How can investors benefit from China’s 1-child policy?

When Maslow's hierarchy of needs is applied to the increasing GDP per capita in China, it becomes obvious that stocks related to human being’s basic needs will be good investment candidates.

In fact this investment opportunity has existed as early as June 1993 when the first H share company was listed in Hong Kong, and that company was Tsingtao Beer (HK: 0168, TSGTY). Even for non-Chinese this name shall not be too unfamiliar to you as Tsingtao is available in some 95% of Chinese restaurants in the US and it was first introduced into US in 1972. How good was Tsingtao’s performance? Just look at the chart below:

Now the Chinese beer market is very competitive and it may be too late to invest in Tsingtao. So what’s the next Tsingtao?

When investing in China, we always need to take the Chinese cultural factors into our consideration in order to increase our winning chance.

To control population growth in China, Chinese government has enforced the “1-child policy” very long time ago (at least as early as my first visit to China more than 30 years ago).

Any family violated this policy and raise more than 1 child is subject to heavy penalty imposed by the government.

As this policy applies to all families regardless of their income level, it is easy to imagine that wealthier parents will devote whatever they can afford to their only child in the family. Applying this fact to Maslow’s theory, milk and food juice shall have a very promising domestic market potential.

In China, the leaders in milk and fruit juice are Mengniu Dairy (HK:2319) and Huiyuan Juice (HK: 1886) respectively. The share price performance of Mengniu is shown in the following chart.

Huiyuan Juice (HK: 1886) was just listed on HK Stock Exchange last Friday (23 Feb 2007), its stock price went up by 79% in just 2 days. With P/E of 66x and 84x respectively, it may be irrational to invest in Mengniu and Huiyuan now regardless of how those sell side analysts present the rosy growth stories.

What if there is a company with a historical P/E of 25 and still have a high exposure to the Chinese beverage market? The answer is Groupe Danone (ADR: DA)

Groupe Danone is a French food company that primarily produces dairy products, biscuits and cereal products. The Company's portfolio of brands and products include Danone, a brand of fresh dairy products; Evian and Volvic for bottled still water. It has also a well executed China strategy, it owns 51% in a joint venture with Mengniu Dairy to produce and market yogurts in China.

It also owns 22.18% of Huiyuan Juice, the red hot stock just listed in Hong Kong. As early as in 1996 Danone has invested US$43 million in five Wahaha (China's leading domestic beverage producer) factories and owns 51 per cent of each of the subsidiaries.

With 14% of operating income generated from Asia in 2005, China contributed Euro 1.18B sales and ranked no. 3 in its top 10 country list by revenue, plus a proven track record of well executed China strategy, it won’t be too long before Groupe Danone becomes a prominent foreign player in the Chinese beverage market.

One added advantage investing in Danone is that it can provide a comparatively better reporting transparency, something those Chinese firms are lacking.

China 3G Status Updated and China Mobile

Last week an unofficial source has rumoured that China Mobile Limited (0941.HK NYSE: CHL) is ready to place orders to manufacturers for TD-SCDMA infrastructure network equipment valued at RMB10.4B (US$1.33B).

TD-SCDMA is China's homegrown 3G standard that like any other 3G technologies will provide high speed Internet access, seamless video and multimedia services.

Though Mr. Wang Xudong, who heads the Ministry of Information Industry (MII) still has not confirmed the 3G licensing timeline, he has openly confirmed that there will be 3G service in China for Olympics in 2008.

This week the Chinese authority has also announced that the TS-SCDMA trial network will cover 10 cities including Beijing, Shanghai, Hong Kong and other Chinese cities which co-organize the 2008 Olympics.

It is widely speculated that China Mobile will be appointed by the government to run the home grown standard. It is a dilemma to the Chinese leaders about which operator shall bear this responsibility. On one hand the country must promote and adopt the home grown standard so as to avoid or reduce the amount of royalty to be paid to US and European technology companies as what it did for 2G, so the strongest player probably is the best candidate because it has the cash flow and market power to push the standard; on the other hand any potential damage to CHL’s business is the last thing the authority wants to see.

