July 2023 newsletter
Could the Most Complex International Relations Situation Ever also be a Value Opportunity?
China has a heavy presence in the financial and political news these days. The financial news is very focused on the poor macroeconomic recovery (consensus opinion, at least thus far) that China is currently having. The political news is focused on new rhetoric and measures out of Washington, where anti-China views have become more consensus. This news flow is interesting because we’re all citizens of the world, and the quality of relations between the world’s most powerful countries is vital to the future of the planet. How can challenges such as climate change, sustainable development and future pandemics be addressed if the global powers do not talk? And at Ballina we do have thoughts on China, because ultimately we do have to make decisions about the risk of Ballina portfolios. What follows is a discussion of how we are currently thinking about China and Hong Kong (“HK”), and how we integrate these thoughts into our investment philosophy. We also compare China to some other more popular Emerging Market countries, discuss some valuation anomalies in the region, as well as the attributes of some very cheap (and possibly attractive) Chinese and HK companies that we have researched.
When we consider the current position of China relative to the rest of the world, it presents, in our view, an unprecedented and complex challenge to the understanding of the developed world. Have we seen a country that is powerful deviate from the political and social values of the rest of the world before? Of course. But we haven’t seen the combination of it happening with a country that has: 1) 18% of the world’s population, 2) the world’s second largest economy, and 3) the positive trends going for their economy in terms of growth and innovation. Even if you combined Germany and Japan in 1939, their populations were less than 10% of the world total. As strong as the Former Soviet Union may have been, the peak economic power relative to the United States was probably around 1965, when the Soviet Union GDP was slightly more than ½ the size of the United States (source: World Bank). The population of the former Soviet Union around that time was roughly 7% of the global population (Sources: United Nations, New York Times). According to the IMF, China’s economy is now about 72% of the size of that of the United States, so relatively larger than the Soviet Union at the peak. Now some may believe that China’s issues will sew the seeds of its economic decline, and those arguments may have some merit, but the scale of the situation is far different than the West have faced before.
Source: worldeconomics.com
China has embarked on expansion of internal and external strength to an alarming degree. And yet they seem, in some ways, weaker than before. The property sector is not going to be a positive for some time to come. Youth unemployment is too high. Confidence seems to have been lost post pandemic measures that were in place for far too long. Policymakers implore and induce businesses the world over to “decouple” or “derisk”. The share prices of Chinese and HK equities look like they have been cancelled. However, we at Ballina are quite certain that China cannot be cancelled. They are far too important for the global economy. Over the next five years the IMF forecasts that China will account for more than 20% of global GDP growth. While their economy slows, it still grows faster than the global average. The Chinese economy is almost 6x larger than that of India (source: World Bank). China has a massive manufacturing base, and therefore, they cannot afford to pull back from the global economy. The global manufacturing base of China is almost equal to the combined manufacturing of the United States, Germany and Japan combined, (source: United Nations Conference on Trade & Development) and that gap is narrowing, not expanding. China has more labor to harness, more urbanization to do, and while their population is ageing, they have plenty of room to raise their retirement age. In addition, the fiercest challenge facing western markets is persistent inflation, and China has virtually none of that at the moment. We can debate when and if stimulus will come in China, but the reality is that policymakers there have everything in their toolkit.
We’ve discussed where China is now. There is also the point about where they are going, and by that we do not mean geopolitically. At Ballina, we can actually be bearish on China, and if our due diligence leads us to believe that we have an attractive company at a cheap valuation, we will invest. Now country considerations do matter. We need companies to be listed in countries with relatively strong institutions and stability. China was ranked 21st by the IMD in their 2023 World Competitiveness Rankings (source: IMD World Competitiveness Center). Hong Kong was ranked 7th. Clearly, China has many advantages that other economies do not, and a large part of that emanates from the quality of institutions, infrastructure and policies. China is not just large, but they are innovative. See below. China ranks as highly as very wealthy countries in terms of innovation. Recently the Financial Times wrote an article about Luxshare Precision Industry, a privately owned Chinese contract manufacturer. The article described how Apple CEO Tim Cook has been so impressed by the technology and productivity of this relatively young company, and Apple has responded by giving share of premium Iphone production to Luxshare. Luxshare was only founded in 2004. While Ballina has never analyzed Luxshare, this is an example that despite all the decoupling and supply chain disruption from COVID in China, the country continues to be innovative. In the second table below, you can see how the profits from the most innovative industries among Chinese corporates have expanded massively. There is a lot of discussion about Chinese dominance in supply of raw materials for electric vehicle production, but this misses the technological point. Aside from Tesla, China dominates EV production. BYD and CATL have outperformed Chinese shares by a massive margin, and this is despite U.S. investment sanctions, and despite the technology crackdowns from Beijing. This suggests that these two companies, and the Chinese EV industry in general, are long term winners in the space.
