Why China is a Reason for Optimism
By Robert Horrocks
December 26, 2012
At the start of this year, amid a climate of much pessimism, I wrote about the optimism I felt over Asia (Asia Insight, Jan 2012). Markets are comparatively a bit more expensive now than they were at the beginning of the year and, indeed, some sectors (consumer non-cyclicals and health care) are somewhat expensive. But, overall, Asia ex Japanâ€™s earnings are still trading at a valuation discount of 26% to the U.S. and 10% to Europe. In addition, current valuations are still at the low end of the long-term historic range. But my optimism remains and springs from the fact that I donâ€™t recognize the picture of China that pundits are so quick to paint. Itâ€™s easy to focus on Chinaâ€™s problems but the Chinese, by the way, are focusing on the solutions. In my mind, China is a source of change, vibrancy and evolution. Recently, in discussing China with quite pessimistic Hong Kong investors, I found myself disagreeing with them time and again even though their various points had some merit. I became the â€śnon-consensus view.â€ť But considering Chinaâ€™s 10X forward 12 months earnings*, a 2.5% dividend yield and nominal GDP growth of approximately 10% as of mid-December, I am happy to hold this contrarian view.
The list of complaints against China is long: there is a credit bubble and overinvestment; China's economy is state-controlled; it never innovates; its banks are inefficient; informal financing is unregulated; wages are rising; companies have poor governance and you can't trust the numbers. But for all these criticisms, I have experienced a China that has evolved too much, due to the actions of both the government and individuals, to allow itself to stand still and accept mediocrity.
Government Makes Way for Entrepreneurs
Chinaâ€™s fundamental story of the past few decades has been of government making room for the private sector to flourish. As a student in Beijing in the 1980s, I saw numerous factories all churning out the same goodsâ€”Mao suits, Mao hats and police uniforms. Factories were distinguished by number: Beijing hat factory #1; hat factory #2, etc. So the lack of competition or profit motive was obvious. But I also remember the kiosk at my university, run by an elderly Shanghainese woman who sold beer and cigarettes. The beer, a potentially fatal local brew due to the fungus growing in the bottom of the bottles, was, at 2 cents each, nevertheless impossible for British students to resist. For a few dollars, you could buy her entire stock and lug it back to the dormitory. In a state-run economy with no personal incentives, nothing would ever change. But even back then, this vendor, who was old enough to remember what capitalism used to be like, was not going to let the opportunity of thirsty British students slip by. Progressively, she stocked less moldy, less dangerous beers until she was selling Singaporean, Japanese, American and Irish household brands by the end of the academic year. Where she got them, I'll never know. To this day, whenever someone describes their impression of China to me, I recall this story to remind me of how quickly things can change.
Another memorable character from my student days was a guy named Mei who used to work at one of the state-run watermelon stalls that lined Beijing's streets in the summer. Piles of fruit rotted in the sun as most vendors smoked, played cards or slept to avoid any kind of retail effort. But Mei was different. He set up a beer stall and solicited the help of myself and another friend to write a sign in English that would attract backpackers. "Mei's Beer House" was our grand name for this rickety stall. We found an old cassette player and a cassette of Ray Charles for background music. Pretty soon, Mei's small part of the street was packed with people sitting, drinking and chatting to the sounds of soul music. When someone talks to me about China as if its people are victims of great macroeconomic events beyond their control, I remember the spirit of someone like Mei. I also remember that selling to foreigners was a means to end and not an end in itself. Exports were not the goal of Chinaâ€™s economic growth, they were the means by which China would re-learn capitalism.
People have criticized Chinaâ€™s banks and rightly so. Government-directed lending is inefficient and nonperforming loans are likely rising. But remember that Chinaâ€™s nonperforming loans were estimated at 40% of GDP in the late 1990s. Yet between 2000 and 2010, Chinaâ€™s economy grew at nearly 20% annually in U.S. dollar terms, according to the International Monetary Fund. Today, China is damned if it does and damned if it doesnâ€™t. Pundits say the banks are dangerous because governments do not price risk properly; the non-bank financial sector is dangerous because it is not government run! Well, there are reasons to be cautious about unregulated lending. Are things sold properly? What happens should investments go bad? However, when I speak with companies that use informal lending, I find that they may be paying 15% to 18% interest rates. So, whatever else you think of the informal lending sector, you have to admit that it is pricing risk more appropriately.
Politicians are venal and governments can squelch economic vibrancy. Corruption is an issue in China. But at the same time, the state has been reducing its direct influence on the economy. China has become an easier place to do business, and is more highly ranked than countries like Russia, Brazil or Argentina. Hong Kong, which publicly lists most of the â€śChinaâ€ť companies U.S. investors invest in, is the world's freest economy and also ranks the second-easiest for conducting business (behind Singapore). Chinaâ€™s government spends about 21% of GDP, compared to 39% in the U.S. and even more by European governments. In addition, a survey of entrepreneurship concluded that perceived opportunities in China were greater than in the U.S. and Europe. In China today, small and medium enterprises account for 80% of urban employment, and China has become a champion of the entrepreneur.
Over-investment and Low Wages?
