Investing in Chinese Domestic Consumption
TWST: Please start by introducing our readers to Clough Capital Partners and in particular the China Fund.
Mr. Brock: We just entered our 13th year at Clough Capital. I was one of the Founding Partners along with Chuck Clough, who was the former Global Chief Investment Strategist at Merrill Lynch, and Jim Canty. We have been at it for a long time. The firm comes at the markets really with a global perspective. In aggregate across a handful of funds, we have about $4 billion in assets under management; we have a global long/short strategy with about $1.4 billion in assets, a couple billion dollars in closed-end fund assets and a handful of smaller strategies. In addition, we have one single open-end fund, which is the Clough China Fund.
I like to describe the firm as a boutique. We are not all things to all people, so particularly with public funds you are not going to see us with a large-cap value fund or some generic products. What we are really doing is trying to focus our efforts in markets and opportunities where we see substantial opportunity from an investment standpoint. And inside our global strategies, China is one of our biggest themes, and Asia generally is a big allocation to what we are doing. For us, it made sense to carve out China into a separate fund that we can offer to investors.
We have been running the Clough China Fund for about three years now. The fund itself has a six-year track record. The fund was formerly managed by a unit of Old Mutual. Old Mutual was restructuring, which gave us the opportunity to “adopt” the fund, which we did with ALPS, our partner. ALPS Advisors is a fund adviser and administrator. It’s been a terrific move for us from a business standpoint, but also it’s a way for us to express our enthusiasm for investing in China. In terms of the team running the China Fund, I am a Co-Manager along with Francoise Vappereau. Francoise is based in Hong Kong, and she has been on the fund as a manager since inception. She has lived in Hong Kong since 1995, so she has seen a lot of cycles. She is one of the most experienced fund managers in the market. In addition, we have two analysts based in Hong Kong — Priscilla Chan, who was there since inception as well, and then we just added Florence Liang in Hong Kong, not quite 12 months ago. The Hong Kong team complements the Boston-based analysts. So we have built the team, we continue to invest in our resources in Asia, and now we have internally a 15-person investment team. Eight of us are very focused on the China opportunity, and six speak Mandarin.
TWST: What’s your current outlook for the Chinese market overall? Are you in the camp of those expecting a hard landing or a soft landing for the domestic economy?
Mr. Brock: I’m absolutely expecting a soft landing, and we are very bullish on the market. Perhaps I could start by giving a perspective on what’s maybe changed in 2012 versus last year, because obviously last year was a very weak year in China. It was a weak year for global equities, but China in particular underperformed. We can point to two sources of pressure, or what we call headwinds, for 2011 in China. Those headwinds were both domestic and international. Firstly, on the domestic side, inflation was a persistently stubborn problem in China over 2010, 2011. The genesis of the inflation cycle in China was obviously the 2009 stimulus that Beijing undertook to help the economy recover from the recent global financial crisis. Now, you can argue — and we would agree — that stimulus was excessive. There was a 4 trillion Chinese yuan spending program, mostly on infrastructure, crammed into two years. The infrastructure was needed, but the investment was brought forward aggressively to offset some of the global weakness. That investment surge helped create an inflation cycle, and inflation persisted into 2011 much more strongly than we had anticipated, so it was high and accelerating. Inflation peaked out at about 6.5% in August, and that was a problem for the market, because at the same time we had a very strong property market. Many people argue that Chinese property is in a bubble; we can talk about that later if you’d like. But in any event, we saw an investment cycle in residential property in China that was clearly too robust and also contributed to inflation.
So with that backdrop, the authorities in China were signaling throughout the year that they needed to get this inflation issue under control, and they needed to slow economic growth to do that, so you saw very tight policy. In particular, you saw credit growth under pressure with higher interest rates and, importantly, higher required reserve ratios from the banks, which peaked out at about 22%. So that limited the banking sector’s ability to extend credit, and also as a consequence, contributed sharply to deceleration in GDP growth. Fixed asset investment growth was particularly weak. You can argue that that was successful, because now we see inflation coming down
These domestic issues were unique in a global context, because growth was too strong in China, whereas the rest of the world was struggling with very weak growth and the inability to stimulate. The most significant international pressure point was the European Union’s sovereign debt and banking crisis. Throughout 2011 that was a headline risk, though less of a real economic problem in China, I would argue. Obviously weak developed markets crimp demand for exports, but we didn’t see exports collapse. Maybe there was slower growth, but it wasn’t a real drag on overall economic activity. But the reality is, even if China’s economy has decoupled from developed market demand — that being principally U.S. and Europe — the financial markets have not decoupled. Our financial markets are all linked. When global investors are taking down risk in their portfolios, they sell everything, and that includes China. So again, the crisis in Europe bled into Chinese markets, and despite seeing still strong economic growth of 8%-plus for 2011 and strong corporate earnings growth, we saw a big derating, so p/e ratios collapsed last year.
