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.