As its lengthy process of reform begins to payoff, even in its vast hinterland, China is becoming an increasingly compelling investment case. Chris Ruffle of Martin Currie reports
China’s potential is vast and the opportunity it offers immense. The country’s 1.2bn people are witnessing growth in GDP of 7% a year, and its internal politics are more stable than many believe. Deng Xiaoping started the process of reform in 1978, opening up China’s market. Now the team of President Jiang Zemin and Premier Li Peng is continuing what he began.
Reform, not reaction, has characterised China’s recent politics. The leaders bark intermittently at Taiwan across the Taiwan Straits, but do not bite. Meanwhile, they were strong enough to insist on a tough
austerity programme and to see it through. That is now working, and deregulation
goes on.
More and more of China’s citizens are demanding improved standards of living. That, inevitably, brings them into contact with the wider world.
The speed at which China is changing is nowhere more evident than in Shanghai. The average income of the city’s 13m people is now more than four times that of the rest of China.
Shanghai, though, is but one part of the picture. There are signs that the growth we are seeing there is spreading to China’s vast hinterland. By favouring the ‘special
economic zones’ (SEZs) like Shanghai and Shenzhen, the government intended to attract foreign technology and capital. Their hope was that this investment would filter out to the interior. Unfortunately, it has not, and there are now large disparities in wealth between the SEZs and the
hinterland. In response, the government is in the process of removing tax concessions on the seaboard. At the same time, it has
just increased them for foreigners looking to invest in China’s central or western regions.
But if there are good investments to be made in China, doing so is not easy. The stockmarket is still immature and fragmented. Chinese H-shares are traded in Hong Kong. The A-shares, traded in China, are for domestic Chinese only. There are B-shares for foreigners, but they are traded almost as little as the N-shares listed in New York. In any case, at US$11bn for H- and B-shares, the combined market capitalisation is tiny.
That said, we are unrepentant long-term bulls on China. The exports are picking up. This view is based not only on notoriously unreliable official statistics (August exports +18% year-on-year, monthly trade surplus $4.9bn), every exporter I met in China in September told me so. This was ascribed to a pick-up in the Japanese economy, a strengthening in rival Asian currencies and improved VAT rebates.
Whatever the reasons, this trend should have relieved foreign investors’ latest bout of nerves about whether or not the renminbi will be forced to devalue. Perversely, though, Chinese markets have generally declined from their peaks in early July. The H-share index is down 16%, and the red chip index 23%. After its spectacular jump in June, the A-share index has traded sideways.
The main problem is excess equity supply. After labouring manfully over the summer, Hong Kong’s investment bankers are now keen to sell the fruits of their endeavours to foreign investors before the window of opportunity for fund raising is closed by year 2000 issues or the first failed deal. The centrepiece of this campaign looks likely to be the $2bn issue for China National Offshore Oil Company.
Domestic investors have also been faced with huge IPOs, most recently those of Capital Steel and Pudong Development Bank. The government keeps a tight grip on supply, opening the faucets when they think they can get some State Owned Enterprise (SOE) stock away, and, when the market retreats, closing the tap or attempting to stimulate new demand for stock. The latest wheeze, which will inevitably end in tears, is allowing SOEs to participate in IPOs as ‘strategic’ investors (‘strategic’ equals six months). Local investors are worried by the implications of new proposals on SOE reform, which include reducing state holdings in SOEs to 30% and using the proceeds to fund the social security system.
One encouraging development is official approval of incentives for management based on company performance. Our
company visits have thrown up a variety of structures for these schemes – one software company uses its trade union as a share option scheme! A live example of the effect of such incentives is the roadshow for TCL, the TV maker, whose enthusiastic senior staff receive shares from the state whenever they achieve a return-on-equity of over 10%.
But which stocks should the prudent investor buy? Keynes once said: “The difficulty lies not in the new ideas, but in escaping from the old ones.” We have been escaping from a number of old ideas (lesson: companies in cyclical industries cannot escape the cycle, however good the management). We have concentrated on the technology sector, which we think offers excellent value.
Consider, for example, ‘fulfilment
service’ provider Jackin. The company makes floppy disks, compact disks and DVDs. It adds value through ‘fulfilment services’ which involve replicating software onto disks.
Jackin’s aim is produce first release software titles, which carry higher margins. Jackin controls all its production and printing work and believes that it has benefited from its tight security procedures. Business has been helped by the crackdown on smuggling.
In short, Jackin is a value-added technology company trading on a low rating (we estimate seven times prospective earnings) in relation to its good growth prospects. It is just the sort of company that makes China so compelling an investment case. China, then, merits its place within a considered asset allocation. The risk is high, certainly. But so too are the rewards.
Chris Ruffle is a director of Martin Currie Investment Management and manager of the China Heartland Fund