If you fast forward into 2012, we have a much different situation. There has been a slowdown in growth that’s policy driven, and I would argue now, and I think most people agree, that policy has been successful. CPI, which had peaked at 6.5%, was 3.6% in March, and we could see that going below 3% to maybe 2.5% by the summer if you just look at the year-over-year comparisons and recent trends. Inflation is moderating sharply, and that’s bullish. We have also seen a significant cooling in the property market. That all is important, because what it means is the authorities in China — which had been tightening for the last two years — have now started to take their foot off the brakes. We wouldn’t expect a significant policy response in terms of either fiscal stimulus — i.e., spending on infrastructure — and even monetary stimulus along the lines we saw in 2008 and 2009, again in the midst of the crisis.
Growth in China is strong and authorities are content with a slower, more sustainable pace of economic growth versus the last four or five years, when it was routinely in the low-to-mid double digits on a nominal basis. So if you have a policy that had been tight going to neutral and now somewhat moderately easing, this is a different environment for equity investors in 2012. Then, if you step back and take a look at Europe, there are still major issues. I wouldn’t suggest that there has been a solution to the government debt crisis in Europe; however, there’s clearly been some stabilization. The moves by the European Central Bank to essentially ensure liquidity for the banking system have lowered the risks of “global contagion.” So you are not going to run the risk of a major bank in Europe failing, which I think has probably been reduced significantly. You get less of a panic or edge-of-the-seat position for global investors in the equity markets in China.
So in 2012, we are starting to see leading indicators in China improve in terms of growth. Credit growth is bottoming, and consumption remains fairly robust with retail sales growing around 15% or so. In addition, the prospect of fiscal spending, which had been tightened on infrastructure, starting to improve moderately, you can see your way to a pickup in economic activity in the second half of the year. That, with improved liquidity in financial markets and a very cheap stock market, should bode well for returns for China over the next 12 months, and we think over the next several years.
TWST: What range of GDP growth are you expecting over the next five or 10 years?
Mr. Brock: Looking out five or 10 years is always difficult to forecast. The next two to three years I think you can probably dial in at 8%, plus or minus maybe 100 basis points, for growth. That’s sustainable growth. What we see now is China is rebalancing, but we think a high-single-digit growth rate is certainly sustainable. Longer term, you might see that tick down. In fact, I wouldn’t be surprised to see China’s GDP, looking out five to 10 years, drifting down to a 5% to 6% level, which is real economic growth and is still quite robust.
The more interesting story about China’s growth is how it’s evolving, because China is rebalancing. If you think about investment themes — obviously, we will get into the China consumption boom, which we still think has many, many legs left in it — the overall story in China is one of rebalancing. Fixed-asset investment growth is slowing, whereas consumption growth remains very healthy. So the mix shift there in terms of GDP growth towards the consumer is finally noticeable. The other thing you see going on is eastern China and southern China, which had been the major beneficiaries of that infrastructure boom over the last decade, are now starting to see a pretty significant slowdown in investment. That slowdown is actually being offset by a very deliberate strategy out of Beijing to develop the provinces in western and central China. Heretofore, those areas of China have badly lagged the wealthier coastal regions, and finally they are going to get their much needed investment. They’ve barely been touched; you just have to take a trip into any city in the interior of China and you can see a big difference in terms of airports or rail or highway infrastructure, or power infrastructure in China’s vast inland as compared to what you’ll see in Shanghai, Beijing or Guangdong province.
This is why the growth rate in China is sustainable. You might see Beijing, for example, growing at a 3% to 4% clip, but Chongqing, which has been in the headlines lately and is one of the largest cities in China, is growing at a 15% clip. So that’s the offset you have. China is using the blueprint from coastal development to drive growth in its interior.