Has reform simply been the credit-fueled bubble that we have discussed in previous commentaries? Were that the case, you would now see a deflating economy, not one of the brighter parts of global demand. You would see falling returns on capital, but top-down macro analysis, government surveys and bottom-up aggregation of company statements suggests that returns on capital have been stable or rising. That is not surprising in an economy that has become more market-oriented and more efficient. The weighted average return on capital of the 75 companies in the MSCI China Index is almost identical (17.3% vs. 17.4%) now to what it was seven years ago and the weighted average return on capital of a broad universe of China companies is about 15% versus about 13% in 2005.
It is hard to see how over-investment squares with Chinaâ€™s rising wages. Too much capital improperly used would restrain productivity and wages. When I hear people saying that rising wages destroys Chinaâ€™s low-cost growth model, I think about the opening of first McDonaldâ€™s restaurant in Beijing. It was the best McDonaldâ€™s in the world because there were three different people at your service: one took your order, one rang you up and another just smiled at you. When I bought a burger for my friend Mei, he took one bite and put the remainder aside saying, "A treat for my son." You couldn't afford so many employees in a McDonaldâ€™s today but few urban residents would think twice about buying a burger. In fact, the Chinese have moved on from buying fast food to buying Swiss watches and property in Silicon Valley. So those who worry about the death of a low-wage economy in China will really have to explain to me how that is bad for the Chinese!
China has a high-wage growth model, and the purpose of its growth is to raise people's wages. Skilled labor now earns a high market price. In a single month, my college lecturer in Beijing was paid the equivalent of one night's stay in a Western hotel. Now, China can attract high wage earners for senior positions in some of its largest enterprises as it seeks to lure expertise into the economy to continue its modernization, productivity growth, and, yes, raise wages. In the sphere of productivity growth, China is acting as a role model for the entire region (Asia Insight, Nov. 2012).
China, the Copy Cat, Never Innovates
I do agree that China needs to embrace new technology, but disagree that the only value to be created is through innovating new technology. Leaving aside my incredulity that China will never innovate, the idea that copying is a valueless pursuit is misguided. You can create value by learning about the products, manufacturing processes, logistics, marketing and financing techniques that other economies have already refined. Why not? As an investor, I do not care too much if China's companies are copying business models from established companies overseas. Sure, it is good to have a brand to limit competition. Sure, I am wary when a business is beholden to a foreign multinational. But do I have to invest in such a company? No. Brand and distribution build strong business moats but they are not the sole prerogative of multinationals. Online search and gaming, retail and communications are industries overwhelmingly dominated by domestic companies. The business models may not be new, but once entrenched they are hard to dislodge. I care less about who developed the technology than I do about how a business uses it to maintain a competitive advantage. I expect China to employ more information technology in the future to boost productivity. Between 1985 and 2000, IT investment added on average 0.1% to China's annual GDP growth, compared to 0.6% in the U.S.; between 2000 and 2010, IT added 0.6% annually to Chinese growth compared to 0.5% in the U.S.
And the Rest of Asia?
So why does China lead me to feel positive about the rest of the region? There is of course the direct impact of greater trade, wealthier Chinese consumers, an outsourcing of low value-added operations from China to poorer nations to help them grow. But it is also because China has taught me how to think about growth. Consider its stable political environment: China has gone from revolutionary upheaval to smooth (almost boring) transitions of power. Indonesia has gone from the rioting and chaos of post-Asian Financial Crisis to its current state of stability and a better environment for foreign investment.
China has also demonstrated to its neighbors how to grow productivity based on more efficient capital investment. Despite low rates of productivity growth before the 1990s, (even negative in Singapore and the Philippines), Asia is now the worldâ€™s fastest-growing region in terms of efficiency of investment. Less wealthy nations in Asia are followingâ€”consciously or unconsciouslyâ€”in Chinaâ€™s footsteps. Richer ones, like Korea and Japan, will provide the capital goods to achieve greater productivity and the consumer goods to enjoy the benefits. Asia, too, has shown its ability to not only consume some of the great multinational brands, but also to take them on head-to-head in competition in areas such as cars, smartphones and apparel. Is this copycatting? Or is it showing the world that it can produce high quality products to international businesses and consumers?
Governments have played a role in this growth but mostly that role has been in stabilizing the political environment and limiting the scope of the state. Japan and Australia, Asiaâ€™s biggest spending states, still spend less than the U.S. as a percentage of their GDP; South Korea and India spend about 30% and 27%; ASEAN nations spends between about 8% and 29%, depending on the country. The U.S. corporate tax rate of 35% is higher than even bureaucratic India at 30%. In China it is 25% and 16.5% in Hong Kong.
Earlier this year, Wang Yang, a senior member of Chinaâ€™s Communist Party, said that the country's leaders should not think that the happiness of the people is a â€śbenevolent giftâ€ť from government. In his view, seeking happiness is the right of the people and the role of government is to give the masses freedom to explore their own road to happiness.
I agree with him, and while Wang Yangâ€™s idea may not be a new one, its originality is not important. Itâ€™s all about how well you implement it.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC
* â€śForward 12 months earningsâ€ť represent the current price per share divided by estimated earnings per share expected for the following 12 months, according to FactSet.
Matthews Asia Funds does not hold a position in McDonaldâ€™s Corp.
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The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information.
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