Hong Kong: A Rich Market for Long-Term Investors by Royce Funds

While largely out of favor, we are finding Hong Kong-listed Chinese companies that possess the characteristics we typically look for in our investments—high returns on invested capital, strong balance sheets, and attractive dividend yields. Portfolio Managers Jim Harvey and Dilip Badlani run through some names they currently like and talk about why the market is still appealing.

Jim Harvey and Dilip Badlani Hong Kong

Hong Kong is a market you have visited frequently. What is it about the market that keeps you interested?

Dilip Badlani: Hong Kong is a gateway to China for many foreign investors and a rich financial market for Royce. There are close to a thousand Chinese companies listed on the Hong Kong Stock Exchange (SEHK), and we continue to find a constant stream of new companies coming into the market that meet our quality metrics.

Hong Kong has evolved as an economy. Fifty years ago it was largely centered on manufacturing, but today it is a financial center and service economy that lends itself to companies interested in doing business in China.

So while we do make separate trips to mainland China to do our due diligence on the ground, we typically find ourselves meeting with company management teams in Hong Kong, as that is where their financial headquarters are typically located.

On our most recent trip to Hong Kong we met with approximately 20 companies, zeroing in on those that tend to pay modest dividends, have leadership positions in a specific niche, operate self-sustaining businesses from a capital structure standpoint, and have a high degree of insider ownership.

Jim Harvey: We’ve been to Hong Kong more than four times over the last two years. We also conduct conference calls with management teams as well as host them in our offices in New York throughout each year.

Dilip grew up in Hong Kong and still has friends and family on the ground, so he knows it quite well.

During our visits we’ll often follow up with companies we’ve met with before—which was largely the case on this trip—either because we own them or we just continue to have an interest in them. Revisiting companies adds great perspective.

The management teams we’ve known over the years have been straightforward with us. They are not promotional types. They have a firm grasp on their businesses and the business climate in which they operate.

Over the past few years, we repeatedly heard the message that things were not going great for many of them. On this trip several of the management teams we met with showed more optimism, which was really encouraging.

Dilip: Despite the doom and gloom about China’s slowing economy, the country is still growing at a very healthy rate for the second largest economy in the world. There’s ample opportunity for companies to grow alongside the economy as well as take share from less efficient players. We just want to be correctly positioned with the companies that will benefit from the new trends that are emerging.

Jim: One compelling reason why we’re attracted to this market is the large number of companies that possess the characteristics we covet at Royce, such as high returns on invested capital (ROIC) and high cap rates.

But the primary reason we are interested in these Hong Kong-listed Chinese companies today is that they are almost universally out of favor among investors. In our view, this provides a great opportunity.

Also, I think when many U.S. investors think about public Chinese companies they recall the headline-grabbing stories a few years back about several unsavory U.S.-listed Chinese companies that basically went bust.

So I think it’s important to note that the companies we meet with are all listed on the Hong Kong Stock Exchange where they face a much higher hurdle in order to be listed relative to, let’s say, the Nasdaq or the NYSE in the U.S. So we like this added layer of protection that comes with listing on the SEHK.

Despite the doom and gloom about China’s slowing economy, China is still growing at a very healthy rate for the second largest economy in the world. There’s ample opportunity for companies to grow alongside the economy as well as take share from less efficient players. We just want to be correctly positioned with the companies that will benefit from the new trends that are emerging.

What has changed since your last visit in the summer of 2013?

Dilip: A year ago the sentiment on the ground was more negative, and stocks were not reflecting the negative underlying fundamentals. Now things look more like they’ve bottomed out, and stocks are definitely reflecting that. Sentiment is not amazing but it’s improving.

I think people were expecting a big stimulus initiative from the Chinese government that never came. Now they’ve adjusted their cost structures to this new reality.

The new Chinese leadership is very serious about fixing the structural imbalances in the economy, and I don’t think that, when there’s a downturn, we’ll see any signs of a property market bubble or a reversion to the old ways. There’s been a shift towards more internal growth and a crackdown on corruption, and I think we’re beginning to see this take effect.

Jim: Many Chinese companies have been facing a sort of perfect storm of slowing demand and ever increasing rents. This has led to margins being squeezed.

The demand side of the equation has been impacted partly because the new Chinese leadership has clamped down on the practice of “gift giving” among government officials. But consumption in general has also been weak.

Soon we’re going to start to anniversary all of these events. Consumers will start buying again as their incomes are still growing and rents will have to adjust. It’s not a sustainable situation for retail tenants to surive in an environment where rents keep going up while sales are essentially flat.

We heard several times from management teams that they’re expecting rents to stabilize, or at least not go up as much.

Tell us about the companies you’ve visited, what you are looking for, and what you generally like about the Hong Kong-listed Chinese companies in which you invest.

Jim: Our Hong Kong holdings are very diverse, spanning a range of sectors and industries.

Dilip: The companies we’ve invested in generally have at least five-year track records. We try to find investments with seasoned management teams that we’ve met with multiple times.

We’re sticking to the Royce methodology of trying to find value-oriented stocks. We’re not macro guys, though we are cognizant of sentiment and valuation, so we go where the opportunities are.

We’re long-term investors trying to find good companies using the Royce discipline—patience and a long-term investment horizon. Historically, we think that’s been a trusted formula for good returns.

We’ve known Xtep for a little over four years now. It makes fashion-forward sports apparel and footwear. Like everything else that happened in China when things were going well, the industry got ahead of itself; but now there’s been a cleansing of inventory in the system.

It’s been two years of pain because of too much inventory in the channel—too much optimism built in—and now for

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