Q: There has been continued concern at the scale of bank lending in China and the impact this is having on inflation, particularly in the stock and property markets. How much does this factor into your equity strategy?
A: First of all, we are a long-term investor so we don’t look at short-term volatility. Secondly, we do bottom-up stock picking. While macro factors are important to us, at the end of the day it’s a stock level whether we buy or sell. Having said that, a couple of quarters ago we were concerned about inflation picking up in China and the withdrawal of government support, and so we have been very cautious toward the equity markets. Longer term, we are still very optimistic, although there are certain parts of the market we try to avoid. For instance, my funds have no exposure toward Chinese real estate developers.
Q: Why is that?
A: I am always thinking that the property prices in China are too high and, while in the past I have been proven wrong because prices have gone higher, overall we think the property developers are making profits that won’t be sustainable. Fundamentally, I just disagree with how people value these developers. A better way to play China GDP growth is through infrastructure, power companies. These companies tend to be more state-owned and stable, unlike property developers whose business model can be very volatile.
Q: But the long-term view is that real estate market will continue to grow, driven by continued urbanization and existing city dwellers upgrading to better properties…
A: That is one of the main reasons I have been a long-term bull on China, and it is why we are playing on the infrastructure side. As urbanization continues, China has to put in more infrastructure. The power sector is one sector that we have paid quite a bit of attention to, looking at the upstream suppliers to the power sector as well, like coal producers and equipment manufacturers. Another important consideration is that we are a global investor – we don’t just look at big companies within China. Once we get into the smaller developers, their market capitalization, business model, volatility and liquidity all become concerns.
Q: You two largest China holdings are China Resources Power (0836.HK) and Shanghai Electric (2727.HK, 601727.SH), which would appear to confirm the strategy you have just illustrated. What drew you to these companies in particular?
A: It is a proxy to the power sector but what I also like about China Resources – and the China Resources Group – is that the management is very aggressive, it’s pro-market. In the past, China Resources Power’s earnings were dependent on coal prices, but the last couple of years they have acquired a number of coal mines themselves. This means they can hedge their coal prices. Going forward, we expect the company to be a lot more stable. As far as Shanghai Electric is concerned, we think this company has the potential to become China’s Siemens. Their main business is supplying power generation equipment to the power sector, but they have other areas as well, from subways to elevators. The key is that the stock price is very competitive globally and the quality of the products has increased dramatically. So we have two angles. The first is that Shanghai Electric is an indirect play to the Chinese power sector and GDP growth. The second is the expectation that Chinese exporters will be able to sell goods and services at higher prices because they will have more value-added content compared with 15 years ago.
Q: China’s independent power producers (IPPs) are hamstrung by liberated coal prices and controlled electricity prices. There has been talk about pricing reform, but we haven’t seen a great deal of progress. How important is this to China Resources Power?
A: If you take a mid- to long-term view, power consumption will continue to grow. Typically, power consumption grows at 120% of GDP growth so if China can continue to grow at around 10%, then power consumption will grow at 12%. There is that fundamental demand for more power. Pricing is a very sensitive issue because it would create pressure on the inflation side. But mid- to long-term the government has no choice but to increase power prices.
Q: Environment-related energy companies – specifically those focusing on renewable energy – have become popular in terms of China investment. How does this factor into your thinking?
A: There are a couple of issues there. One is that a lot of the companies in this space depend on government subsidies and it’s really hard to invest in areas where you have difficulty predicting profitability. Another issue, certainly for us, is that companies in this space tend to be very small in terms of market cap and liquidity. We watch this area closely, particularly in China because the country will run out of energy supply options in the not so distant future, but currently the companies we can buy are limited.
Q: The IPPs are already involved in wind power – we have seen Longyuan Power (0916.HK), a subsidiary of Guodian Power Development, list in Hong Kong and there is talk of similar deals in the pipeline. Would you consider these companies as potential targets?
A: We were an early investor in [Danish firm] Vestas (VWS.OMX), a wind turbine producer and made a lot of money about 10 years ago. Back then we were paying just 10-15 times earnings, but now when we see these Chinese wind companies list, the multiple is like 40-50 times earnings. In our mind, that’s too expensive.
Q: There are very few China consumer plays in your holdings. Is this another valuation issue?
A: It depends on how you define consumer plays. I would say China Mobile (0941.HK, CHL.NYSE) is a consumer play because, as people get wealthier, they spend more on mobile services. The good thing about that one is that all the revenue is in renminbi so you have a currency play as well. In terms of other consumer names, we have looked at some sportswear firms and so on, but again, these companies tend to be too small for us.
Q: Your fund is a global fund and you look at opportunities in China in comparison to other areas. How do you assess China’s potential in comparison to, for example, other BRIC nations?
A: I am very optimistic on China – and the fund is overweighted on China compared to the index. The index is about 2% and we have anything from 8-10%. We are not an index investor – indexes are a lagging indicator rather than a leading indicator. We look at China more in the context of its share of global trade, its share of global GDP. As for other BRIC nations, our exposure tends to be on the commodities side and they are all interconnected. If China continues to do well then commodities will continue to do well.
Q: To what extent is all this a bet on China?
A: Exactly. We were probably the largest investor in [mining company] Vale (VALE.NYSE) in Brazil in 2000-2001 and were able to buy it at just four times earnings. We had labeled it as a China play long before anyone else did.
Q: Viewed in this way, is your exposure to China actually far greater than the weightings might suggest?
A: Yes. Back in early 2000 we did an internal study of all our holdings globally and assessed their China exposure – what it meant in terms of incremental revenues. We did that analysis sector by sector, company by company and found that quite a number of companies had quite meaningful exposure to China. Take Tohatsu, the Japanese heavy equipment manufacturer, for example: almost 100% of its incremental revenue came from China.
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