The extent to which China is now driving global economic grow th cannot be understated. Goldman Sachs predicts China will contribute around USD7.5 trillion of new growth to the world economy by 2020, more than the US and Europe com-bined. It will also remain a leading contributor toward aggregate global growth of 4% – a faster rate than in any of the three previous decades.
The implication is clear. Investors can no longer decide whether to invest in China. Rather, they must determine how to best build their China portfolios to capture long-term growth.
China has polarised the investment community. Bears dominate the headlines by tapping into deep-seated fears of slower growth and banking woes. Others argue a more sustainable, consumer based growth model is emerging. A rebalancing is underway and a middle class is expanding. The ratio of retail sales to industrial production is rebounding and the vision of a China dream, and continuing reforms, is resonating among citizens.
Economists and Chinese policymakers broadly agree slower growth is justified and desirable in exchange for restructuring the economy toward domestic demand. Meanwhile, offsetting the justified fears about debt bur-dens, China’s savings rate remains very high. Savings will be better utilised over time as Chinese citizenry’s concern about stability and social security ease. We concur with Jim O’Neill, Goldman Sachs Asset Man-agement’s outgoing chairman, who made a similar point when he said recently that China needs to save less and, in a better-channeled manner, borrow more.
With rebalancing towards robust Chinese consumer demand taking place, China may be one of the largest and most exciting consumer markets in the world for the foreseeable future. Consider that in 2000 the majority of households in China were poor or value-conscious consumers, who bought on price, not brand. Today, Chinese consumers are moving from value-seekers to mainstream consumers, embracing, for example, iPhone applications to help determine which brand of milk, water, toothpaste, clothing or snack foods are the healthiest, safest and best. Middle class concerns are emerging in the Middle Kingdom.
Unfortunately, the speed at which this has all occurred has often blindsided investors. Like race-car drivers fix-ated on the rear view mirror, investors have looked back-ward and lost sight of the road ahead, particularly as the poor performance of Chinese equity indices has con-founded and confused. Few recognise, however, that Chinese indices are overwhelmingly exposed to a handful of businesses poorly positioned for the rebal-ancing underway. Just seven companies comprise over half of the Hang Seng Index: two energy companies, three banks and two telcos. These are neither private, nor consumer, nor attractive for investors seeking value.
In order to seek out attractive fundamentals and sus-tainable value in China’s consumer sector, selection must be focused, local and highly diligent. Overwhelmingly there are local Chinese private enterprises benefiting from better management, governance, product quality, branding, scale and liquidity. Examples are abundant. Since the onset of the financial crisis in 2007, Ajisen, a leading domestic restaurant chain, has grown sales at 23% CAGR; Great Wall Motor, a leader in domestic SUVs, has grown at a 42% CAGR; Tingyi, one of China’s largest instant food maker which acquired Pepsi’s China business in 2011, has grown at 23.4% CAGR.
The difficulty for non-local managers to identify, con-duct due diligence and value these targets has resulted in many foreign investment advisers advocating investment in multi-national corporations (MNCs) as a “safer” way to gain exposure. This can be a riskier strategy. While MNCs are benefiting from Chinese demand, their market share is often small and their diverse presence and products makes analysis difficult. Euromonitor for example, estimates that MNCs account for less than 4% of the Chinese market for both apparel and dried processed foods.
Other areas show MNC leadership under threat. MNCs have 35% market share in the soft drink sector for example, but are faced with the stunning rise of local competition like Wanglaoji, a niche traditional herbal tea drink with limited revenues a decade ago that has modernised and has overtaken Coca-Cola as China’s top-selling canned beverage. MNC dominance in certain luxury products is less under threat, but ironically has provided Xingtai with a best hedge against the risks of political change, overca-pacity and changing consumer tastes.
That certainly does not mean that MNCs should be dis-missed in their entirety. Yum! Brands and Mead Johnson, based in Kentucky and Illinois, derive 50% and 30%, respec-tively, of their revenues from China and have leading fran-chises. To be sure MNCs are also very well run companies, but this has challenged Chinese firms to up their game, invest in products, and develop smarter marketing strategies. They have also trained a broad cadre of managers who understand how to run best-in-class businesses.
China is rebalancing toward the consumer so under-standing specific businesses targeting this demand is essential. Equity indices do not capture this dynamic, and overly-simplistic strategies such as an MNC-only focus will prove risky. To successfully invest, boots on the ground understanding how Chinese businesses are run is critical, as is an appreciation of the products and services emerging mainstream consumers want.