CHL has gone up by over 40% in past 6 months, the main storyline has been around CHL’s growth potential with new 3G services. However, once it is confirmed that CHL will run TD-SCDMA, I expect there will be short to mid term pressure to the stock as the industry is saying the TD-SCDMA standard is immature and there is a lack of production scale that will result in a lowered CHL profit margin due to higher 3G handset cost subsidy.

Taking this potential risk into account, I am still positive with CHL’s mid to long term future as I believe:

• 3G role out is a slow process with manageable CAPEX impact
• 2.5G voice and value-added service will continue to grow healthily

My analysis as follows:

No matter which standard is being chosen, the national launch of 3G will be a slow process because there is no commercial reason to be hurry. CHL’s GSM network is still expanding rapidly, for the last 3 months in 2006, it has signed up 50M new subscribers monthly which is equivalent to an impressive monthly grow rate of over 10%.

From the figure below (source: CHL interim report), we can see that the YoY 1H06 value-added service (VAS) revenue has grown 37.1%, and over 70% of the total VAS revenue was came from SMS and voice based value-added services (e.g. IVRS service such as dialing a number for weather forecast, etc) which are of low bandwidth or voice based applications. Of the remaining 30%, they are mainly MMS traffic and ringtone download which are still not bandwidth hungry type of applications.

From all the numbers, we can conclude that valued added service revenue still has much room to grow even without the high data rate 3G technology, and the demand for high data rate service is in fact not there yet.

To further substantiate my rationale, let’s look at CHL’s deployment history of its GPRS service (the GSM version of 2.5G data service). The service was launched in China in 2001, however, as of 2004 CHL is still buying new network equipment for different provinces. It means CHL has taken a phrase by phrase role out approach instead of a national roll out in one go. The past history when Chinese companies invested heavily and blindly on capex without solid business plans was long gone. In 1H06, CHL has invested US4.1B in its profit making GSM network expansion, which is 3 times the US1.33B TD-SCDMA trial network investment it is rumored to make. I expect the build up of 3G assets will be slow and hence it shall not impose a huge downside risk to CHL’s financial performance as its 2.5G voice and VAS services will continue to grow healthily. Major 3G investment will not happen until such bandwidth hungry killer applications are identified. (by the way, as of today 3G operators worldwide still cannot identify such applications yet!)

In Vodafone’s (VOD) announcement this week about its acquisition of 67% holding in Hutchison Essar, it mentioned that mobile penetration is China is already 40% while that in India is only 10% and how the Indian market can deliver long term growth to Vodafone. However, I would look at China (CHL) as a lower hanging fruit comparing to Indian market in which the timeframe to fully materialize the potential market opportunity into profit is still unknown.

"Face" Factor is critical in analysing Chinese market trend

Policy risk is among the highest risks for any investment in China, as China is famous for unexpected and sudden change in its policy. In order to minimize our exposure it is important for investors to understand Chinese culture and apply it in our market analysis. If we only look at hard facts and numbers, chances are we will miss out the most important part of the true message.

There are a lot of well written articles recently about ‘Chinese market bubbles’, however, I’ve not seen too much coverage about this very fundamental but important factor.

I understand that there is nothing more important than ‘Face’ in our culture. ‘Face’ (面子in Chinese) has the meaning of pride and dignity.

Here I’m not only talking about the ‘Face’ of the Chinese leaders (which is itself important), but also to the ‘Face’ of the country which will affect the sustainability of the Chinese economic growth.