We’re also seeing the manufacturing economy being less export driven, because you have large end-markets in China now developing as wealth in the country has grown. We are also seeing the manufacturing sector move up the value chain, so it’s less about the light industrial activity — whether it would be low-end components or apparel, things of that nature. China is now producing higher-end electronics such as iPads, automobiles, excavators, products that really hadn’t been a big part of China’s manufacturing sector even if you look back five years ago. Importantly, those products are increasingly being produced for domestic consumption, not for exports. I think that’s an important story to tell and a perspective to have.
TWST: The last time we spoke you put great emphasis on meeting with as many management teams of local companies as possible. What kinds of investment themes is that generating for you now?
Mr. Brock: We are still doing that, absolutely, that’s the core of the process — to meet as many teams as we can. That’s how way we develop investment themes and generate company specific ideas. We do this work both in Hong Kong, as well as in Boston. Of course we travel extensively to China as well. It’s worth noting our travel isn’t generally to major Tier I cities, like Shanghai and Beijing. Those cities have become global financial centers and don’t offer a real good window into the “real China”. You need to travel around China, to smaller cities or those located off the beaten path, like in the inland provinces. We don’t see as many financiers there, and that’s good for us. Many times we get to see the same company several different times during the year. In aggregate, we will hold more than 1,000 meetings with corporate management teams this year.
In terms of themes, we continue to emphasize the consumer sector in the China Fund. We are also very positive on the technology sector, which is benefitting from both household consumption trends, but also corporate spending. The IT sector is a great way to gain exposure to China’s domestic growth and the rebalancing themes we discussed. In China there are many companies that are leveraged to these new growth dynamics that are investable. And of course, the consumer continues to be probably the area that we have the most interest.
TWST: You mentioned the property market possibly being in a bubble, and that’s been a concern. What are your thoughts on that sector?
Mr. Brock: My take on property is that it has been, up until recently, an easy area for policy makers to stimulate economic activity and growth. Anyway you slice it, China actually has a housing shortage. Now the issue in China is, are they building the right kind of homes for their people? And I would suggest that over the last several years, there’s certainly been an overinvestment, at least for the near term, in what I would call luxury housing or mid-to-high-end housing. Affordable, lower-end housing has been somewhat neglected. And so we are seeing a couple of things going on, firstly, market forces at work. And market forces do work in China, even though we have a command economy. But market forces are dealing with an oversupply, particularly in Tier I cities, of high-end homes. There has been a sharp slowdown in demand, and developers are responding with a sharp cutback in new home starts.
That could pose an economic issue for China, because property investment is a significant part of the economy. Although, because we do have a structural shortage of housing in China, there is a social housing story that’s developed over the last couple of years which has been supported by the Chinese government. What we see now is subsidized housing being built, across the country. I make the point of highlighting that because even though we are seeing a slowdown in investment in the higher end, or what they call private housing, social housing is offsetting that to a certain extent. You’re not seeing a real sharp contraction in that area of the economy. It’s not growing like it used to — it’s flattened out, certainly — but that provides a bit of a cushion.
Now in terms of overall risk to China with housing being extended, I would say we’ve seen higher-end luxury housing prices correct something like 10% over the last 12 months, and the bulk of that correction has happened more recently. I would expect that to continue maybe a little bit more, it’s hard to say. But you have to remember that housing investment has been slowing for the last two years already, so the correction there is well underway. Meanwhile, we’ve seen a significant rise in household incomes. China is an interesting place, because you do see double-digit income growth, and even if prices were to hold flat over the next several years, which is plausible, you will start to see housing affordability improve pretty meaningfully. So I don’t worry that much about a housing bubble. I always suggested that housing is going to be a less interesting place to invest over the next several years, and as investors we can avoid that. We don’t have to have the portfolio tilted towards property.
TWST: Is there anything else you would add in terms of sectors or industries that you are excited about or are cautious about right now?
Mr. Brock: I would add one thing. I think most investors are interested in China, but not everybody knows how to invest in China. There has been a big boom in infrastructure investment over the last decade, and that was obviously very commodity intensive. So many have looked at the growth there and said, “you know, I don’t really know what’s going on in China; it’s a country that’s far away, but I do know that they are consuming a lot of metals, steel and iron ore, agriculture and construction equipment.” So they look at the market and say, “why don’t I just buy the suppliers to that infrastructure boom, the commodity producers?” They might look at a copper company like Freeport-McMoRan (FCX), or they might look at a iron ore company like Vale (VALE) out of Brazil, or a global construction machinery company like Caterpillar (CAT). That’s what I call the “old playbook” in China.
