Investors are pulling money out of China.
The Wall Street Journal recently reported that China’s banks were net sellers of renminbi in July. Asset prices are declining in line with these outflows. The Shanghai Composite Index is down 17% compared with a year ago. Housing prices have fallen – anywhere from 8% in wealthier cities like Hangzhou, to nearly 20% for new developments in Tier 2 Cities. Capital Vue estimates that capital raising by Chinese firms has fallen 35% versus last year.
The recent obituaries being written about the Chinese economy cite further worrying statistics. Construction of new residential floor space fell 13.4% year over year through June, while unit sales of excavators dropped 19% over the same period. We see signs of this within parts of our portfolio. The selling price of plywood fell 2.5% and for logs fell 7.2% in June. Businesses with exposure to the construction sector are struggling to obtain working capital, and plans for capacity expansion been shelved.
China has eased monetary policy and reserve requirements in response to economic weakness, but investors have worried about the absence of a large fiscal stimulus package. However, eliminating overcapacity and deflating asset price bubbles, while transitioning toward domestic consumption-based growth, is the clearly articulated goal of China’s leadership. Further, we do not share the market’s yearning for another 2009-style fiscal stimulus. We fear the law of unintended consequences, and believe such measures inevitably lead to future bank bailouts.
We also believe that the reports of the death of the Chinese economy are premature. To be sure, conditions have deteriorated. We speak with Chinese entrepreneurs every day, and all believe that these are terrible economic times. The rate of growth of fixed asset investment must fall further, and this will impact GDP. However, consumer sector is picking up a lot of the slack. Yum China’s second quarter same-store sales rose 10%. Nike China revenue rose 14%, matching the government’s official retail sales growth figure. Within our portfolio, our baby-wear business has achieved revenue growth of 35% year to date, and our meat processing business is on track to see a 20% rise in sales.
We therefore believe that asset price corrections must be anticipated and viewed in the context of representing more appropriate long-term earnings growth assumptions. By our estimation, asset prices in 2009 and 2010 assumed sustained 25-30% earnings growth, even amongst the largest and most established businesses. Our conservative tendencies have always been to look for good value on more modest assumptions. To the extent the Chinese economy is entering into a new normal of lower, sustainable growth rates, our best advice is to look for businesses where reasonable 10-15% earnings growth assumptions provides good upside. We are finding plenty of private businesses that are effectively pricing in limited or no growth, where we can obtain the involvement needed to protect our downside and look to achieve or exceed modest growth targets. Similar opportunities are emerging in the public markets as well.
For all of these reasons, we maintain that accumulating stakes in good businesses at a measured pace in the current environment makes sense. While the bad news cycle is unlikely to abate in the near term, we are approaching the most attractive risk-reward ratios for equity valuations that we have seen since the Asian financial crisis. Additionally, the most dynamic businesses in China are those that best fit our mid-market buy-out/active-involvement oriented investment strategy. According to the People’s Bank of China, small private companies account for 60% percent of GDP, employ 75% of the workforce and create 90% of new jobs. These businesses remain highly competitive – a recent CLSA report noted that while they are suffering from wage inflation, this has been largely offset by productivity gains.
Looking at our internal dashboard, we have conducted preliminary due diligence on 112 opportunities year to date. We continued due diligence on 42, prioritized 19, and are in late-stage negotiation on 5 transactions. Businesses that have reached the later stages of our process are in the familiar areas of branded food products, baby-related products and apparel retailing, consumer staples and agriculture, and reflect our long-held view on the Chinese consumer, inward/inland development and our belief in entrepreneurial involvement – providing plenty of choice to execute on our investment thesis, and scale into investments at reasonable prices.
We believe that our platform and process are a key competitive advantage in underwriting these investments. The intellectual rigor and our differentiated approach is a product of an institutionalized platform that ensures discipline and rewards analytical thought, due diligence and prudent risk taking. The distributions we have been able to make from our portfolios, even in difficult years, give us confidence that approach is working, and that we will continue to find attractive portfolio candidates that deliver value to our investing partners.
