Postcard from China – Investing in China

Postcard from China – Investing in China

Investing in China seems like the absolute cant miss investment opportunity of the decade if not the century. The stunning economic growth, the rapid industrialisation of the most populous nation on earth, the surging demand for everything from concrete and copper to ships and steel, the container loads of manufactured items making their way to markets throughout the world. How could you NOT make money investing in China ? But is China the saviour for investment portfolios over the next few decades or is it simply another trap for wide-eyed investors fresh from losses in the Asian crisis and the tech bubble.

Lion Nathan Ltd is a favourite company of your hardy correspondent. Not only does it produce ample supplies of a certain amber coloured ale that soothes the occasional writers block, but its management has continually rewarded investors with consistent profits from its core beverage business. News of its decision to invest in a Chinese brewery during the late 90’s was met with cooing from the financial press. Early entry into largest and fastest growing beer market in the world was surely another shrewd move from the management team.

Thus, in the name of research, we naturally included the odd stop for a quiet beverage in several of China’s rapidly flourishing bars. We drank some of the cheap local beer and some of the much higher priced foreign brands. We couldn’t help but notice our Chinese barmen (who despite their nametags of Dave, Bob and Tom spoke not a word of English) seemed to be awfully busy serving beer to the throngs of patrons surrounding us at some of the trendy bars that make up Xintandi in Shanghai. How could you not make money selling beer in China ?




Yet seven years and $200 million in losses later, Lion Nathan announced last year that they would be selling its Chinese beer business. This was despite volume increases in the previous six month period of 63%. Rampant competition from local brewers, splintered distribution networks and poor infrastructure meant that Lion felt they could not generate a sufficient return on capital invested for their shareholders. An admirable decision from shareholders’ perspective but perhaps also a portent of the difficulty of making profits in the Middle Kingdom. As I learnt during my time in the freight industry, it is very easy to become a ‘kilo millionaire’ and shift a lot of freight. But profits do not necessarily follow from volume and / or growth. China may be the panacea for those seeking ‘growth’ but investment returns are based on making profits ? What chances of that ?

It is the most common utterances of CEO’s of large multi-national companies. “Our company sees strong growth prospects in China and is investing accordingly.” All manner of companies from car makers (GM / VW) to service companies (Wal-Mart / Starbucks) are focused on a rapid expansion into China. Banking is the latest to hit the craze with just about every major bank in the world attempting to buy pieces of the tightly held Chinese Banks. Last year, the British-based Hong Kong and Shanghai Banking Corporation (HSBC) bought 19.9 percent of the Bank of Communications for $2.25 billion and Bank of America, the Royal Bank of Scotland, Goldman Sachs and Singapore’s Temasek have all committed to similar deals. When the Bank of Communications made an initial public offering (IPO) in Hong Kong in June, it was oversubscribed 200-fold by retail investors and 20-fold by financial institutions.


Brand new Wal-Mart in China

The Chinese Government is being extremely shrewd as it oversees the sale of its home grown companies. It is not possible to buy outright control of a Chinese firm. You must form a joint venture with a Chinese company and this will include a technology sharing clause as a quid pro quo to China opening up its 1 billion+ consumers to foreign firms. Thus local firms will obtain design, research, marketing and sales expertise to accompany their already formidable manufacturing prowess. Experienced commentators project that China will soon start developing their own global champions in most key industries.

So the answer seems to be to invest directly into China to take advantage of these potential multinationals. Well, not so fast. If there was one common theme that emerged from our meetings it was that the listed Chinese companies on the Shanghai market were to be avoided at all costs. Most have little or no concept of the true cost of capital and are focused on socialist goals which generally means achieving volume, volume, and more volume. Anecodotal reports suggest that 9/10 industries are beset by overcapacity in China. Added to this, most companies remain 75% Government owned which is an extraordinary overhang of shares (like our national airline !). The notion of corporate governance is also, to put it charitably, somewhat behind Western markets.

So what to do ? How to access the opportunities that will certainly emerge from the Chinese growth that will inevitably come over the next decade or so. Here are some investment ideas that we came back with. We have listed them in reverse order in terms of ease of access :

• Invest into private Chinese companies – one commentator said that it doesn’t matter which industry you chose, each Chinese company would benefit from the growth of the underlying consumer market and where appropriate would export globally. He did say that investors must be mindful of the secondary line of control which exists in Chinese companies. Buying a company outright gives you control over management but all Chinese companies also have a horizontal level of control which includes Party and Government representatives.