‘Face’ is especially important for China from now to 2010. Beijing Olympics will be held in 2008, and the Shanghai Expo will be in 2010. Nothing is more important than to show case these two global events to the world, in order to update the global visitors about what is China; why is China a good business partner; why is it a win-win to do business with China; what sort of infrastructure is in place to support businesses, what is the quality of Chinese people nowadays; and so on. If China failed in this once a life time opportunity, the leaders and the country as a whole will loss 'face'.

I want to show you some examples of what our country is doing, down to very detail behaviour, to support my rationale:

• The Chinese government has recently provided training to the customs officers and asked them to be friendlier to visitors with smile on their faces. If you have visited China previously, you probably noticed that those officers were very cold.

• The government has also taken actions to standardize the proper English translation of restaurant menu. (Previously those translations were so bad that you have no clue what they really mean. Look at "stewed bean crud”; "badly cooked starch cubes” or “fish in first position")

Why is the Government doing all these? To prepare our country for the grand reception of huge number of global visitors coming to China and provide them good experience so that China can have 'Face'.

How does ‘Face’ factor relate to the debatable bubble? My view is that for sure the Government will try to manage the over-heated market by different means, such as open statements from senior government officials about their view of the market; leveraging high profile expert’s opinion [See Jim Rogers’ opinion here], and introduction of new policy.[China has banned the usage of re-finance mortgage to invest in stock market]

High volatility is expected, however, it is important to understand that China's objective is to manage the heat of the market in a controllable manner before a real bubble is formed. Market correction is not the same as bursting of bubble, I will not believe the leaders would have any intention to collapse the market. Just think about if the market is collapsed; do you think the immigration officers can still wear smiling faces to welcome visitors? How can the leaders show the world the result of the stock market reform (conversion of stated owned shares to free floated A shares in stated owned enterprises) and the promised healthier market ? If a healthy equity market cannot be shown to international investors, how can a debt market be created which in turn will directly affect the risk managment capabilities of listed banks and manage the non-performing loan problems? The country will lose 'face' if any of the above failed.

If you are short term (in terms of weeks) speculator, this may not be a good moment for you to play the Chinese game. If you are looking longer horizon of 2-5 years, I still believe China can beat the other emerging market returns by a high degree on a risk adjusted basis.

This week the authority has approved 5 local equity funds with total value of RMB30B after putting a stop for 2 months. This may be a sign from our leaders that "Party is allowed but do behave yourself".

I still have a long position in CAF (see here for our blog's recommendation), and I will maintain my position at least untill the Olympics party is over.

Chinese Banks: A Non-Traditional Approach to Predicting Their Performance

中文版請按此

The most commonly used traditional valuation approaches are DCF model and PE comparables, and each has its own intrinsic flaws. In DCF method, analysts are required to make assumptions on a firm's initial growth rate; terminal growth rate and in interest rate trend. The outcome share price is also highly sensitive to those assumptions. Analysts generally will adjust those parameters until the result is within a reasonable range. I always doubt the usefulness of DCF model as there are so much guesswork involved.

In using PE comparables, market PEs are affected by supply/demand of the stock and investor's sentiment about a particular sector. Hot sectors (like PRC companies recently) are unavoidably overpriced.

As we all know, stock price is a reflection of investor's view about a company's future earning power, historical performance data hence would be of little value in forecasting a company's future. In most cases this is absolutely correct, however, as we know China is an interesting country and counter-intuitive things do happen.

For the three listed Chinese state-owned banks, I believe their historical performances do have predictive power to their future performances. My rationale is based on the following three China specific factors:

The Duty To Support Government Policy

Chinese state-owned banks [Industrial & Commercial Bank of China [ICBC], Bank of China [BOC], China Construction Bank [CCB], Agricultural Bank of China [ABC]] carried the role as China's policy banks. By 'policy bank' it means their activities are more of political rather than commercial in nature. For example, if the government's policy is to support the agricultural sector, banks will offer policy lending to farmers and companies within the sector without proper consideration of commercial risk. That explains the astronomical size of NPL (Non Performing Loan) inherited with the banks before their listing. Although they are now listed (in Hong Kong as H-share) and are supposed to operate in a more business oriented fashion, I believe their obligations to support government policy still remain. That is why foreign investors are still restricted to own no more than 19.9% of share in those stated owned banks so that government can still maintain control of the board and management.

