Chinese puzzle as mystifying as ever

Fraud, corruption, impenetrable ownership structures, credit bubble, underdeveloped financial markets, command economy, ageing population, dodgy accounting. These are just some of the reasons for not investing in China.

I’ve never analysed any businesses listed in Asia, but after recently visiting Hong Kong, Beijing, Shanghai and Singapore you might see a couple of reviews later in the year comparing some local stocks with similar businesses in Asia.

China certainly has problems, but before getting into that let’s look at a few stock ideas for those prepared to follow them up with their own homework.

City of dreams

Macau is the undisputed world heavyweight of the gambling industry. In 2013 this special economic zone, lying 64km across the Pearl River Delta from Hong Kong, raked in US$45bn of revenue. That was up 20% from a year earlier and a staggering seven times what the Las Vegas Strip produced. It’s not surprising then that the Macau gaming index is the best-performing sector in Asia, increasing an incredible 14-fold since the depths of the global financial crisis.

Unlike Australians, the Chinese prefer table games to poker machines so we’re not expecting Aristocrat Leisure to produce further rapid growth in this market, for example. That’s despite around 10 major developments due for completion by 2018, with industry profits expected to triple.

There’s plenty of room for new developments, as there’s currently a shortage of hotel rooms. Other bottlenecks include the lack of an international airport and congestion crossing the borders and at ferry terminals where the junkets arrive.

A bridge between Hong Kong and Macau is under construction, but there’s a yawning gap between the quality of entertainment in Vegas and Macau, which is yet another opportunity.

Macau is far more profitable, though. US$19bn has been spent on developments on the Las Vegas strip over the past 10 years, which produces annual revenue of around US$7bn. Only US$1bn less has been spent in Macau, yet revenue is nearly seven times higher at US$45bn.

Licenses are restricted in Macau, and the threat from new casinos in nations such as Japan and Singapore seem limited. It could be seven years before Japan opens its first casino, and the 19m mainland Chinese that visited Macau in 2013 are unlikely to prefer gambling in foreign nations due to cultural tensions and the additional travel; it’s much easier to board a cheap high-speed train or local flight to Hong Kong.

As we ferried across to Hong Kong Island each day from our base in Kowloon, we wondered if the junket operator that had recently gone missing owing US$1.3bn was somewhere beneath us.

With four of the Macau gaming companies paying out over 80% of profits as dividends and several with net cash on their balance sheets, it’s a sector worth investigating now.

Listed infrastructure and Logistics

Our model portfolios made a lot of money buying unloved infrastructure stocks during the GFC. The cash flows are reliable and predictable, some (like Sydney Airport’s) will grow relatively quickly for many years to come, and their monopolistic assets are unlikely to be too affected by the Internet (The case for essential infrastructure shows you how to value these types of businesses).

Looking down at the shipping straights from the 68th floor of Two International Finance Centre building in Hong Kong and later (coincidentally) the 68th floor of the IOB building in Singapore, it was unsurprising to learn that these two countries operate some of the busiest ports in the world. But there are several headwinds facing the Asian logistics industry, such as increased competition, slowing economic growth and slowing exports within Asia.

Logistics companies International Container Terminal Services (ICTS) and Neptune Orient Lines (NOL) were mentioned as potential buy ideas chiefly due to their exposure to increased economic activity in the US and Europe. No-one we spoke to was particularly bullish about China or the Asian region.

ICTS is expected to benefit from growth in its Latin American business ahead of the expansion of the Panama Canal, while the steady progress of NOL’s US operations apparently isn’t being reflected in its share price. Malaysia Airports and Airports of Thailand were other buy ideas that might make an interesting comparison with Sydney Airports, which is our biggest holding in the model portfolios.

Banks

The banking analyst we spoke to expected a Japan-style response when the credit bubble bursts in China. China won’t let the economy adjust on its own given the size of the bubble, and the global economy remains in a weakened state. He believed the Chinese banks could still be a decent investment at current prices if losses were limited to 10-15% of their loan books, which seems optimistic given the massive oversupply of unaffordable units in tier three and four cities that we saw.

About 15 years ago, several asset management companies were financed with public money to deal with bad debts in the Chinese banking system. Recently they’ve been listing, suggesting they may be used again if China’s credit boom pops. The time to buy Chinese banks may be when the losses are acknowledged and the asset management companies are called in to assume the bad debts.