• Chinese private equity funds – these are becoming increasingly popular and widespread as experienced managers launch funds which they will then deploy in their specific area of expertise.

• Use a Chinese manager running a Chinese investment fund – there will undoubtedly be some opportunities in the sharemarkets but it is probably best to outsource finding them to someone intricately involved in the market and aware of the underlying issues that they face. Increasingly managers based in Hong Kong are launching China equity funds.

• Buy Chinese property – despite the recent price increases, this is still the easiest and best way for foreigners to access the Chinese growth while earning a consistent return. The yields on Chinese property are still reasonable if you look outside the Shanghai and Beijing CBD areas. These two are overpriced and have large vacancies, not a great combination. However owning areas in Tianjin or Shenzhen or secondary property in Shanghai / Beijing will still likely yield in the region of 7-8% with strong prospects for capital growth.


There is no shortage of building activity China

• Chinese property REIT’s listed in Hong Kong / Singapore – one company we spoke to was launching a business undertaking to purchase Chinese properties and bundle them into a real estate trust that was then listed on the Hong Kong or Singapore stock markets. This struck us as an exceptionally good way to access the income and growth while still receiving the shareholder protection and governance of a investment in a Westernised stock market.

• Buy an Asia pacific manager with specialty in China – this remains a potentially attractive way to access the growth. Investment into China itself can be very risky, but accessing the companies in markets like Hong Kong / Taiwan (which are basically China anyway), Korea and Japan seemed to be a good mix of return opportunity and risk minimisation.

• Simply buy surrounding countries – a number of people we spoke to suggested that simply buying the surrounding countries was the best way to access the China story. Japan, Korea, Hong Kong, Taiwan, Singapore, Malaysia are all benefiting from their proximity to the runaway growth of China. All have reasonably sophisticated markets with adequate shareholder protection.

• Commodities – one of my favourite ways of accessing China remains investing in commodities or even commodity companies. If you cant get in on gold prospecting, then sell the miners the tools they need. Chances are you will end up richer ! Gold in particular strikes us as a potential (oh dear) gold mine. Not only will the Chinese Government likely start adding gold to their reserves to diversify away from US dollars but the Chinese public have an absolute fascination with the yellow metal. However currently they own less per capita than Cambodia ! As consumers grow richer, it is inevitable that they will start owning more gold jewellery.


Chinese fascination with goes back to at least 2000 years

• Buy NZ companies benefiting from China – last but certainly not least is to access NZ companies that will benefit from the China boom. Tourism comes to mind. The Chinese have just recently been given permission to go on overseas holidays. About 20-30 million venture abroad each year but this amount is expect to triple in the next five years. Other examples might be food manufacturers and casino operators.

Investing in China is also likely to have its fair share of risks. It is definitely going to be an upward sloping curve but there will be booms and busts along the way. We were also somewhat surprised to hear that the environment for investing in China is likely to be very benign for the next five years. The Chinese Government is extremely anxious to ensure that the 2008 Beijing Olympics and 2010 World Expo in Shanghai go off spectacularly. So they are likely to be on their best behaviour in dealing with external issues in the political sphere.

However, after that there is an increasing likelihood that China might start to rattle its sabres a bit more in relation to issues like Taiwan. Compulsory reading for anyone investing in China should be the summary of the Chinese military spending issued by the Pentagon in July this year. In it, they ominously noted that:

“China does not now face a direct threat from another nation. Yet, it continues to invest heavily in its military, particularly in programs designed to improve power projection.”

Investing in China brings to my mind a quote by the late Bruno Lawrence in the cult classic “Goodbye Pork Pie”. As he bids the yellow mini and its inhabitants farewell, he notes

“Remember, there is only one thing certain in this life and that’s doubt……. I think.”

We feel like that about investing in China. It is a gold tinged certainty that there will be a lot of money made in China over the next 30 years but I wonder if the Western investors seeking to profit from China will end up looking like the famous yellow mini; a bit lighter in the pocket, missing a few parts and crashing in flames.