What I would tell you is that those sectors are not going to be major beneficiaries of China’s growth over the next five years. That’s the last cycle. This next cycle is going to be more about China’s domestic companies benefiting from the growth in China, and it’s going to be much less commodity investment driven. So if you ask me what sectors I would try to de-emphasize or avoid, those would be the sectors. The flip side is, we just couldn’t be more constructive on opportunities in the consumer sector. I think that’s where, if you can find a portfolio that has large exposure to the Chinese consumer, I think you are going to do a lot better.
TWST: Would you give us a few examples of top holdings or favorite names right now, and tell us how they illustrate your investment strategy and the best opportunities you see?
Mr. Brock: I could start with Vinda International (3331.HK), a leading tissue paper company in China. When we last spoke I had highlighted the Holy Grail of emerging markets investing is when you can find an end market that’s potentially large — so it’s a product that everyone can use and may even need — but where current market penetration is low. Combine that with income growth which allows more and more people to afford the product, you can get exponential growth. We call that the “S curve,” where affordability allows for a long period of market expansion and high growth. In a sense, luxury items become staples. We’ve seen that with cell phones; China Mobile (CHL) has gone from very few subscribers a dozen years ago to 700 million today. We saw more in the middle of the last decade with sneakers. Before the Beijing Olympics, nobody wore sneakers; now, that’s a huge, massive end market that just came out of nowhere.
And now we see that S curve today with tissue paper. If you do any traveling in China and venture outside of a four or five star hotel, go to maybe a second-tier city or just out to visit a corporate headquarters, one thing you will notice is that tissue paper is not widely available. And that’s, in our view, an opportunity. As incomes grow, tissue paper is going to become less of a luxury. I’m talking toilet paper, paper towels in the kitchen, Kleenex and things of that nature.
According to its CFO, Vinda saw high-20% level growth in the first quarter as compared to last year, and we think that’s a level that can be maintained over the next couple of years. And this is really a market penetration story; the company is now getting scale and developing a brand image, which is very important. If you can build the brand in the early stage of market development, which Vinda is doing, as the market grows you just sit there and capture that growth and you take market share. Vinda is one of the leading companies doing that. We see Vinda growing their earnings 50% year over year for this year and next, and the shares now have a p/e ratio of about 19 times. Consumer staples companies in China in markets that have already gone through this S-curve phenomenon routinely trade at 25 times or higher earnings. And with 50% earnings CAGR for the next two years, you are going to have an earnings base that’s much higher to put that multiple on. So we see substantial upside on Vinda.
Vinda is a good example of many of these private sector companies in China that have just terrific balance sheets. One of the reasons why they have terrific balance sheets is they haven’t had access to capital and access to credit like the state-owned enterprises have had historically, so they’ve had to do more with less and they’ve had to run their business very efficiently as a result. That shows up in margins and returns. I think that’s another thing worth highlighting when you look at some of these companies benefiting from the consumption story.
TWST: Do you have another example or two?
Mr. Brock: Samsonite (1910.HK) is a company that went public in 2011, and this is obviously a well-known global brand. It’s got a strong management team, and it actually has an interesting strategy where they’re segmenting the market at both the high end and the low end. The high end is obviously targeted with the Samsonite brand and variations of that brand; the lower end, with American Tourister. Samsonite today is largely an Asian company; today 40% of the sales are in Asia, with most of that being in China. They just reported that first quarter sales were up 26% in Asia, and that compares to overall revenue growth of 15%, so it’s a very strong growth story. And it’s a company that also has a very strong balance sheet, and trades at 16 times earnings. We see earnings growing at 15% to 20% for the next several years.
