Picking the winners in the Asian success story

Despite the choking, pungent smog enveloping the Chinese capital of Beijing, even at the start of the chilling winter months, China is going green, officially at least. The country’s energy consumption, measured per unit of gross domestic product, has dropped by 20 per cent in the last five years, according to vice premier Li Keqiang.

And more of the same medicine has already been cooked up for the next policy-making window.

It is by listening to and forecasting these policy announcements that the increasing universe of stockpickers clustered in Asia’s financial capitals can best profit from the one of the world’s fastest growing economies, believes Louisa Lo, head of Asian equities at global fund house Schroders.

That’s why Ms Lo has confidence in stocks investing in development of new energy, one of the key innovations in the Chinese government’s 12th Five Year Plan. The key to success in Chinese investment, believes Ms Lo, is identifying a company which can benefit from such government policies and is then able to gradually move up the value ladder before exporting into other markets.

China is a policy-driven market, she says. “You need to look at government decisions and then decide which companies will benefit from them. If you follow these stories, you will do quite well, but you need to understand the government policy mindset and be selective.”

It is politically imperative for China’s government to do everything in its capacity to keep growth at higher single digit numbers as a minimum, believes Ms Lo. “Some people are expecting GDP growth to come down sharply, but this is a highly political issue,” she says.

“Below 7 per cent would not be acceptable in terms of the pain and layoffs this would create.”

With exports now falling and domestic consumption “not huge”, the emphasis will switch to new sectors such as pharma business, she says. Ms Lo also expects significant investments in China’s railway system to drive growth. Expected local government changes during 2011 should also bring more fiscal stimulation, with Schroders “not overly bearish” and still expecting growth of between 8.5 and 9 per cent.

While many regional funds tend to be organised around countries, investors should not ignore specific sectors and stocks within them, warns Wilfred Sit, chief investment officer for Asia Pacific at Mirae Asset, a fast growing Korean fund house, developing a second base in Hong Kong for cross-border investments.

Powering these sectors are distinctive themes, including the all-pervasive Asian ‘consumption’ story. This, says Mr Sit, involves the emergence of a middle income class, with China leading the way and India closely following. “We are about to enter a consumption boom in China,” he says, backed by figures from the Boston Consulting Group showing 48m middle class Chinese households in 2010 to expand to 134m by 2020.

“Like Japan in the late 1970s and 1980s, or the newly-industrialised Asian Tigers of the 1990s, China is entering that stage now.”

Following on from its exporting success and speedy infrastructure developments, China is shifting to a domestic, consumption-led economic growth, which will prevail during the forthcoming decade, says Mr Sit, favouring stocks in consumer discretionary spending sectors, such as fashion, travel and tourism.

While there is much made by Western bears of potential Asian overheating, consumption is a fairly risk-free theme, believes Mr Sit. “We are at a stage where it is not going to stop anytime soon.”

Some smaller groups run funds which are almost purely based on this theme. Coupland Cardiff Asset Management, which employs a small team of managers in Singapore, is an example. “If you are a large fund manager, you come to the conclusion that there are not enough stocks based to profit from such a theme,” believes Rory Dixon, portfolio manager of the CC Asian Evolution fund. Larger investors need big, liquid brand names such as Glaxo Smith Kline, Unilever and Nestlé, which are active in China and India.

“But in the consumer space, of 2,000 listed companies, 90 per cent of them are under $1bn market cap. That is the space we are looking at, due to the embryonic nature of the development of this sector,” he says.

“People have been talking about the Asian consumer sector for years and years, but in reality, it is very small and has only just got started.”

The beauty about the consumer sector in China is that it bypasses government policies, says Mr Dixon, so stockpickers do not constantly have to second-guess policymakers regarding regulation and political favours. In this way his selection philosophy differs fundamentally from that of a large house like Schroders.

“I can’t buy a company not in control of its own destiny, where the regulatory environment and political winds can change very quickly,” says Mr Dixon. “I don’t want to be hostage to that.”

One of the themes he is currently addressing in China is concern over food safety, with a consequent shift to branded products. “Chinese consumers increasingly want to buy a brand they can trust from the supermarket rather than cheap stuff from a stall on the corner,” he says.

Alternative policies

But not all investment houses are as bullish about domestic consumption, believing the country must look at alternative ways to boost its economy and quell any potential social unrest. Ms Lo at Schroders warns against following themes that are too narrow in Asia. Schroders has looked at the idea of thematic funds but decided against this approach.

“We found these are very niche and narrow focused,” she says. “How many stocks do you have that are pure cleantech or consumption stocks? There are a very small number and they have high volatility. They form just a small part of the index, so there are a lot of things to think through. If you go too big on a theme-driven product, you can get stuck.”

Despite the factors in favour of its expansion, the Chinese market faces many different influences, with inflation and labour unpredictability currently major concerns.

The combination of rising prices and employers being forced to relocate factories to meet labour demand patterns are leading to a re-assessment of profitability models among many businesses in China, says Mr Sit at Mirae Asset.

“Chinese employers have arrived at a stage where they need to share more of their profits with the workforce,” he says. “Labourers now have the chance to demand higher pay. They know how much guys are on in the outside world and they know how much their companies make. A lot of companies cannot just continue with the cheap labour cost business model any more.”

The latest stage in the inflationary spiral follows events at Foxconn, the secretive high-tech Taiwanese manufacturer of the iPhone, which improved conditions and increased remuneration for its 800,000 Chinese workers, after a damning report from 20 Chinese universities described some of the production sites as “labour camps”.

Competing manufacturers in the Chinese tech space were then forced to make wage adjustments of 35 to 40 per cent last year. “Other multinational companies had to face higher than normal wage increases, which led to inflationary pressure,” says Siew Hua Thio, senior portfolio manager at Tantallon Capital in Singapore.

Global manufacturing companies are now reassessing how China fits into their long-term plans. “China to them is no longer just an outsourcing base, but a market in itself,” says Mr Sit. “They are no longer just manufacturing in China for a low cost, they will also sell within China.”

While some manufacturing capacity may be moved further afield in Asia, on a selective basis, he does not believe companies will shut up shop en masse. “The whole manufacturing chain is still delivered well in China and it is very difficult for other countries to compete in terms of distribution. Execution capability is world class.”

Rise of india

That is not to say Chinese growth is the only story in Asia, and most equity managers across the region expect the Indians to give the Chinese a close run for their money. “Middle class consumption is led by China, but India will move along the same path, as will Indonesia,” believes Mr Sit. “Indonesia is a country of 240m people, a huge domestic, under-penetrated market starting from a low base.”

Schroders is also investing in India for the medium-term, but there is a belief that economic risk may be too high in the short-term. In contrast to China’s more holistic approach, with the government taking a strong role in building infrastructure and paving the way for its companies to build external markets, India’s success seems highly opportunistic, though fuelled by similarly high expectations.

Indian companies, some with already stretched expectations, are still in “build-up phases,” says Schroders’ Ms Lo, with the country needing significant infrastructure investments and the government not yet playing a major role in industrial expansion.

“India is China, 10 to 12 years ago,” she says. “The strategy is very similar when you meet management. They are doubling capacity and trying to conquer the world.”

Louisa Lo