China growth outlook – is anyone concerned?

The Federal Reserve Bank of San Francisco published a recent review (‘Is China Due for a Slowdown‘) of the Chinese economy and whether  we can finally expect a slowdown. The summary reads “While average income in China appears to be headed towards levels that have been associated with growth slowdowns in other countries, high income inequality between wealthier coastal provinces and the less-developed interior suggest that deceleration may not be severe”. So is this good or bad news? As to the consumer story, we look to the US and Asia’s regional consumers in a little more detail below.

Further we read the Goldman Sachs A-Share piece with great interest. In its recent update, Goldman Sachs suggests the following companies, among others, as a Buy-Rating:

– Baosteel – Steel company
– Beijing Capital – Real Estate Developer: Residential, Office, and Commercial in Beijing
– Better Life – Supermarkets
– BlueFocus – Public Relations
– Fiberhome – Telecommunications
– Hualu-Hengsheng – Chemical manufacturer
– Industrial Bank – Industrial Bank, Top 10 in the country
– Jiangsu Yuyue – Medical Equipment
– Jizhong Energy – Coal products
– Ping An (A) – Insurance
– SAIC – Automotive
– Yantai Wanhua – MDI manufacturer, largest in the region

Other stocks that offer a potential upside (on current share price) are Lushang Properties, Jiangsu Zhongnan Construction, China Merchants Bank (A), Shenzhen World Union Properties and Zhejiang Yankong Group.

While this list is interesting and gives a broad range of exposure to various sectors, it masks the wider implications that currently drive the regional and global economy. Access to the these companies is restricted to many investors. Therefore other proxies may serve as an indication of what is truly happening in the region. Below, we take a look at the state of the domestic Chinese banking sector, the regional and global consumer sentiment as gauge for current consumption trends.

Deloitte commented in a report on China’s Banking Industry in its 2012 outlook. The conclusion of the report starts by stating:

“The banking industry of China faces challenges on many fronts – to asset quality, non-performing loan levels and liquidity, to name a few. Emerging risk is perhaps the greatest challenge. With the expected
slowdown in domestic economic growth and weak external demand, new risks in the industry are growing. Industry risk is being controlled, in part, through greater regulatory scrutiny, monetary policy easing, and
local debt approval. The reform of rural financial institutions continues to move forward, further supporting growth in “Agriculture, Farmers and Villages”.”

We couldn’t agree more. The transition from an inward looking banking sector towards an industry that strives to be part of the globalization effort will take time but the forces are at work. Not only is the sector catching up fast, it will certainly lead in a number of segments not before long. The easing of the RMB exchange rate ‘gridlock’ is likely to enable a more balanced approach by its domestic banks in line with investor expectations both domestically and internationally. The domestic banking sector certainly must get its act together to avoid any of the fallacies of earlier decades. Nonetheless, while the housing sector is overheated for some and therefore poses a significant risk, the individual consumer is still striving and aspiring to developed market levels.

To balance our (global) view, we explored KPMG’s US Retail Industry Outlook Survey (2012) to look for evidence that spending on the domestic, eg consumer level, are intact and demonstrate signs of robustness despite the gloom in the global economy. After all, someone has to spend their income for (consumer) goods and thus make the trade to go round; if not the Americans who else we ask. The authors of the report conclude “…retail executives expect the industry to proceed on a path of gradual growth over the next year, supported by continued modest gains in revenue and hiring. Concerns over the US economy are evident, as many executives have pushed back their expectations for a substantial recovery until 2014/2015 or later. While waiting for the recovery to take hold, sector executives are focusing on spending the cash built up on their balance sheets by investing more over the next year in information technology, including data analytics and digital marketing channels.” This makes an OK reading and does not worry us too much as we would expect some level of re-balancing at the individual consumer level. But signs are certainly pointing sideways if not upwards over a medium term view.