Source: Alpine Macro
Source: Alpine Macro
We discussed the current comparisons to the former Soviet Union, but as China grew in the 2000’s and post GFC, and its companies prospered, many investors began to apply a lens and framework for analyzing Chinese equities as if they were from the West. For example, analyzing Alibaba with the same thought process as researching Amazon. Winner take all momentum stories were the best investments in the West, and this must be the case in China. When this investment analysis backfired in recent years, many of these well known investors responded that China was “uninvestable!”. The reality was that these investors were embarrassed. And as with all investment mistakes, the investors should have looked in the mirror at themselves for the blame. The risk of loss of capital due to Chinese policy decisions should never have been considered low. What was different was that in the one party system, industries that have grown too large and possibly could be viewed as posing exploitative risks to society, or possibly the political structure itself, they would be reined in. Notice that Contemporary Amperex Technology (“CATL”) and BYD Co., key to the future electric vehicle market, were not “cracked down upon”. In the West we are used to companies and industries that become large attaining lobbying power. While these companies and industries do come under attack in the West, they have the means and influence in our societies to impede harsh and sharp actions. Status quo is typically maintained.
Chart of BYD shares relative to Hang Send Index – last five years
Source: Factset
Now that many have moved beyond the embarrassment, the weightings in China and HK shares remains low. And we believe that is due to three reasons: 1) the macro assessment that has always prevailed for Westerners making allocation decisions on China has been negative, 2) the past performance that always carries a disproportionate weight on allocation decisions in every asset class has turned relatively negative for Chinese securities over several timeframes, and finally 3) growing fear that Washington will limit and or sanction investment in China and Hong Kong. For many of the largest asset managers in the world, #3 probably carries the most weight. China brought attractive liquidity features for large managers in the past, but given the overnight nature of investment sanctions on Russia, and the chaos that ensued for portfolios and custodians, large positions would now be a negative. Better to avoid exposure altogether than be forced into a painful unwinding, or even worse, stuck holding securities that you’re not allowed to sell (as happened with Russia).
We find these appraisals to lean too much on the political. And we find inconsistencies in the views. Yes, Russia and China are allies. Russia also has friends in India. Russia has friends in the Middle East, Brazil, South Africa, and even some in Israel. Among these Russian friends, India seems to have benefited from investment flows out of China and Hong Kong. The thinking must go, well, India is a Democracy. Modi seems like a much more market friendly leader than Xi Xinping. These are truisms. But India is not without fault lines that should provide caution for foreign investors. China actually ranks well ahead of India in every Global Competitiveness Index of recent vintage. (Also take note of where India places in the earlier Innovation table) See below. According to the World Bank, depicted in the charts below, China has a much stronger Control of Corruption score. Government effectiveness, according to the World Bank, is an area where India is very weak, while China is quite strong.
Both India (Satyam, Punjab[1]) and China (Sino-Forest, Luckin Coffee[2]) have had their share of public company accounting frauds or malfeasance. Interestingly, most of the Chinese accounting frauds were committed at companies listed in the West. The pain from frauds in India happened with domestically listed shares (Source: SEC, Bloomberg, Reuters). And arbitrary Government intervention is not only confined to China. Here is a quote from Bloomberg just this month:
“Narendra Modi’s government pulled the carpet out from under technology companies in yet another example of India’s sudden policy shifts. Apple, Samsung and HP are among the biggest names freezing new imports of laptops and tablets to the South Asian country after it abruptly banned inbound shipments without a license. The restriction adds to longstanding Indian measures designed to discourage bringing in foreign electronics.”
