China: three reasons for some cheer
Written and accurate as at: Jan 25, 2016 Current Stats & Facts
In the midst of the negativity and sell-off in Asian markets, I am starting to turn a bit more optimistic. By no stretch of imagination am I suggesting that we do not have issues to deal with. The risks from China are obvious and repercussions across the region could be severe. The debt overhang across many countries impedes growth (we have, in effect, borrowed from the future to consume) as well as affecting valuation. Increased debt in a disinflationary, low growth environment is a big problem. Some even suggest that with central banks at the end of their tether, we might be facing a serious crisis. All of this is certainly a very real possibility.
But I do think that some requisite conditions for turning positive on Asia are starting to fall into place. The first of the three conditions I note, and one of the most important ones, is a change in attitudes from entrepreneurs across the region. After years of being accustomed to growth as if it is inevitable, companies are increasingly talking about restraint. Capital expenditure plans are being curbed and cost control is now a focus. Companies are thinking of defending margins, conserving cash and managing for low growth. That means firms are starting to refocus on return on capital and not just growth for growth’s sake.
As an illustration, this week I met the CFO at Hengan International. Long considered one of the best consumer staples businesses in China, it sells tissue paper, diapers and sanitary napkins and became a proxy for Chinese consumption. I used to hold the stock in the portfolio – Hengan met several criteria we look for in our companies (high return on capital employed, high return on assets, strong cash flows, defensible margins and growth, just to name a few). But I sold out in 2014. Apart from the business challenges, from competition from multinationals and the changing nature of distribution through e-commerce, what I least appreciated was Hengan’s foray into financial engineering.
Between 2009 and 2014, total borrowings grew approximately six-fold, from close to HK$4bn (US$500m) to HK$22bn (US$2.9bn). The company generates so much cash that it does not need to borrow. But borrow it did, to execute a ‘carry trade’, borrowing in Hong Kong dollars to invest in RMB deposits. The CFO now describes these trades as ‘avoidable’ FX transactions. When the RMB appreciated, Hengan made gains, but in the past three months the company has scrambled to unwind those trades and book exchange losses. This is how a Hong Kong-listed, so-called well-managed, cash flow-generating business behaved. Hengan is not alone in this. I’ve seen many other HK-listed companies do the same thing. As to the ‘A’ share-listed firms, several bought stocks in the frenzied markets of H1 2015. Besides unwinding this financial engineering, Hengan mentioned it is freezing wages for 2016, while capex is now being recalibrated and reducing inventories is a priority.
The second trend I observe is a slowdown in bank lending. Finally, most banks (ex-China) now accept that we are in an economic slowdown in Asia, even facing a crisis in some cases. Banks are no longer looking to grow but are focused on preventing non-performing loans – too late in my view – or recovering bad loans. As this trend accelerates, the first casualty, theoretically, should be unviable and unprofitable businesses. A slowdown in loans will certainly reflect lower demand growth, but in the long run the inability to access credit helps reduce the number of irrational competitors. What I do really want to see is whether the ‘funny money’ from venture capital and private equity funds gets turned off as well. Surely, with markets in this state, there must be an impact on valuations for new businesses? If that indeed does follow, we could witness a fall in the indiscriminate funding for online businesses. All that these start-ups did was generate top-line growth by throwing away money. Neither profits, nor margins, nor cash flows mattered. This will directly affect several listed firms, who will start to see lower irrational competition. I can’t say this is already happening, but believe it could be a logical fall out.
Finally, we are seeing low valuations combined with revulsion for the asset class. On valuations, I do not want to suggest cheap P/Es or low price-to-book values for the Asian market are totally representative. With Chinese banks and other financials, as well as commodity-related cyclicals, accounting for such a large part of the listed universe, those valuations in my view are misleading. But I mentioned Glencore previously. That is an apt analogy to draw. When debt levels rise as they have, the key valuation parameter to consider is EV/EBIT multiples (enterprise value / earnings before interest and tax). This volatility in markets and especially currency deprecation is, in my view, the best thing to happen for long-term investors. As emerging markets (and more recently Asian markets) have performed so poorly for the past five years, 2016 could be the year when there is general revulsion towards these markets. If that happens, I would hazard a guess that we are being set up for a very good longer-term investment opportunity
By: Samir Mehta
Senior Fund Manager, JOHCM
BT Investment Management