PwC - 2012_Retail_Consumer_Products_Asia_Chart16

PwC: 2012 Asia Retail and Consumer Products, Chart 16

The Asian regional consumer behaviour is certainly becoming an ever more important factor as far as the decoupling from the developed world versus developing world is concerned. PwC put out a report entitled 2012 Outlook for the Retail and Consumer Products Sector in Asia and hits the nail on the head. Numbers in China are always big and staggering but these do not change the fact, there are what they are. China’s spending on Food, Beverages and Tobacco will double during period 2011-2015 potentially achieving US$1.4tr in sales. It is thus interesting to note that China has only 2.5 hypermarkets per million people. France, the US, and South Korea have 25, 12.3 and 7.6/ per million respectively. The conclusion is obvious.

In a nutshell, the consumer story in Asia appears to continue to gain traction. Although some believe it is slower than analysts had forecast, it is still a momentum that is gathering pace. And if the classical S-Curve is anything to go by, Asia will soon have a major impact on corporates that serve the regional consumers.

We look at the global conglomerates that can serve the market (Unilever, Kraft, Mars, Procter & Gamble, Johnson & Johnson, L’Oreal, Walmart, Carrefour, TESCO, Metro to name but a few), have the capabilities to develop regional if not local strategies, and the capital to have staying power when things get tougher than anticipated. A clear road map is certainly required to take on these markets. Entering them all at the same time, may just a little bit too challenging for most.

Water – Where is the money?

Deutsche Bank’s piece on the Water sector (World Water Markets, pdf) presents an interesting read. Following on from our research Water Scarcity – An investment Opportunity, Deutsche Bank echoed some of our thoughts. In particular, two areas stand out.

First, the agriculture sector plays a vital part within the water value chain. We maintain our view that ‘water efficiency‘ remains the primary factor in extending the use of fresh water. Further, the challenge with respect to putting a price on water is discussed in the DB paper although no clear recommendations are being made how to overcome the conundrum.  We previously looked at tradeable water rights, Full Cost Recovery, and Polluter Pays Principle and suggested areas for thought how to establish a market mechanism.

Second, Deutsche Bank raises the issue of how to find credible investments in the water sector. KPMG, also, put out a research report that looked at private investments in water infrastructure (2008, pdf). Although the primary investment focus in both reports is on water infrastructure, we are not comfortable with the likely returns that may be earned in this space. Specifically, the requirement for sewage plants may be interesting but the returns to be earned will likely mimic utility and/or project finance like returns. The high up-front capex is something we normally shy away from. Rather, we look at the technology side of the investment theme and focus on efficiency plays. Deutsche agrees: “A large range of technologies is needed. The demand for efficient irrigation technologies, seawater desalination and sewage treatment facilities, technical equipment (e.g. pumps, compressors and fittings), filter systems or disinfection processes (e.g. using ozone or ultraviolet light) and efficient sanitation facilities will probably pick up sharply.”

Another area that we explored a while back are the business and management issues for companies based in India and China that lack access to fresh and/or clean water. For investors who like to look at the state of the Chinese Water sector and how to potentially participate, we recommend KPMG’s report ‘The Water Business in China – Looking below the Surface.’ In a nutshell, the report explores ways to participate in the urbanization and how to invest in Joint Ventures at the Municipal level. JPMorgan explored business risks associated with water access in their report ‘Watching Water – A Guide to Evaluating Corporate Risks in a Thirsty World‘ which extends our thoughts from our Water Scarcity piece above. We mentioned a glass and pharmaceutical company which admitted that they were accessing ground water deeper and deeper under ground every year. At which point, does this become a clear cost and business risk issue?

We note that Fidelity Investment Managers has put a note out on the their take on the water sector; better late than never one might say. There isn’t anything new or jaw-dropping in the report, Fidelity lists the usual investment ideas such as Veolia, Hyflux, Doosan Heavy Industries, Jain Irrigation Systems, General Electric, HaloSource (recently IPO‘ed) and RusHydro as potential investment targets. We previously eluded to the fact that although GE only generates a single digit portion of their group revenues from water, in absolute terms these revenues ($2.5bn+) still rank them as a Top 10 water investor and supply chain player in the world.

Update: A list of some water ETFs can be found here.