While there is fraud and government intervention in both markets, one would surmise that the democracy (India) must be more transparent. Transparency International, which ranks countries on measures of Transparency, has China ranked #65, and India #85. The emerging democracy of India has work to do there as well to catch up to the one party system. And maybe this is what is happening? The investment flows to India are getting ahead of the reforms and improvements to come. But doesn’t that sound a bit like what investors believed about China in the 2000’s? China was getting wealthy, the middle class was growing, clearly reforms were a matter of time.
We are not India bears. But it is worth mentioning that while China (17% of companies passing our screen) and HK (12% of companies passing our screen) present an ample supply of companies meeting our screen criteria, India presents very few (3% of companies passing our screen). Basically, is the market already discounting the bullish future for India, and bearish future for China and Hong Kong? Is it in the price? See the investment charts below that depict valuation criteria for iShares MSCI India in comparison to iShares MSCI China. The discount of China to India appeared to be narrowing as recently as 2021, but then in the last two years it has expanded again. The P/B level for the Indian stock market is 2.6x that of the Chinese equity market. This means the Price to Book for India is more than 3.6x. (source: Factset) See below. While Return on Equity is higher in India than it is in China, the ratios are not that far apart at 14.5% in 2022 for India as compared to 11.2% for China.
Source: Factset
As mentioned, our screens have many companies from China and Hong Kong. This means that there is a deep roster of listed companies there with strong records of profitability, high % of tangible assets and low valuation. Our screens require companies to pass all parameters. Upon inspection, some of these companies are lacking. For example, we will not consider Chinese banks because we do not believe in the quality of the credit process in China. But over the years, we have found a number of companies to like. Now one would think that with all of the negativity about China’s economic growth, that these companies would have declining profits. But as we know from developed markets, the linkages between a country’s GDP growth and an individual company profitability, and the resulting share price, are poor. And this is true for China. In the table below are some sample companies listed in China or Hong Kong from our rank sheet. What is evident is that: 1) these companies all had very impressive financial performance in the last five years, 2) the dividend yields are very high, the lowest being more than 6%, and 3) the Balance Sheets are very strong, with four out of six companies having Net Cash. Forward estimates for sales and earnings growth are more modest, or in some cases, the companies are not covered, and do not have estimates. And we believe this is a fair takeaway. Growth from Chinese companies will be more modest going forward. At Ballina we prefer modest forward expectations because it improves the risk reward profile. Looking over what we own in China/HK today, I see companies specializing in sanitary napkins/tissues, pharmaceuticals, electric bicycle batteries, clothing brands and logistics. These companies have market caps in the range of $800 million to $7 billion, i.e. they are small to medium sized companies. They are not extracting massive economic rents from the Chinese consumer. Even if China does aim to take Taiwan by force some day, we think it is possible that domestic demand for these products in China would remain vibrant. Our aggregate list of Chinese/HK holdings trade for less than 1x book value. They pay very strong dividends. Aside from the logistics group that we own, they are owned by private entrepreneurs.
Source: Factset, Ballina Capital
You’ll notice that most of the companies above are listed in Hong Kong. Part of the explanation here is a valuation anomaly. Basically, Hong Kong, despite the friendly long term investment history with the West, trades at a discount to the onshore Chinese companies. In some cases, the discounts are perverse. Some Chinese companies have listed A shares onshore, and H shares in Hong Kong. The shares have essentially the same rights, and should have the same intrinsic value. Now these shares trade in different currencies, with the HK shares trading in Hong Kong Dollar. But when you take the A share and H share and convert them into the same currency, the discounts for the HK shares can be massive. We did not cherry pick this list below. We picked the most familiar companies to us at Ballina. And the median discount for the H shares was 58%. See below. Hong Kong has basically been getting cheaper, relative to essentially every major market in the world, beginning in about 2014. See second table below. We’re not 100% sure why the HK discount has become so perverse, but we believe this is the impact of European and North American allocators exiting China. These allocators never owned material amounts of shares in onshore China. They could only sell what they own, and there hasn’t been a natural buyer of HK shares. Chinese domestic retail investors are limited in how much they can invest in HK through the Stock Connect program.
