Tuesday, 29 July 2014
Last updated 3 hours ago
Sep 30 2013 | 7:57am ET
By Anders Lund Larsen, CFA
Senior Portfolio Manager, Aros Capital Partners
China’s rebalancing from investment and export-led growth to domestic consumption creates opportunities for structural trend pickers. The China growth story is not over. It is changing.
The Great Rebalancing
The rebalancing in China and the accompanying slow-down has been one of the most important themes in the financial markets over the last year. The Chinese leadership has chosen to pursue a strategy of rebalancing the economy at the expense of growth. While still early days, this is already being felt, leading to lower commodity prices and a general consensus that the China growth story is over. It is not, but it is changing. The old economic model systematically favoured producers over consumers. By keeping real interest rates close to zero, China incentivised investments while starving depositors. Ironically, the low interest rates led households to save even more as they scraped to reach their saving target. An abnormally high household saving rate has been an integral part of the old growth model in China, and has gone hand in hand with an increasing reliance on exports and investments. In order to assess the prospects for a shift to a consumer-driven economy, it is important to understand why the Chinese have been saving so much despite rapid income growth. In short, the answer lies in the gradual phase-out of “cradle-to-grave” universal welfare. The increasing private burden of education and health care expenditures has forced the Chinese to increase savings. The uncertainty associated with the ongoing move to a more market-based economy has amplified this. This has been further augmented by the privatisation wave of the housing stock putting additional pressure on existing savings. Finally, the lack of developed financial markets means households do not have the opportunity to borrow against future wages and smooth out consumption, which has also increased precautionary savings.
China’s excessive savings and subdued private consumption creates structural growth opportunities in the consumer space. These opportunities are currently being exaggerated by the investment community’s fear of China’s slowdown and the outflow of capital from emerging markets. While GDP growth is certainly slowing, domestic consumption is set to rise. As shown in figure 1, household consumption as a percentage of GDP has been falling steadily over the last 10 years and is now half the US level. This is clearly unsustainable and this is what the Chinese leadership is trying to address with their reform priorities.
If Chinese consumers are to absorb a larger fraction of the goods produced by Chinese factories, their precautionary savings rate will need to be brought down. This requires improvements in the social safety net so risks associated with idiosyncratic income shocks and health expenditures can be pooled, thereby reducing the need for households to save in order to self-insure against these risks. Increasing public provision of education will also lower household savings by reducing the need to accumulate assets to finance future education expenditures. Perhaps most importantly, development of financial markets and interest rates liberalisation should enable consumers to borrow against future incomes and get a better return on their deposits leading to diminished needs for savings. While still far from being fully implemented, these reforms areas are on top of the Chinese reform agenda and should act as structural tailwind for private consumption in the medium term. Even without structural reforms, Chinese retail sales are growing at double digit rates and have been for the last decade as shown in figure 2.
Moreover, Chinese retail sales have largely been resilient to swings in the global cycle. They are being supported by solid wage growth and continuing urbanisation. The rise in the minimum wage can be seen as a first step in the leadership’s preference shift from producers to consumers in an attempt to rebalance growth towards consumption.
How to Capture the Opportunity
While the case for strong growth in household consumption is clearly evident from a pure macro perspective, it is perhaps less obvious how this should be played at a micro level on the investment side. The prevalence of state-owned enterprises with all but shareholder values on the agenda and the general slow-down in the economy means buying the Chinese market is clearly not the way to go. Another aspect to consider is the risk of increased government intervention and regulation, which some sectors are more exposed to than others. Risks like these call for a basket approach, where a small basket of companies with the right exposure is composed to diversify away idiosyncratic risks. This also means a more granular bottom-up approach is needed, so we get the exact exposure we are looking for. As investors, we want to have exposure to basic consumer goods to capture the rise in disposable income and the lower saving rate in the future. The continuing urbanisation and gradual rise in living standards should also benefit basic consumer goods. The next thing then becomes considering which product categories are going to experience the highest growth. Here we look for untapped growth opportunities like higher penetration rates, new regions etc. New categories like snacks, cosmetics and nappies enjoy better growth prospects than established categories like processed food, laundry care and paper products. This exercise leaves us with a list of potential candidates with the right exposure. Not all companies are created equal though, and comments from some of the major global players in this space like Unilever, Procter & Gamble, and Nestlé highlights that the toughest competition is from the local players. They have a leg up in terms of understanding local needs and preferences, and they are able to capture cultural nuances that western companies are not. These local companies are where we want to be invested. The competitive advantage of being local is part of the reason for this, but the most important criteria is valuation. As shown in figure 3, our basket of companies targeted the rise of the Chinese consumer trades at a significant discount to their international peers.
This holds for metrics like Enterprise Value/Est. EBITDA, but the difference becomes even more pronounced when one adjusts for growth by using a PEG ratio based on the estimated 5 year earnings growth. The combination of strong structural growth and attractive valuation makes the rise of the Chinese consumer a high conviction theme at Aros Capital Partners right now.
Anders Lund Larsen, CFA is a senior portfolio manager at Aros Capital Partners, where he focuses on thematic equity investments bridging the gap between macro and company-specific investment opportunities. Aros Capital Partners provides thematic investment management via the discretionary global macro fund, Aros Paradigm Fund.
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