by Ric Palombi, CFA & Edward Friedman, CFA, MBA
China’s Shanghai Composite Index was down 32 per cent (from June 12 to July 8) in the past month, carving an estimated $3 trillion off the market capitalization.
The market shakeout began when the People’s Bank of China (PBoC) tightened credit (in the form of margin lending) as part of a regulatory shift in order to increase oversight and control the risk primarily caused by mainland Chinese investors, who were using leverage to purchase predominately small-cap tech stocks. These stocks had seen enormous gains, with very little earnings to back them up. Despite the stock market volatility, our thesis on China seeking to move the economy from growth driven by infrastructure and exports to a greater reliance on consumer spending to meet ambitious GDP growth targets remains intact. Building dams and coal power plants and exporting electronics and clothing are no longer sufficient to propel continued growth of an enormous economy. To meet its target of 7 per cent real GDP growth, China is aiming to rebalance and transition to a more consumer-driven economy.
The margin increase and subsequent liquidity crunch caught huge numbers of leveraged retail investors offside as their portfolio values declined. As brokerages called on investors to cover their margins, those investors began selling stocks to meet the call. The government reacted by suspending trading on large numbers of stocks and the resulting liquidity crisis forced many investors to sell stocks on the Hong Kong market to cover margins on the Shanghai market, thereby spreading the contagion. The sell-off was further accelerated when Western institutional investors, alarmed by simultaneous uncertainties in China and Greece, also began selling Chinese holdings.
The Chinese government intervened and, along with the PBoC and the Chinese Securities Finance Corporation, introduced policy support in the A-share market to buy blue-chip stocks. The list was then expanded to include small/mid cap stocks and the amount pledged to stock market stabilization was increased to CNY3T in liquidity support. In addition, the PBoC instituted a wider spectrum of collateral which was allowed to be pledged against margin accounts. Since mid-July, cooler heads have seemed to prevail and market has shown signs of stabilizing.
Rather than attempting to manage volatility, we believe in the fundamentals of buying strong companies where we understand their key drivers and catalysts, with compelling risk/reward characteristics, priced below our intrinsic value, and where we believe we have an edge. Our strategy dictates buying companies that offer:
- stock prices below our estimates of intrinsic value (as an overriding first principle);
- sustainable competitive advantages, potentially including significant barriers to entry for competitors;
- stable or growing returns on investment and returns on capital exceeding their costs of equity;
- free cash flows that are expected to grow over the medium term;
- balance sheets appropriate to the business model; and,
- proven management teams.
In the midst of panic selling, we saw significant opportunities to acquire additional holdings in strong Chinese companies at deeply discounted prices. Acting on the first principle of our investment strategy, we took the opportunity to acquire quality companies whose market prices had declined well below our estimates of intrinsic value.
McLean & Partners has, for several years, maintained a measured exposure to Chinese markets, based on the potential of the second largest economy in the world transitioning from a one dimensional export led economy to an economy which is better balanced and more domestically demand driven. Specifically, we’ve invested in those sectors deemed to benefit most from government policy and reforms, namely consumer discretion/staples, technology and financials. Below we highlight three companies in each of the sectors:
China Life is the largest provider of life insurance in China, and also provides group life insurance, accident insurance, and specific health insurance plans. We purchased China Life for the following reasons:
- China Life has the largest agent network in the country and it is the only insurance company that has a license to sell insurance in all provinces.
- Life insurance is underpenetrated in China. We believe that in the coming years, insurance penetration will increase, and beyond 2020, the increase will accelerate. The reasons for this are:
- China declared that it would reform the Hukou system, an urban population registration system, to make it easier for people to move from the village to the city. City dwellers rely more on insurance for their protection needs as opposed to villagers who rely more on family to care for them in case of emergency.
- China declared that it wishes to double its GDP per capita by 2020 compared to 2010. This implies GDP per capital of $9,000 by 2020. Research shows that as GDP per capita increases, consumers are more inclined to buy insurance. Beyond a certain threshold, $10,000 according to that research, the growth intensifies.
- Following the National Congress in 2013, China decided to give markets a bigger role in allocating capital and allow interest rates to better reflect supply and demand dynamics in the treasury market. We believe that the result will be higher interest rates as they were held artificially low for long. Due to asset and liabilities mismatch, insurance companies benefit from higher interest rates. Even though 10 year rates returned to their pre-congress levels, we believe that they are at the bottom as these rates are influenced by inflation and economic growth. With growth at 7 per cent and inflation at 1.4 per cent, we believe that inflation is more likely to rise than decelerate further as the impact of low oil and food prices recedes.
- China Life has the largest exposure to the A-share market. Due to the sharp decline in the A-share market in recent months, the A-shares now trade at a forward P/E of 13.5x, 9 per cent discount compared to its average P/E over the last 10 years. We believe that the Chinese government is taking the right course of action to stem the declines and we believe that based on the fundamentals of the Chinese economy, the market is undervalued at current levels.
Tencent is one of the largest internet companies in China. The company provides online advertising, online games, instant messaging, e-commerce and other internet value-added services. Over the past five years, Tencent grew its revenues by an annual average of 43 per cent while its net income increased by an annual average of 36 per cent.
We bought Tencent’s shares several years ago, expecting that the Chinese internet sector would experience strong growth as internet connectivity in China increased. From 2009 to 2014, internet users in China expanded by 64 per cent from 390.5 million users to 641.6 million. We also purchased Tencent due to its undisputed market leading position.
We believe that internet usage in China will continue growing fast as companies expand their services online from advanced search, to video streaming, and to better and more exciting games.
Hengan is one of the leading manufacturers in China of hygiene products. The company’s products include sanitary napkins, disposable diapers, and tissue papers. The company also produces food and snack products.
Hengan is impacted by several trends:
- In China’s 2013 national congress, China somewhat alleviated its one-child policy, a policy that has been in place since 1980. Under the old policy, couples were allowed to have two children if both parents were single children themselves. Under the new policy, only one parent has to be a single child to be eligible to have two children. This change is expected to impact 11 million couples. We expect diaper sales to increase as aresult of this change; however, the higher birth rate has not yet materialised as prior to having a second child, eligible families have to get approval for having a second child and the quantity of families that applied is below the government’s expectations. Nonetheless, since social changes are slow to materialize, we still believe that diaper sales will expand above trend.
- Penetration of sanitary napkins and tissues is still relatively low. As China strives to increase its GDP per capita and personal income, demand for these products is expected to increase as it is directly related to higher standard of living.
Over the last five years, Hengan increased its sales byan annual average of 17 per cent and its net income by 13 per cent. The stock trades at a multiple of 24x, which seems high. However, considering that Hengan’s return on equity is 22.7 per cent, we believe that this multiple is justified.
We continue to monitor the developments in the Chinese markets, and are taking advantage of the emotional selling by purchasing Chinese companies that meet our six-step investment process.
If you have questions on the developments of the Chinese markets and how this may impact you, contact us at (403) 234-0005 or [email protected]