 per square metre (c. Euro 5,000 or c. US$6,000/sqm). An old house with a garden can go for as much as RMB100,000/sqm (c. Euro 10,000 or c. US$12,000 /sqm). Funds have been set up in London and Singapore to invest only in this market. The luxury property agent whose office is next to ours told us of a foreign investor who set up a fund in Europe to invest in old houses in the French Concession in Shanghai. He arrived two months ago, was in town for three days, and bought five houses for his fund during his stay. Since then, prices have come down slightly following recent government measures aimed at cooling off speculation in large cities such as Shanghai and Beijing. In the short term, there is a risk that the environment could deteriorate further as local people are becoming more concerned about their real estate investments and speculators may start to exit the market, especially if local governments manage to enforce the new rules.
However, we still think that, in the longer term, investing even at these prices is better than buying real estate in New York or London. The emergence of Shanghai as a major financial centre should push real estate prices higher. The financial sector has almost no presence in Shanghai at present, as all foreign banks are still concentrated in Hong Kong, but we believe that this will change in the next five to ten years.
It is also worth keeping in mind the macro picture: the government estimates that somewhere between 300 and 500 million people from the countryside will migrate to the cities by 2020, the biggest migration in history. (To put this figure in perspective, accommodating this population influx will be roughly equivalent to building two metropolises the size of New York City every year for the next 15 years!) This gives us confidence in the long-term picture for real estate and we would be buyers were the market to tumble more seriously.
On the positive side, one key phenomenon that is occurring at the moment is the emergence of a significant middle class.
Saving rates are as high as 45%, and since a large number of people still do business in cash only, there is a lot of non-recorded money. As soon as revenues reach a certain level, consumption explodes. When we ask our Chinese friends what they do during weekends, the answer is always: “Go shopping, watch DVDs, and rest.” The current generation of 20–30-year-olds is the “New China” generation and, as such, the first one to learn the meaning of leisure. They are still very mindful of Deng Xiaoping’s slogan of the 1980s — “To get rich is glorious” — and we are often surprised by how much they like to show off the material goods they can afford to purchase. They like to wear foreign designer clothes and expensive gold watches, and to drive the latest foreign cars. The young generation is different from their parents and behaves more like Westerners. This emergence of a leisure culture that goes with the newborn middle class gives us strong confidence in businesses such as retailers of consumer goods and airports.
This brings us to look at the domestic stock markets, which reached an eight-year low on June 3 amid a chronic lack of confidence from domestic investors and an ongoing overhang risk from non- tradable share disposal. We believe that this is only part of the problem. The domestic market is still definitely not cheap, especially compared to other emerging markets and, most notably, Hong Kong. Companies also are of questionable quality. We spent a lot of time looking at the 1,300 companies listed on the domestic markets, thinking at first that the smaller A-share listed companies would be hidden gems. On the contrary, we found more value in the mid-sized and large state-owned enterprises. The main issue with companies is diversification. Unfortunately, it is very common to find companies that are involved in three or four different businesses, attracted by their better margins, but which typically have no synergy between them. And the sector that most companies have entered in the last three years is property, reinforcing our current cautious stance towards the sector. Why? Property prices have been up over the last few years; borrowing money for property developments was easier than for industrial projects, and it was more profitable, since the leverage and returns were often better. Those days might be coming to an end.
When we carried out in-depth research on domestic companies, we were surprised by the very large number of companies whose sales were up but whose profits were down over the last three to five years. The reasons are: (1) the cost structure, which is highly dependent on input costs (that is, raw materials, where we expect prices to continue to be strong in the coming years) over which the company has no control; (2) fierce competition; and (3) cultural reasons: once the company is listed, the founders often consider the business no longer to be theirs and may take as much money as possible out of the company.
Finally, corruption (from the top management down to the humble company driver) and the approach taken by local investors to investing remain major obstacles in developing China’s financial markets.
We had an interesting meeting with some domestic institutional and private investors in Harbin in January (when it was –25 degrees Celsius) who told us that it wasn’t possible to make money in China using fundamental analysis and that the only way was insider information, which they all had. We ended the meeting by asking them how they were performing, and they were all down over the last five years, even when compared with their own benchmarks.
Nevertheless, there are some very good businesses in China, but they are rarer — and harder to find — than in other more transparent markets. There are a few points that make us feel positive about this market. First, valuations are becoming more reasonable and we are starting to see some value in the market. The FTSE Xinhua A 600 universe is now down to less than 15x 2005 earnings.
