Charles Brandes’ commentary for the third quarter 2014 on China at a crossroads.
“I hear, I know. I see, I remember. I do, I understand”.~ Confucius
Charles Brandes first invested indirectly in China more than 20 years ago when the primary way of gaining exposure to this vast and growing country was through investments in conglomerates listed on the Hong Kong Stock Exchange, such as Jardine Matheson Holdings Limited (SGX:J36), Hutchison Whampoa Limited (HKG:0013) and Hopewell Holdings Limited (HKG:0054).
Today, the opportunities to invest directly in Chinese listed companies are vast and rapidly expanding (see box on page 8). Alibaba’s recent IPO on the New York Stock Exchange indicates that some companies are even leapfrogging China’s own markets in favor of more global ones. This improved market accessibility has occurred alongside China’s rise as the most influential emerging market, as shown in Exhibit 1, and as the world’s second-largest economy. In our view, the Chinese economy is currently at an inflection point as it has become increasingly clear that the fixed capital investment growth model of the past is becoming tapped out. As China transitions to a more balanced, sustainable and strategically focused economy, there could be profound implications for the global market.
As global value investors, we closely monitor and research China’s developments because of their potential impact on the value of individual companies. By understanding China’s influences, we can remain primed to identify when and where value could emerge. We devote this commentary to the findings and insights of three of our analysts who recently visited China: Jeffrey Germain, on materials; Ted Kim, on the auto industry; and Yingbin Chen, on technology.
First, let us set the stage for China’s evolution and its impact.
Materials Sector Insights: Jeffrey Germain, CFA, Brandes Senior Analyst, Basic Materials Team
Charles Brandes: Fixed-Capital Growth Phase Has Resulted in Excessive Investment
China’s economic growth over the past 10 years was primarily fueled by investment in fixed capital. While large-scale investment in infrastructure, manufacturing capacity and residential/commercial real estate is to be expected in any developing economy, China’s has reached historically high levels. Specifically, fixed-capital formation now represents over 45% of gross domestic product (GDP), which is considerably higher than other major economies and well above peak levels reached by other countries at the time of similar stages of their development. See Exhibit 2.
Evidence that this investment may have been excessive includes very high levels of overcapacity in many of China’s basic industries (such as steel, aluminum and cement), a rapid increase in real estate investment, as shown in Exhibit 3 on the following page, that has led to residential property supply outstripping demand, as well as a rising incremental capital output ratio. 1 To put the magnitude of its rapid investment growth into perspective, China has used more cement in the last three years than what the United States used in the entire 20th century.
Compounding the overall investment issues is the fact that such questionable capital allocations were fueled in part by increasing levels of leverage across China. For instance, in just over five years, China’s total debt/GDP has ballooned from 125% in 2008 to 200% as of June 30, 2014.3 Should the Chinese economy slow and be unable to absorb this excess level of investment in a timely fashion, credit quality issues could impact the country’s banking system by pressuring earnings and capital levels.
In May, Jeffrey traveled to China for a metals and mining due diligence trip and investigated the excess capacity issue. He also met with consultants and officials to discuss policy issues and the options available to reduce excess capacity, commenting that: “It’s clear overcapacity is a significant issue facing the Chinese economy. China’s rapid fixed-capital buildup and resulting excess capacity has depressed returns for many industries and has greatly strained the environment.”
Charles Brandes: Far-Reaching Implications of China’s Commodity Demand
This rapid increase in investment for an economy the size of China’s, with a GDP of $9.2 trillion (compared with other emerging markets such as Brazil, with a GDP of $2.2 trillion and India with $1.9 trillion), has had a dramatic impact on a wide spectrum of industries and economies outside of China. 4
Since 2004, one of the biggest beneficiaries of China’s economic expansion has been the basic materials used in fixed-capital investments, such as iron ore, coal, copper, nickel and aluminum. Exhibit 4 on the following page, highlights just how significant Chinese demand has been for these major commodities. Specifically, it shows that for the materials represented, China has been the main incremental demand center since 2004. In fact, for some metals such as nickel and copper, China represented over 100% of the incremental growth during this period; which means that Chinese demand has more than compensated for a decline in consumption from the rest of the world.
While China has some indigenous mining operations, generally, it is a net importer of most basic commodities necessary for heavy construction. Accordingly, the obvious beneficiaries of this increase in demand and price for materials have been both the mining companies themselves and the countries where they operate.
Australia is a prime example of a country that has benefited from China’s rapid fixed-capital formation. As one of the world’s largest exporters of iron ore and coal, the boom in commodity demand has resulted in a major rise in Australian exports 5 and in mining-related investments to bring on new supply, as well as a strengthening currency. 6
In addition, Australia’s housing sector has also experienced robust growth amid this China-driven commodities-export boom. To illustrate, the Australian Bureau of Statistics’ house price index of eight capital cities doubled from December 2002 thru June 2014. 7 At this point, we fear that property prices have gone too far and that a correction could be in the cards as China tempers growth in fixed-capital formation. To underscore this concern, the Bank for International Settlements, which represents global central banks, stated in a news report that the Australian housing market is overvalued, with some of the highest price-to-rent and price-to-income ratios among 14 advanced economies. The agency warned of the risk of a correction in markets where house prices were more than 20% above their historical average. 8
It is clear that Chinese demand has benefited industries and countries exporting to China in the last several years. Looking ahead, the sustainability of these gains is uncertain, especially if and when China moves away from the fixed-capital intensive growth model.
Auto Industry Insights: Ted Kim, CFA, Brandes Senior Analyst, Industrials Team
Charles Brandes: Beneficiary of Strong Economic Growth: Auto Industry
Another industry where China’s global influence looms large is the auto sector. Ted recently visited China to study the dynamics of its automobile industry and the global impact of the country’s immense demand for cars.
“When people talk about the growth in automobile demand in China, we often hear words such as ‘stunning,’ ‘unprecedented’ or ‘spectacular’,” Ted comments. “While other countries may have experienced a similar type of rapid growth as their economies grew strongly in the past, with