Our friendly banking analyst also likened the Australian banks to Wile E Coyote in the Roadrunner cartoons, where he is initially suspended in the air after running off the edge of a cliff. The reasoning wasn’t anything new. The looming end of the massive resources and energy projects in Australia is a risk, as is a downturn in China where recent defaults by two wealth management products were signs that ‘the wheels are starting to fall off’. On a contrarian note, our analyst thought the ANZ board was growing tired of ANZ’s Asian expansion, which has moved far slower than anticipated.

Although he was prepared to wait for more pain in Russia before buying, his eyes lit up talking about Russian bank Sberbank. Kerrisdale Capital (whose founder Sahm Adrangi we recently interviewed in Las Vegas) published a review of the company here.

Sichuan conundrum

Aside from the pollution, my first thought about China was how much development there was to go. While Pudong – the central business district in Shanghai – is modern and eye-catching like the world’s other major financial districts, you don’t have to walk far on the other side of the river to see derelict residential buildings that would never pass inspection in Australia.

The process of developing modern buildings to increase people’s living standards still has decades to run despite the country’s remarkable progress over the past 20 years. The Chinese people have a lot to look forward to.

There are major issues, however. The pollution is not only a health risk but after several days it starts to affect your overall mood. I always look forward to returning to Australia after travelling abroad, but I’ve never considered that blue skies would be something I’d miss. We take our environment for granted in Australia, but many Chinese who have grown wealthy from the property boom are leaving the country at least partly because of environmental concerns.

A lady we met who worked in advertising was given €500,000 by her parents to get a Portuguese visa, after the value of their home increased tenfold over the past decade. While record numbers of Chinese are graduating from university, a lot of brains and wealth are being exported overseas.

Bubble trouble

The housing bubble is also impossible to ignore. On our five-hour journey between Beijing and Shanghai on the high speed rail travelling at 320km/h we saw thousands of empty apartment buildings at various stages of development that are unlikely to ever be lived in. They were mostly in regional areas and too expensive for the local population.

Unfortunately generations of family wealth has been poured into overpriced property either directly or through wealth management products that invest in property development because there are few alternatives. Deposit rates are kept artificially low, the bond market is underdeveloped, investors are wary of the sharemarket given its lousy performance and locals are barred from investing overseas. I have 800 yuan (about $140) at home in my drawer because it cannot be exchanged. Wealthy people often gamble in Macau because they can exchange yuan into foreign currencies.

The productivity benefits of China’s massive infrastructure spending are also declining rapidly. China has roads that Sydneysiders can only dream of and the extensive rail network always runs on time. The high-speed Shanghai Maglev delivers passengers to the airport in just eight minutes at 430 km/h.

With so many useful projects now complete, new infrastructure is lying unused (airports without planes, stadiums without fans and malls without shoppers or retailers) and more wasteful stimulus programs are only likely to produce more bad debts. China’s private debt levels are reportedly higher than Australia’s, which lead the western world. As far as fixed asset investment is concerned, the low hanging fruit has already been picked.

Exposed to market forces

In stark contrast to when I visited Russia 15 years ago, I never felt like I was in a communist state except in Tiananmen Square in Beijing. But there’s a raft of financial, political and social changes that China will make over time. The economy currently doesn’t have many shock absorbers, such as a readily convertible currency market and a liquid bond market.

There’s not much of a social safety net, either. The pension is apparently $50 per week, which is why families save so hard and there’s so much pressure on children to get a good job. There are also many jobs that will eventually be replaced by machines, such as street cleaners that earn US$5,000 per year. As growth slows and property prices fall, all eyes will be on how the population reacts. They have never been so exposed to market forces.

It might not happen in my lifetime, but I expect China will eventually become a democracy. As China’s development continues and more citizens are exposed to western ideas, it’s inevitable that the population will seek greater input into their future. Much to my surprise, the local newspapers were filled with critical analysis of social, financial and political issues. 

Lastly, China is a place of opportunity. But the lack of western brands and advertising shows that it’s not an easy market to crack. Aside from the familiar luxury and alcohol brands, Starbucks, McDonald’s and KFC were the most common western franchises we saw. You should be sceptical of any company that’s betting on China to transform its business.