Don't give up on China

	China

Aug 01 2010 09:25 

Anet Ahern*

It is almost impossible to have an investment debate without the conversation at some point drifting towards China.

At the moment there seems to be two camps developing – those who are increasingly concerned about China and those (probably in the minority) who still believe in the long-term growth story.

I had the privilege of listening to David Grier, who ran along the Great Wall of China in 2006 – over 4 000km in 98 days.  Scenes of overloaded three-wheelers and communities of millions living in caves highlighted the untapped potential of the wave of modernisation sweeping over the country.

Watching the footage of his journey, I realised again how little most of us understand China and how inevitable the continuation (if not the trajectory) of the path they have set out on in the 1980s is. This lack of understanding is often underscored by the perceived poor quality of statistics out of China, the poor governance in many of the companies, and the involvement of the state.

An interesting assessment of the statistical situation was made by an experienced China analyst over dinner last week. His take was that in fact with bureaucracy so dominant in China, the figures should be very reliable indeed! I remain sceptical about stats from government departments, though.

As for poor governance, it is something one needs to accept – acting like an owner in the US or SA may mean paying out a good dividend or buying back shares, but in China it often means hanging on to cash and spending it on investments, sometimes poor ones, to build a larger empire. In return, you can find several shares on single-digit price to earnings (PE) multiples, trading at low price to book multiples.

Having said that, Chinese shares have been incredibly volatile so far this year, with the overall market down 20% for this year and over the past 12 months. There is a growing concern that China's growth is not sustainable, especially given the high debt levels.

The dilemma with concern over debt levels is that average small businesses and individuals actually have incredibly high levels of savings, but the overall figure is skewed by government and state-owned enterprises whose borrowing has mushroomed over the past few years. The split between retail and corporate bank lending in China is 15/85, compared to 50/50 in the US.

One reason for the high savings rates in certain segments of the economy is that they simply do not have access to debt. Small businesses, for example, have to keep funds on hand for working capital and expansion, as they have little chance of being able to borrow it.

So the impact of any austerity measures by the Chinese government is more complex to understand in the way it affects domestic demand.

Along with investment teams around the world, we constantly debate whether the low valuations of Chinese stocks we're invested in will compensate for periodic wholesale sentiment-driven selling.

In previous columns I've discussed Chaoda, a food producer. This company is still trading on a historic PE of 5.5 times, but has not been immune to volatility when Chinese stocks are sold. However, the share price is still up 70% over the past year.

Great Wall Motors, great expectations

A share that has defied our expectations for years now is Great Wall Motors. The share price has almost doubled over the past year and is up more than fourfold over the past five years.

The basis for being interested in vehicle companies in China is that there are only 29 cars per 1 000 people in China. This compares to 1 200 in the US, which is staggering and probably not a fair comparison.

In Europe, the number is generally around 400. What is interesting though is that the Chinese are not only buying cars, they prefer SUVs, a market in which Great Wall Motors is well positioned.

In the latest car sales numbers they gained market share despite a slowing in the fantastic growth this market has seen in the past year, with car sales up 53% (Chinese Association of Automobile Manufacturers' numbers). Great Wall sold 94% more cars during this period.

 Unfortunately the car market cannot be separated entirely from the Chinese property market. People tend to buy a car when they have space to park it. With property sales dropping sharply in May due to government tightening, concerns about capacity and inventory in the car market grew.

The next few months are likely to be quieter for both property and car sales, so a pickup is only likely in September.

If we assume that Great Wall Motors will retain the position it has taken 14 years to build up in the Chinese market, and had to ask the simple question whether Chinese people are likely to own a lot more cars in 10 years' time, a company achieving a return on equity of close to 20%, trading at 1.4 times book value and at a PE of seven times a year out does look like something you may want to hang on to.

Chinese shares are going to be sold down periodically for all the reasons mentioned here. But as an investor, given the long-term outlook and the valuations, maybe it is not time to write China off just yet.

Maybe one just needs to look harder and be a little resilient to sentiment-driven sales of good companies at good valuations.

- Fin24.com

*Ahern is with SIM Global, a division of Sanlam Investments which travels the world researching listed companies with potential unlocked value.