Management and Company Culture

Even though the banks have invited foreign financial institutions as strategic investors as part of the listing process, they are only minority shareholders and their capability to influence the management are in doubt. Though banks such as China Construction Bank and Bank of China had replaced their senior management teams and recruited professional management from overseas, in those huge state-owned enterprises with long history, it's easier said than done to change the company culture to a truly professionally run organization.

Tale Of Two Markets

Lastly, banks are having their hands tied in improving credit risk management due to the immature credit market as opposed to the rapid developing equity market in Shanghai and Shenzhen. The introduction of SHIBOR (Shanghai Interbank Offer Rate) last month is a significant milestone in China's credit market, however, it will still take a long time before instruments such as interest rate swap and credit default swap [CDS] are available and become popular. Those instruments are essential to the securitization and efficient transfer of banks' credit risks to market participants.

Because of the above reasons, I believe there be no significant changes in the banks' future relative performance comparing to their past and hence historical data can offer certain amount of predictive power.

As the biggest problem with all banks is non performing loan [NPL], I would use NPL as a major parameter to rank the banks' historical performance.



As can be seen from the table, in 2002 (which was the year prior to the government's capital injection to package the banks for listing) China Construction Bank's non-performing loan ratio (22%) is the lowest among the three, while that of ICBC is the worst. To take into account of the different branch network size, I created the ratio [(nonperforming loan %) / (number of branch)] and that will give us a feeling how worst is the situation per branch per bank. With this ratio Bank of China is the worst performing bank.

Now let's look at their profitability. As the tax rates of the banks also differ, I've used pre-tax profit as comparison. (It is expected that in 2008 the Chinese Government will reform the tax policy and all banks will have the same tax rate.) Similarly I computed the per branch profit contribution per bank. Again China Construction Bank performed the best.

From the above analysis, CCB is historically the best performing bank in terms of both credit management capability and profitability, while Bank of China is the worst.

We also noticed that CCB was also the first stated owned bank listed overseas. This is by no means a coincident. The Chinese leaders have to ensure the success of the first listed so as to set a stage for the others, as such it is reasonable to assume that the leaders should have selected the best bank to be the pioneer. Who else would have better insider information than the Chinese leaders? It would be your decision to bet with the Chinese leaders' choice or analysts' DCF models.

Evan though there is no direct channel to invest in CCB, we can still indirectly invest in ETFs with Chinese exposures. Before we make our investment to those ETFs, it would be wise to take a look at their top 10 holding first.

歷史能預測未來? 以歷史不良貸款率推測中國三家上市銀行的未來表現

Click here for English version

在估計一間公司的市值時，一般會用現金流估值模型(Discounted Cash Flow DCF)或PE比去估計。但這兩種方法都有其壞處。現金流估值方法中, 分析員需要對很多參數作出估計，例如加權平均資本成本(Weighted Average Cost of Capital WACC) ；初段增長率 (initial growth rate)；末期增長率 (terminal growth rate)；利率走勢等等。計算出來的股價對這些參數的敏感度(sensitivity)又往往較高。比如說，只要把末期增長率提高一個巴仙，預測的股價便會作出很大的反應。分析員一般會用反向工程的方法(reverse engineering)去對這些參數作出調整，直至估值模型得出來的結果跟他心目中的價位吻合為止。

另一個常用估值的方法，就是用相同行業公司的市場PE作為參考，這個方法的好處是計算頗為簡單，但是，市場PE受往往受當時投資者情緒及股票供求關係所影響。如果當時投資者對某一種行業比較睇好，那行業的PE便可能會被過份高估。