Another one is China Modern Dairy (1117.HK); it’s an interesting company. It’s leveraged to higher incomes and wealth in China in a couple of different ways. This company operates dairy farms, so they own the cows that produce the milk, and they sell the milk to the branded milk companies who sell through the retail networks. So they are a supplier of high-quality milk. There are a couple of things going on. Historically, China has had challenges — not just in milk, but in agriculture generally — in ensuring quality. It’s a hugely fragmented business. You can see small dairy farms across the country; sometimes farmers just own one or two cows, and they supply the milk. It’s very difficult to ensure quality. Consumers have been very suspect of the milk they buy as a result. There have been a couple of instances over the last five years where there have been some quality scandals. Quality scandals become less and less acceptable to the general population as wealth increases and as the ability to pay for higher-quality milk increases.
China Modern Dairy recognized that opportunity and said, “if we can create high-quality milk, we can have a premium product, generate higher margins and returns for investors” — that’s an interesting scenario. Again, if you look at the S curve, milk consumption is really right there, income and affordability are just kicking in. You think of quality milk in the U.S. as a staple. You don’t really think about safety when you visit the supermarket. It’s all quality, but in China, quality milk has been a luxury. Over the next five years, I would say it’s going to become a staple in China as well, and China Modern Diary is going to be right in the middle of it. They import very productive cows from New Zealand and Australia, and have a very, very carefully managed process and facilities that are best in class to produce a high-quality product. So they have a substantial edge, they have built-in growth just in the maturation of cows and their capacity expansion, and they’ve got pricing power in this long tailwind of demand. So we like this company a lot. It trades at about 13 times earnings, and we think the growth opportunity there is substantial.
TWST: What do you use to benchmark the fund’s performance, and would you talk a bit about its track record?
Mr. Brock: We use the MSCI China Index as the benchmark, and our performance has been very good actually. Through the life of the fund we’ve had a four- or five-star rating from Morningstar. We compare ourselves to the MSCI China Index. Both longer term and year to date we have been able to outperform.
It’s an interesting question you ask, though, because we try to run the fund without consideration of the benchmark. We are not benchmark-oriented investors, which I think a lot of our peers are. We try to focus on best ideas, and often, as I mentioned earlier, it’s thematic and sector focused. So if you look at the positions, you will see in our fund that we are significantly more leveraged to and overweight the consumer area. Collectively the consumer discretionary staples are about 35% of the fund’s assets, whereas the MSCI China Index has about 12% of the benchmark index in the consumer area. We’re not afraid of making out-of-index bets, and in fact that’s really the core of what we do.
I think it’s worth highlighting that a firm like ours is a boutique. We are small enough that we can operate with these large overweights — whereas if you have a multibillion dollar fund or a firm that has not only a China fund but a regional fund and a global fund and a national fund all competing for the same ideas, and if you look at the consumer discretionary sector alone inside of the MSCI China Index, it’s only 6%. So it is not really possible for those funds to all have that same level of overweight that we do in the consumer area. I do think that’s an advantage we have.
I would also highlight for those people who are using index ETF’s, like the iShares FTSE China 25 Index Fund, for their China exposure, they are not achieving consumer exposure. There is not one single consumer stock in the FXI. So if you’re using the FXI, you are really investing in the winners of the last 10 years, not the winners over the next 10 years. If we are right on the China consumer, the ETFs and the MSCI China index will have trouble keeping up with a portfolio like ours that has large consumer exposure.
TWST: Would you like to wrap up with some final thoughts and some advice for investors in terms of how they should think about including investing in China in their overall portfolio?
Mr. Brock: I would say there’s going to be no country in the world that’s going to outgrow China over the five-plus years, and I think you want to be exposed to that growth if you can be. The Chinese markets are much larger than most realize. If you look at China, it’s about 12% of global market capitalization today; that’s a larger weighting in global market cap than France, Germany and the U.K. combined. I don’t think everyone appreciates that. I think people are generally happy to have some allocation or some level of diversification by investing in those European countries, but China is a big market, and I think you really have to have a view on China.
I would encourage people to have direct investments in China, because as I mentioned earlier, you can’t get exposure to China’s consumer through an international fund, you can’t get exposure to China’s consumer through a regional fund. I think you have to go directly and invest in a China fund. Today, if I look at both the near term and the next several years, China’s markets have corrected quite a bit, so stocks are cheap, and you’re coming from a pretty low valuation standpoint in terms of what you are paying for that growth.
TWST: Thank you. (MN)
Eric A. Brock
Partner & Research Director
Clough Capital Partners L.P.
1 Post Office Sq.
Boston, MA 02109