We think there is some upside potential, with a saving rate at 45% representing US$1,500 billion compared to US$380 billion for the total A-share market. Most of this saving pocket is in cash and real estate. Every person you talk to (from taxi drivers to CEOs of listed companies) is negative about the market. Over the past few years, they have all lost money. Should property prices come down, there might be some asset reallocation to the market, especially because Chinese people love to gamble and more than 70 million existing personal brokerage accounts in China are waiting to jump in again. So, as soon as the confidence of local investors is restored, we expect “chaogu” (to speculate) to be back in fashion and the market to rally again.
The government has finally realised that in order to keep GDP growth at the high single-digit rate, China needs clean and strong financial markets. In doing so, private firms — which are the new growth driver of the country — can eventually access domestic savings to finance their development.
For the first time, we feel, the government is determined to solve the problem with sensible solutions involving large companies and including more decent compensation for minority shareholders on the non- tradable share issue. The government is also studying the possibility of allowing companies to buy back shares, and there is talk of launching warrants and other security derivatives as well as a new index with the 300 best companies. All these initiatives are very positive and confirm our view that market reform is a top priority for the government.
Eventually, in line with the WTO agreement, China will progressively open its financial market to foreign investors. Accordingly, asset allocation of foreign asset management companies and investors will result in a flow of liquidity to the market.
Our approach to investing is fundamental analysis. We invest for the long term in cheap companies that we understand. The large investment banks currently have a very limited number of analysts researching Chinese equities. (Out of the 1,300 or so companies listed on the A-share market, maybe 60 to 70 have got real coverage.) There are still a very limited number of foreign asset managers based in mainland China and the market is certainly not mature. Therefore, we think it is a market full of opportunities for stock picking and have built quite a concentrated portfolio to take advantage of this situation. Being based in Shanghai gives us a considerable edge as: (1) living with and among the Chinese gives us a pretty clear understanding of the Chinese way of thinking and behaving; (2) it allows us to build a strong network of contacts in various industries, which is key when cross- checking the information we get from management and people from the operations; (3) it is very convenient to go and visit companies; (4) it gives us more credibility and better access to local companies; and (5) it allows us to improve our Mandarin on a daily basis.
We are quite conservative in the way we look at investing. Our idea is to identify cheap companies that have a simple and solid business plan with strong barriers to entry and possibly a competitive advantage in sectors with good fundamentals. Our major themes are agriculture, middle- class growth, and natural monopolies, although we have more of a bottom- up approach to investing.
As an example, one of our main exposures is in agriculture. The background is that farmers’ wellbeing is one of the main goals of the Chinese Communist Party. With about 1.9 million mu (or 125,000 hectares; 15 mu equals 1 hectare) suitable for cultivation, China doesn’t have enough land for its farmers. Today, according to estimates given by three of the largest companies in this sector, 46% of farmers cultivate less than 1 mu of land. The sector is therefore extremely fragmented, with the largest company representing less than 1% market share.
We believe that agriculture is one of the very few sectors where there is little evidence of price control and the government is happy to allow inflation to rise.
The latest CPI figures are consistent with what we see on the markets and what companies are telling us. CPI was up 1.8% yoy, food items up 2.8%, and vegetable prices up 10.1%.
We continue to believe that prices of agricultural goods, particularly grains, are on the rise, as total land size is diminishing along with the urbanisation of the country, yield improvement has peaked, and increasing pollution and climate changes are contributing to a decrease in supply. Some of those soft commodities haven’t behaved as well as the industrial commodities, and we wouldn’t be surprised if they were the next ones to experience a strong bull market. The very few large companies in this sector receive generous subsidies from local and central governments, they don’t have to pay taxes, and they are extremely competitive compared to the rest of the world, with prices at only a fraction of European, Japanese, and US prices on some products.
One of our biggest holdings is a major producer of fruits and vegetables in China. Their business model is as follows: they purchase 1 mu of land for 30 years, costing RMB10,000, but they only have to pay one-third upfront. The total infrastructure costs, such as irrigation, are another RMB18,000 to RMB20,000. It then takes six months to begin production and a year to reach full production. The revenues per mu are RMB13,000 to RMB14,000, and the operating cash flow margin is 45%, giving a very decent 30% return on capex. Recently, the company has borrowed money in US dollars, increasing its leverage to an eventual RMB appreciation. (The company sells in the single-digit P/E with a growth rate above 15% a year.)
To date, a smart way to take advantage of China’s development has been to invest in other markets benefiting from its growth, thus avoiding its risks. This approach may still be very attractive and is the reason why we are open to the possibility of investing in H shares and Taiwan, where a substantial part of our portfolio is currently invested.
Nevertheless, we believe that every investor should have a long- term allocation to China in its portfolio. (There will be some setbacks along the way.) While we are not market timers, we strongly believe that not investing in China now would be like choosing not to invest in the US over the past century.