眾所周知，股價是投資者對一間公司未來的賺錢能力的反映，所以一般會覺得歷史數據對市值預測沒有多大用途，在大多數的情況下這是絕對正確的。但這也是基於一個假設，這假設便是歷史不代表將來。

歷史是否肯定不代表將來呢？對於中國幾家國有銀行來說，歷史數據可能對他們未來的表現有一定的啟示及預測作用。這是基於以下三個特殊的原因:

第一，基於中國的國情，國有銀行以往一直有承擔國家政策的責任，也是因為這樣產生了龐大的政策性不良貸款。雖然已上市了，但我深信他們仍是有執行國家政策的責任。這由它們的股權仍然比較集中於數家政府或其有關的機構也能推斷出來。這就是說這些雖然已經上市了的銀行，它們仍是不可以完全地以商業模式運作。

第二，有關風險管理能力方面，中國的銀行仍是在幼兒班階段，雖然差不多每間銀行都有國外的銀行作為戰略性投資者，但是他們都是小股東，沒有實在的能力去影響董事局或管理層。有些銀行例如建設銀行，在上市前曾經也轉換了一些高管，但是在這些龐大的國企裏，企業文化並不是更換數個領導便可以改變。就算真的會改變，亦不是三五年間的事。

第三，就算銀行本身的管理能力有所提升，在風險管理方面也不會短期內能夠改善。這是由於在中國市場上根本沒有提供所需的工具去讓這些銀行去作風險對沖或轉移。中國的資本市場發展在過往兩年突飛猛進，但主要的發展仍是在股票融資方面，企業債的發展仍是相對落後。市場上根本沒有一套客觀的、以風險為基礎的利率機制。上月中國剛推出的SHIBOR (上海同業拆息利率) 實在是中國資本市場發展的一個里程碑。但是，從現在到推出風險管理所需更複雜的工具，例如，普及化的利率掉期合約(interest rate swap) [試驗性的利息掉期合約已經推出，但市場深度並未足夠]；信貸違約掉期合約 (credit default swap)等等，我相信還需要數年時間。在這些工具推出之前，銀行想做好貸款風險成本計算，實在是有心無力。

我搜集了幾家國有銀行歷史不良貸款有關的數據，基於這些數據我大膽地對這些銀行的未來表現作了一些推測。

從上表可見，在２００２年時，亦即是國家注資去解決問題貸款並包裝上市前，建行的不良貸款率(22%)是相對地低的，工行的不良貸款率(25%)顯著地高於建行。建行亦是第一間到香港H股上市的銀行。由於三間銀行的分行數目都不同，我建立了一個不良貸款率/分行數目的參數。這參數亦即是說每一分行對銀行整體的不良貸款率的「貢獻」。以這參數來作比較，這三間銀行質素最好的是建行，中行相對是最差的。

再看看他們的盈利能力，因為三間銀行的稅率都不一樣，這裏我用了稅前盈利來作參考, 反正預計在２００８年，隨著稅務政策改革它們的稅率將趨向一致，所以我覺得稅前盈利的參考價值更高。同樣地我計算了每間分行的盈利能力，建行在這方面亦跑出了，第二位的是工行，表現最差的是中行。

得出的結論是，建設銀行在未來數年的盈利能力及壞賬管理方面都應該是做得比較好的，相對地中國銀行表現是最差的。

領導人先讓建行上市絕對不是隨意的，由於他是第一家上市的國有銀行，國家肯定要使她上市成功以作為其他銀行的模範。所以在質素方面建行肯定是最好的，試問有誰會比國家領導人更了解這些銀行真實的營運情況呢? 分析員或國家領導人誰比較可信，請你自己想想。

最後，再看看這三間銀行目前的PE是否跟我的結論吻合:

可以見到，建設銀行目前的PE是三間銀行中最低的，這跟我的結論剛剛相反，究竟我的分析是否有錯? 請大家過一兩年後再給我評分吧！