Henderson’s Lofthouse: Why I’m swapping Europe for China

Lofthouse-Ben-Henderson-2014

Since Mario Draghi, president of the European Central Bank (ECB), outlined his intention to do ‘whatever it takes’ to stop the break-up of the Eurozone in 2012, European equities have undergone a significant re-rating. While the bloc still remains strong – unemployment is down, the ECB has become more dovish, and attractive valuations can still be found – I’m less enthusiastic than in recent years, cognizant that the next strong driver needed here is more robust GDP growth.

As such the trust has realised some profits in Europe and reinvested capital elsewhere in the search for new opportunities; the weighting in Asia, and in particular China, has markedly increased.

Taming the dragon

The government in China is currently undertaking an enormous economic re-balancing in an attempt to produce more sustainable growth and improve the corporate culture. Aware of the lessons of its neighbours, the change was prompted by China’s reliance on export (highly cyclical and locked to global demand) and state investment (which consumed vast resources and acted as the progenitor to current inefficiency and over-capacity). Putting the brakes on the economy, however, has spooked investors up to now, who worried of a ‘hard-landing’ in GDP growth.

Two recent changes underpin the investment case. Firstly, new economic data is instilling some confidence. If we look to the recent Purchasing Managers Index (PMI) for example – which indicates the health of the manufacturing sector – we see it is expanding again from the contractions earlier in the year. Secondly, the government is starting to stimulate specific areas of the economy to encourage more focused growth, such as in social housing and in small and medium sized enterprises (SMEs).

With improving data and a more accommodative government, a number of opportunity sets arise. Please note that stock examples are for illustrative purposes only and nothing in this document should be construed as advice.

The SOEs

A large part of the restructuring in China is focused on state owned enterprises (SOEs) – launched in the 1950s to enact the commercial activities of the government.

With investment at the heart of the economy they contributed enormously to GDP growth, accounting for 70 per cent of government spending, but state authorities governed rather than market forces. Problems arose: a high degree of inefficiency, over-inflated pay structures and severe constraints to advances in innovation & technology relative to private counterparts.

In the late 70’s the first steps to reform began but the task ahead was herculean. Subsequent rounds of reforms followed. The latest, announced in November last year and known as the third plenum, has made the biggest commitment to date.

The overarching pledge was to let the ‘better’ SOEs become national champions: less financially risky, more efficient, and more innovative; whilst allowing the lesser able to exit their markets. This continuing reform has encouraged investors – ourselves included – whom are acutely aware of the low valuations of SOEs. 

One of our SOE investments is PetroChina, the oil & gas company. Debt is falling, earnings are growing, return on investment is improving, and the man who built the company, known as the ‘Godfather’ of PetroChina and former Chinese security chief, Zhou Yongkang, is being investigated for “serious violations of discipline”, or corruption as it is commonly known. From an asset perspective they have high quality reservoirs and the shale gas potential is attractive; seemingly this is the ‘champion’ envisioned for tomorrow.

State enterprises are not uncommon – Freddie Mac and Fannie Mae in the US are examples (known as government sponsored enterprises), set-up to aid mortgage lending, as is Gazprom, a Russian oil & gas company. In China there are around 147,000 non-financial SOEs and 1000 financial SOEs.

A leisurely investment

The burgeoning middle class provides another opportunity set. Within it a new generation is emerging: born in the mid-80s or later and more wealthy and sophisticated than generations from the mid-70s, they have greater consumer confidence and place increasing demands on the products and brands they buy.

The emergence of these enthusiastic consumers and their disposable income come hand-in-hand with the evolution of internet connectivity. Online gaming has been one area of explosive growth and a handful of leaders have emerged. NetEase is one, China’s second largest online gaming company and a hub for internet news. Still run by its founder, it has powerful growth drivers.

The strongest of these is the extremely well-received games it develops. They have a cult following and new offices in the US and Korea will start to broaden their reach globally. In addition, NetEase has tied up with Activision Blizzard, maker of the extremely popular World of Warcraft, to distribute its games in China.

We also find their movement into mobile games interesting. These have a much quicker development time (3-6 months vs. 1-3 years) therefore higher margins, and the 3-4 releases have been well received; 10 in total are slated for the year.

With an attractive valuation and a strong cash position, even though its yield currently sits at only 1.9 per cent, we believe the potential for upside is significant here.

Ben Lofthouse is manager of the Henderson Global Investors Income fund and Income trust