Research Postcard: Australian Ethical International Equities

26-Jun-2014

By Nathan Lim

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Australian Ethical international equities portfolio manager Nathan Lim speaks with theinstoreport about his recent trip to China, where he found manufacturing is becoming much more efficient.

Where and when did you go on your trip?

We travelled to China from June 9 to 13. Over these five days, we visited companies in Tianjin, Beijing, Changzhou and Shanghai.

What was the purpose of the trip?

China remains a major engine for global growth and its development has far-reaching ramifications for commodity and energy markets.

We visited 14 companies involved in the construction, industrial and energy sectors to better gauge local trading conditions and to hear what challenges and opportunities each company faces today.

There are many intangible signs and insights frequently missed by broader macroeconomic surveys, so these meetings bring the research process full circle for us.

What stood out most about the people you interviewed?

In those meetings where we had a chance to visit the factory floor, it was insightful to see lean manufacturing being rolled out.

China may have lost its low-wage advantage, but its move into advanced manufacturing will be a wake-up call for all European and US manufacturers and their workers.

In some factories, it was reported that the products being made in China exceeded the quality standards overseas and were amongst the most efficient factories anywhere. A US multinational with 100 manufacturing facilities globally said that of the five that had achieved silver certification, three were in China.

The move to lean manufacturing is seeing a dramatic impact on productivity as Chinese divisions of multinationals are making the investment into advanced equipment and bringing even their most sophisticated components and products into the country.

Granted that implementation had clearly achieved varying levels of success, it demonstrates yet again the competitive forces emerging from this country.

What can local investors learn from this market?

The corruption crackdown is real and will have a long-lasting impact on doing business in China.

Everything from the way government tenders are awarded to ensuring pollution regulations are enforced has taken a massive step forward since the appointment of Premier Li Keqiang.

In the short term, this has had a chilling impact on the economy as government-related economic activity slowed down due to arrests and officials taking excessive care, however, as tendering activity has resumed we heard from two companies who won tenders despite not being the cheapest bid for the first time ever because their solution better matched the requirements.

Merit-based competition will favour foreign multinationals as they have a generational lead on salesmanship. The typical local competitor competes almost exclusively on price and when faced with annual national wage inflation of between 5 and 10 per cent, they will struggle to maintain margins.

The Chinese government has recognised that its previous rounds of stimulus were excessive and led to massive misallocations of capital that has resulted in excess capacity in numerous industries.

As one local manager put it: “China is no longer building ghost cities.”

The lessons learned from these prior experiments means stimulus will be far more directed and, at this time, is going into rail, offshore drilling, renewable energy and anything to do with pollution abatement.

How is China performing at present?

The slowdown in China has already happened and it appears the economy has settled into a lower gear. Amongst the weakest sectors right now are steel, coal and chemical refining.

The strongest include automobile manufacturing, shipyards and the logistics sector. In a broader sense, the weaker companies are those with a mix of customers leaning more towards the government or construction.

There is a general view that the second half of 2014 will be roughly flat or only modestly higher than the first half as there does not seem to be another major stimulus program on the horizon.

Do you have any holdings in China?

As a firm, we do not hold any Chinese listed stocks. However, we learned during the trip that the Shanghai-Hong Kong Stock Connect should be operational by the end of this year.

This will eliminate the need for foreign investors to undergo the current qualification process to trade A-shares. A-shares are mainland listed shares open only to mainland citizens and those firms that go through the tightly regulated Qualified Foreign Institutional Investor system.

China’s importance to Australia cannot be understated as it is our largest trading partner, so we have a keen interest in staying abreast of local developments. We will revisit investing in mainland shares once Stock Connect is operational.

What are the risks facing China?

A risk we see near term is reports of broad inventory destocking. Running warehouses so thinly can have a chilling effect on sentiment as it represents a lack of confidence. We worry that excessive pessimism could be a self-fulfilling prophecy.

Looking a bit further afield, China is redefining its economic playbook to be less dependent on fixed asset investment.

It is trying to transition to an economy that is more balanced between investments and domestic consumption, while simultaneously dealing with the legacy of unproductive capacity and their attached loans. Balancing the need for short-term growth, while allowing the excesses to wash out of the system will take time and constant vigilance, but at this time the authorities seem to be doing a good job.

A more abstract risk is China’s crippling pollution.

While it is being addressed, a concern we have is the rate of improvement is insufficient to offset public unrest as even ‘clear’ days with particulate matter readings in the low triple digits is still well above the World Health Organization’s recommended level of 25.

Enforcement of industrial discharge standards and waste disposal is another area we hope will benefit from the government’s crackdown on corruption.

What implications do these findings have for your portfolios?

From a global macroeconomic perspective we tend to be more bullish than perhaps the broader market as we get the sense that the economic challenges facing China, while large, has not resulted and likely will not result in economic dislocation.

Most interesting or unusual custom you came across?

There were a number of remarkable differences that I noticed.

It always strikes me on these trips how far technologically behind it seems Australia is. On our way to the first meeting, we were able to watch game two of the NBA (National Basketball Association) finals between San Antonio and Miami live from the bus.

In a world that is becoming more interconnected, it is instructive that English is now mandatory from elementary school, whereas previously it was only required from high school. China has made it a policy imperative that its populous is at least bilingual.

 It has been around six years since the melamine milk scandal surfaced. When we were boarding the plane in Hong Kong for Tianjin, passengers are still reminded that they are allowed to only bring in one can of milk powder.

The complete loss of trust in local milk manufacturers still has not reversed despite the strict enforcement of new regulations and standards. As a result, foreign milk suppliers continue to win share in this market. One of the companies supplying equipment to this sector reported infant formula growing at a compound annual growth rate of 14 per cent.

Some Chinese business cards are written in English on one side and Chinese on the other. However, a phonetically similar western name is typically used on the English side without a last name. As such, do not be surprised to see business cards from Sheldon or Andy without any last name.

Next planned trip?

We are due to visit some of our investee companies in Europe later this year.

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