There is no doubt in anyone’s mind as to what part of the investment cycle we are in – the late part. Albeit with bouts of volatility here and there since 2009, overall, it’s been a pretty good outcome for investors in risk assets.
But where to from here given we have a rising (albeit slower) rate environment in the US, and a slowing local economy started by sharp corrections in house prices? And what will China’s role be in this environment?
The first hit we had to global confidence was in the first week of January with Apple declaring a revenue warning over its most popular offering – the iPhone, citing a significant proportion was due to a drop in sales in China. This shook the world into the belief that we are facing the beginning of the end.
When you look deeper into the situation though, one must realise that Apple is facing tougher competition in China from the likes of Huawei and Xiaomi rather than simply demand falling off. Again – you must read into context more than simply the headline. There is always a cause and effect below the surface.
As at the time of writing, China and the US are continuing trade talks to try to find a compromise to prevent protectionism rearing its ugly head reversing almost 100 years of globalisation and the development of free trade.
Sooner or later, when the real economy (seen via corporate earnings) weakens due to the impacts of the tariffs, leaders will be more motivated to act. One case in point is that Trump continues to use the S&P500 as his barometer of success as President and Commander in Chief. If the S&P falls in a big way, Trump will be motivated to cut a deal with China as he would have other fights he needs to take on domestically (for example, government shutdowns and wall building).
Now to understand China’s role in 2019 and beyond in relation to the world, one must look back at what it did during the Global Financial Crisis.
China launched an unprecedented level of stimulus (the world’s largest in recorded history) in 2008/9 to the tune of $4tr RMB (A$823bn). This, in simple terms, saved the world from collapse as it was looking very dark for a period while the world’s liquidity dissipated and no one had the ammunition to stimulate.
While China saved the world, their actions caused some unintended consequences via the build-up of excesses within the economy, such as over supply from steel mills, overbuilt infrastructure, and shadow banking. So, this time round, China has learnt its lessons and will stimulate gradually.
While the current market correction reflects some of what we saw during the correction seen in 2015/16, where many global investors ‘knew’ the Chinese economy was going to succumb to a hard landing (which never eventuated), the economy is under far less pressure.
The market didn’t fall quite as dramatically and as such also didn’t trigger as much concern about the financial system state of health. The renminbi is also under less pressure and foreign reserves are also above the $3tr USD figure. So, while the Chinese government is stimulating through increased liquidity injections and cutting of the RRR rate, it is nowhere near what it was in previous years.
Whenever the next major global recession occurs, China will not be the one to bail the world out, nor do they have any incentive to.
So, in this environment and being in the late part of the investment cycle, are there still investment opportunities in Greater China equities? Yes, there are.
What the last 12 months has shown us is that there are many quality companies that have emerged due to the correction. We believe there is only one way of achieving investment success, and that is patience and time in market. If you asked us 12 months ago what we thought about valuations, we said that while the market is cheap, the companies we want to invest in are not within our buying range based on valuation metrics. Now they are.
The instant noodle market, for which there will continue to be strong demand no matter the state of the investment cycle, is one good example. Instant noodles are considered a staple to the Asian diet and no matter which part of the income or wealth spectrum you belong to, they’re something that you will consume as a comfort food or simply out of convenience. Think of it like the humble meat pie or sausage roll here in Australia.
Chart 1: China instant noodle sales value growht rate (%), 2012 - 2021E
Source: Premium China Funds Management
While the overall market is reasonably mature with CAGR in China of under one per cent in the last six to seven years, the premium market, which is defined by noodles costing more than five RMB ($0.80 AUD) per pack at the retail level, has been growing at double digit levels over the same timeframe (11.5 per cent CAGR since 2012).
At the same time, one must also take into context the composition of the instant noodle market. As at the end of 2017, it was still 90 per cent mass market (< five RMB per packet). So, ultimately this is a consumption upgrade story (alongside many others in China). As the middle-class population grows, they are demanding higher quality goods.
This is where a company like Nissan Foods comes into view. Nissan has its history back in Japan with its flagship products well recognised in both Hong Kong and Southern China.
Table 1: Nissan Foods versus peers
After spinning off from its Japanese parent in 2017, management have been focusing on building their China distribution networks and now they are the second largest premium brand in China with 20 per cent of total market share. In Hong Kong, they already have a 65 per cent market share which serves as a successful case study as to how high penetration can get with a higher median income level population set.
The current valuation level is very attractive (40 per cent and 15 per cent discount to its parent and peers respectively on a P/E basis), which affords us what we refer to as a ‘larger margin of safety’ no matter what short term blips were to hit market sentiment.
So, just as in this example, no matter which part of the investment cycle we are in, opportunities are there for active investors who do more underlying fundamental research to seek out stocks which are unloved by the market. While you can never time the market, you do know when markets are relatively more or less attractive to enter for the long-term.
Jonathan Wu is an executive director and the chief investment specialist at Premium China Funds Management.