Source: Factset
iShares MSCI Hong Kong ETF valuation vs iShares MSCI ACWI ETF
As we said at the beginning, the news coverage of China is interesting. At Ballina Capital we select stocks from the bottom up. We begin our investment process with initial screens that keep us disciplined to stocks with the value characteristics that we find attractive. Today, there are many stocks listed in China and Hong Kong that populate our screens. We have our choice of companies large and small, across all sectors. We are not bulls on the Chinese economy. Likewise we are not huge fans of the geopolitics and economies of the UK, Japan and Germany, and we invest large amounts in those markets. We don’t believe that Chinese and HK equities will become anything but cheap in the near term. In several cases, we believe the cheap prices are too hard to ignore. We keep a close eye on overall exposure. We retain our sell discipline. If a stock is hurting us too much, we do not allow it to become a large distraction, and instead we cut our losses. As always, retaining humility is integral to being a good investor, and this must be at least as true in regard to views on China.
Strategy Performance
International All Cap Value returned 5.03% on a gross basis, and 4.95% on a net basis, in July 2023 versus 3.89% for the benchmark. Year to date performance was 14.27% on a gross basis, and 13.62% on a net basis, versus 14.15% for the benchmark.
International Small Cap Value[3] returned 5.01% on a gross basis, and 4.93% on a net basis, in July 2023 versus 4.93% for the benchmark. Year to date performance was 12.8% on a gross basis, and 12.15% on a net basis, versus 13.76% for the benchmark.
International Developed Market Value[4] returned 6.51% on a gross basis, and 6.47% on a net basis, in July 2023 versus 2.70% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in July was Ryohin Keikaku. The Japanese retailer was strong as Q2 earnings surprised on the upside at more than 90% above sellside estimates. Selling price increases in Japan and China aided sales and gross margins. The strategy’s top detractor was Qingdao Port. The Chinese port operator was down modestly in July, as investors continue to be disappointed in the pace of the Chinese economic recovery. There was no company specific news.
International Small Cap Value’s top contributor in July was Ryohin Keikaku. As mentioned above, the company had to increase prices in the Winter time to get the Gross Margins back to an acceptable level. Overseas performance is leading the way. The strategy’s top detractor was LSR Group. This is a Russian property stock that our Small Cap portfolio is unable to sell, given sanctions (this is the only portfolio that owns the security). Russia is struggling with stabilizing their financial system at the moment.
Disclosures:
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmarks being shown for comparison purposes are: a) for International All Cap Value - the Vanguard Total International Stock ETF (VXUS), b) for International Small Cap Value - Vanguard FTSE All-World ex-US Small-Cap ETF (VSS), and c) for International Developed Market Value – the iShares MSCI EAFE ETF (EFA). The information contained herein is not investment advice. The information contained in this commentary represents the opinion of Ballina Capital and should not be construed as personalized or individualized investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. The securities identified and described do not represent all the securities purchased, sold or recommended for client accounts. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return. Data show is from a representative account of the International All Cap Value and International Small Cap Value. All returns are Gross of Fees. Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented. The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the measurement period are available upon request.
[1] Satyam Computer Services’ accounts had been falsified, and this was discovered in late 2008. This became the largest fraud in Indian history at the time. Officers of the company were convicted, and the company was sold. In 2018, Punjab National Bank discovered that a single branch had committed fraudulent transactions equivalent to roughly $1.8bn. (source: Wikipedia) [2] In 2011, Sino-Forest corporation was accused of inflating its assets and earnings. In March 2012 the company filed for bankruptcy, and it was later found to have committed fraud. In April 2020, Luckin Coffee admitted to having inflated 2019 Sales by $310 million. The stock price crashed, and the company delisted in June 2020. (source: Wikipedia) [3] On October 17, 2022, the Global Small Cap Value strategy transitioned to the International Small Cap Value strategy. From this date forward the focus of the strategy will be on International Small Cap stocks. The benchmark changed on 10/17/22 to Vanguard International FTSE All-World ex-US Small-Cap ETF (VSS). [4] International Developed Market Value is a new composite. The strategy funded during June of 2023, and July 2023 was the first full month of performance.