Partners Desmond, Gordon and Hugo were all back in China in June, covering a total of eight cities between them in a comprehensive check-up on the economic recovery. The chance to get off the beaten track of Beijing, Shanghai and Shenzhen was also a welcome reminder of the depth of the opportunity in China, and the continued existence of pockets of genuine quality well below the radar of even local investors. The combination of very deep capital markets; intensely short-term focused local investors; and (in our view temporarily) absent foreign investors currently creates near-ideal conditions for active management.
As we expected, our visit did not suggest a broad-based, robust economic recovery. The slowdown remains persistent, but with regional and sectoral nuances. Central and Western cities such as Chengdu, Hefei and Changsha appeared relatively buoyant, with still-growing populations as workers flock towards some of the ‘hard tech’ operators present in these cities. On the other hand, the prognosis in ‘rust belt’ areas still seems grim, as well as those most dependent on the export market. Across our two most recent trips, this perhaps applies best to Dongguan and Xiamen respectively.
When it comes to the overall economy, we are under no illusions that overall GDP growth will ever return to the dizzying heights of the last decade. But given that this was a decade where China poured the same amount of concrete as the US did in the entire 20th century, perhaps this makes sense.
Having come to represent 40% of China’s total output, the property sector’s days as the principal driving force of economic growth are certainly numbered. If property prices are allowed to correct, the drag on household ‘wealth effect’ and on fixed capital investment will be significant. Our base case expectation is that some measure of short-term stimulus is used to ‘buy time’, on the path to realising the government’s vision of a (somewhat less powerful) growth engine powered by new industries and domestic consumption.
With foreign sentiment at rock bottom, many are tempted by a comparison with Japan in 1989, noting a similar case of massive capital misallocation, overcapacity and an ageing population. However, even if we accept that China is entering a similar period of lower growth and deflation, the key difference is that equities are, if anything, in ‘anti-bubble’ territory, with valuations as cheap as they have been (assessed as MSCI China P/E) since 2015. And in a two-speed new reality, there are still pockets of the economy which are growing like wildfire. The luxury of a large market like China is that even niche segments can represent enormous profit pools.
Exposure to GDP-defying structural growth trends is freely available to us as public investors. You may already recognise our alignment with, for example, the ballooning healthcare needs of an ageing population; with an increased focus on health and wellness; with the growing trend of national pride/localisation (as well as premiumisation) in consumption habits. Our recent travels have reaffirmed the tailwinds behind domestic substitution, and behind ‘little giants’ focused on building world class expertise in a specific niche, comparable to the German ‘Mittelstand’ companies.
Indeed, to our minds it is overlooked amid the hype around ‘China +1’ and ‘friendshoring’ the degree to which China has established likely unassailable global leadership in critical industries of the future. Its electric vehicle segment, now becoming totally dominant over ICE vehicles domestically, is likely to destroy huge swathes of the German and Japanese car industries as the focus of the new Chinese giants shifts towards exports. The country already dominates the upstream renewables space to the extent that Western countries are forced to choose either cheap and rapid decarbonisation or promotion of domestic industry, a politically impossible dilemma. We believe medical devices business Mindray represents a prime example of how ‘China quality’ has evolved from being a mildly derogatory descriptor to a badge of honour. In this sense, China is beginning to emulate the path (from cheap manufacturer to technology leader) of its much smaller neighbour South Korea, albeit on a vastly greater scale.
Our view on the geopolitical risk of investing in China has not substantially changed – we believe a full-on confrontation with Taiwan (and therefore the US) is highly unlikely, and we believe Xi Jinping when he says he values the contribution and continued presence of foreign investors. We were also reminded on our latest trip that local management teams also greatly value the input of international shareholders.
But even if we accept a continued escalation of tension between China and the US and an economic decoupling, it is possible to de-risk this to an extent by focusing purely on domestic Chinese demand. Companies that do this are now available at the discount which has been applied indiscriminately across the whole market. Unlike private companies, they are also disposable at the drop of a hat on hyper-liquid local exchanges. Our June travels helped us identify promising leads in B2B foods (ingredients), local snacks and in healthcare. None of these will be overly dependent on either a geopolitical rapprochement, nor on favourable domestic policy, to greatly reward the patience of their investors over the coming years.
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