By Simon Edelsten
Last year we suggested that China’s growth was slowing, and that the ASEAN countries offered better prospects. We have not changed our view on the demographic differences. What has changed is that we feel the market may now be overpricing the growth of ASEAN; and be taking too gloomy a view of investing in China. That means opportunity for those, like us, of a patient investing disposition.
It is now 10 years since I first visited China with a view to investment. At my previous firm we participated substantially in the early floatation’s of large financial companies: Bank of Communications, PICC, Bank of China, ICBC. International investors fell into opposing camps at the time. Broadly speaking, they have remained entrenched since. The state had taken over large chunks of bad loans, arguing that they were for social projects, and had injected fresh capital into the banks ahead of floatation. Some believed these bad loans had just come from bad lending disciplines. Thus were established the two views: one that believes nothing and waits for the apocalypse; and the other that applies normal investment criteria (with appropriate adjustments applicable to any emerging market). Readers may not be surprised that we fall into the latter camp. This has still left investing in China challenging, but profitable.
The Shanghai market fell as much as most other global markets in 2008. In our view this was due to over-exuberant ratings in 2007: banks on 5x book etc. It was a shame that the fall from ‘bubble valuations’ eliminated the diversification benefit that investing in this economy should have brought that year. The smart investor would have bought at IPO and sold in 2007 when it reached 4.5x. Today that ratio is close to 1x. Those waiting for the apocalypse overlooked this inconvenient evidence of resilience and pointed at the housing market as a time bomb. China has indeed seen speculative development funded by off-balance sheet funding. Those who have spent time in Hong Kong are generally aware that the Chinese like a punt; and if there isn’t a horse running, property will do. We regard the authorities’ clampdown on speculation as being well advised and look forward to hearing more tales of speculative property schemes delivering losses.
There is also a lack of confidence in China’s official statistics and financial reporting. State-owned enterprises generally have provided enough data for us to do our diligence; and while the banks use local definitions of what is or isn’t a nonperforming loan (NPL), the trend data we observe seems to have fitted the facts over time. The largest accounting and governance issues seem to have been with ‘entrepreneurial’ businesses, often quoted on overseas stock exchanges. In these cases shareholders do not own the Chinese company, but merely have rights over its economic rent. We have taken the stance that such structures are unusually open to abuse, and so we have preferred to miss out rather than take the governance risk. Many US-based investors have taken the opposite view and avoid investing in the state-owned entities and Hong Kong-listed stocks which we prefer. So far I think we have won that argument.
All this said, there are of course issues which should not be ignored. Capital does not move freely in China and the economy is prone to areas of oversupply and scarcity. Meeting growth in demand for electricity alongside increased car ownership has led to appalling pollution, especially in Beijing. The ageing population combined with the one child policy gives the country a rapidly rising dependency ratio. However, the economy is still growing rapidly (if only around 7% rather than 10%) and inflation is currently subdued. Our approach has been to invest as if China were a fairly developed country.
Simon Edelsten is co-manager, Artemis Global Select Fund
Comments