Inflation, regulation and depreciation: Is it the right time to invest in Chinese equities?
The key is to take a long-term approach and invest in high-quality companies which can pass on higher production costs to their customers
RISING inflation and higher raw material prices are eroding corporate profits in many parts of the world. Household income cannot keep pace with inflation, which affects those with mid- to low incomes the most. But, while inflation is a challenge globally, in China it is only 2 to 3 per cent – much lower than in the United Kingdom and the United States, where it has reached 9 to 10 per cent.
In China, the increase in the Producer Price Index (PPI) is higher than the rise in the Consumer Price Index (CPI). To overcome this challenge, it is important for companies to be able to pass on their costs to customers. As a bottom-up investor, we focus on selecting good companies that can do this successfully.
China’s more notable challenge is its zero-Covid policy. For instance, there have been cases where consumers placed online orders during the lockdown but could not get them delivered. This is a much-bigger issue than inflation and affects corporate investment and consumption. Investors are thus looking out for announcements regarding the relaxation of this policy.
Meanwhile, tighter regulations, the risk of property-bond defaults, and concerns about an economic slowdown have driven down the valuations of Chinese stocks, prompting the question: Does China still offer attractive long-term growth opportunities?
In such an environment, rather than being attracted by the latest “hot” themes, investors need to maintain a disciplined approach.
Our team holds 1,600 calls and meetings with companies every year. We talk to chief executives to understand their views, their management capabilities and how they address market changes. We also look into their business franchise, that is, their margins, operating cash flow and return on equity (ROE). What we are looking for are companies with long-term and sustainable growth drivers that we can buy at reasonable prices.
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The key to making the right investment decision is to take a long-term approach and invest in high-quality companies, even as others are worried about the markets. The value of a company lies in its profit and net asset value (NAV), rather than the macro environment. And our investment timeline is typically five to 10 years, although there are many companies that we have invested in for much longer. When everyone is selling, there are good opportunities to buy, because that’s when company valuations fall.
In our view, investors generally pay too much attention to macro factors, or economic data such as inflation, interest rates and regulation. But concerns such as these often come with the best opportunities. In contrast, it would be worrisome if everyone was walking in the same direction, doing the same thing or focusing on the same sector.
While the “common prosperity” agenda, which aims to reduce living costs and alleviate poverty, has driven higher regulatory standards, share prices have already factored in these challenges – and in fact, the regulations can help industries improve.
With increased regulatory scrutiny on the education, Internet, healthcare and property sectors, for example, companies might take a more disciplined approach instead of making unnecessary expenditures. And smaller, unprofitable companies may have to close, resulting in a healthier industry environment overall. Meituan, JD.com, Pinduoduo and Alibaba all improved their profits after regulations were imposed on the technology sector, as they faced less competition.
In the property sector, sales have dropped by 30 to 40 per cent, and prices are falling. But when a sector is in such bad shape and becomes under-invested, new growth opportunities may arise over the next two to three years. A sector in the trough of its cycle could offer attractive investment opportunities for the future.
Geopolitical risk and currency depreciation are additional factors to worry about. Sino-US trade tensions are increasingly challenging to navigate, which has made it more complicated for Chinese manufacturers. China’s weakened economy and rising US interest rates have caused the yuan to depreciate against the US dollar. If the US continues to raise interest rates while China cuts its rates, the spread will widen further.
Strong brands and quality
This does not necessarily translate into a boost for Chinese exports, as there is concern about the possibility of a US (and global) recession. It is therefore important to identify Chinese companies with a strong brand and which produce high-quality products. These companies can pass on their increased costs to clients and continue to grow sales both internationally and domestically in the long run.
Over the past 10 years, we have noticed improved product quality in China, and the emergence of domestic champions. For example, half of the world’s electric vehicles are now China-branded.
Household appliance manufacturers Haier and Midea have replaced Sony and Panasonic to become the biggest players in China. Anta Sports has become the second-largest sportswear maker. Proya Cosmetics has grown from a small company to one of the most well-known cosmetics companies in China.
Like Japanese and Korean brands in the past, Chinese brands were once regarded as weak, but are now more widely accepted. As China’s sense of nationalism becomes stronger, Chinese people will have greater confidence in their own domestic brands, which in turn can drive up demand for domestically branded products.
Meanwhile, labour shortages, coupled with export tariffs to the US and Europe, have encouraged Chinese companies to relocate their factories to South-east Asia, or countries where their clients are, to minimise transportation or carbon emissions. Chinese companies that can produce their products globally, be it in Europe, Cambodia or Mexico, and have the ability to pass on their costs to their customers, will sharpen their competitive edge over the others in the long run.
Lastly, we also see huge potential opportunities in Chinese medical equipment manufacturers, in a sector that still relies heavily on imports (70 per cent of medical equipment in China is imported). China’s largest medical equipment company, Shenzhen Mindray, is gaining market share from its foreign competitors. As companies invest more into research and development, there could well be a future Samsung or a future Sony from China, we believe.
Despite China’s short-term challenges, we believe the economy will continue to grow. The rise of the middle class will continue to drive premiumisation in the consumer sector, and the consumption upgrade trend is still intact.
Opportunities outside China
However, for investors looking for growth opportunities beyond China, we believe India has good potential. IT services in India are well developed in an economy with high-quality banks such as ICICI and HDFC. Another interesting area is South-east Asia, which has been ignored by investors who have tended to focus on China and India. In fact, valuations of companies in South-east Asia are relatively low, offering good potential investment opportunities.
As more companies move their manufacturing bases to Vietnam, this will create new jobs, lift income levels and lead to increased consumption power. And Indonesia also has a competitive advantage, with its rich resources.
South-east Asia has a large and growing working population and rising domestic consumption, especially in the Philippines, Malaysia and Indonesia. The under-25-year-olds account for almost half the population and the proportion is still growing, which should translate into an economic engine for the region in the future.
The writer is a managing partner of FSSA Investment Managers.
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