As we have seen repeatedly in other markets and over the past year in China, a combination of high valuations and a weakened outlook can lead to significant corrections in the equity market.
An actively managed portfolio with a focus on stock picking is able to withstand external pressure so can perform well under these types of circumstances. SKAGEN Kon-Tiki has been patient in its approach to investing in China, precisely because of the high expectations. It is only now that these have come down to a more realistic level that we see greater opportunities. This was confirmed when SKAGEN Kon-Tiki visited China in January.
Share price drop
What has caused expectations to fall? First, it is clear that external pressure, particularly in the form of the trade war with the US, has had a negative effect both on export sensitive companies, especially in the Guangdong province, and on consumption, particularly among the middle classes in the largest cities.
In addition, the economic and political climate in China has hardened due to the authorities’ attempts to get to grips with uncontrolled credit growth outside the traditional channels of banks and public institutions. This has resulted in a reduction in liquidity, particularly for small and medium-sized (non-governmental) companies. This has in turn led to lower activity levels, higher financing costs and, in several cases, payment issues in the value chains of many companies. Some larger owners in many listed companies have also loaned against their own stocks to free up liquidity, which has further amplified the fall in share prices.
Consumer goods still strong
When it comes to consumption, tighter financing has caused the most discretionary purchases of, for example, cars, electronics, white goods and, to a certain extent, luxury goods, to fall. What is interesting to note is that this is not reflected in consumer goods where growth is still relatively strong, particularly in smaller cities where earnings growth is still high compared to western standards. It is common to see local companies taking market share from foreign players thanks to a better understanding of local preferences combined with innovative concepts. In Shenzhen, which has a population of 13 million and is a short 15-minute train ride from Hong Kong, we had to wait 40 minutes to get a table at Haidilao (a Sichuan hot-pot chain) on a Wednesday night. Meanwhile, there were no western fast food chains to be found.
Electric cars rule
Another thing that struck us during our visit, was the incredibly rapid development of electric cars in the largest cities. While Elon Musk’s announcement of a new Tesla factory in Shanghai may have dominated western media headlines, China has already developed its own vast electric car industry. With over 1.2 million electric cars sold in 2018 and plans to increase this number by 30 percent this year, this is a strategically important move for China, which is the world’s largest importer of oil and where many cities struggle with air pollution. In Shenzhen, the majority of taxis and all buses are already electric and many cities only permit electric cars to be newly registered.
Although a large part of the growth is driven by public subsidies which will inevitably wane, we believe that growth will continue given the rapidly increasingly number of makes, models and engines available to choose from. This is precisely the type of trend that our Korean battery manufacturers (LG Chem and Samsung SDI) and our copper producers can benefit from in the years to come.
China’s most interesting finance company
We also met with several companies in the finance sector. The most interesting of these in our view is the insurance giant Ping An Group, which entered the portfolio in the autumn. In addition to being the world’s largest life insurance company, Ping An has built up an impressive portfolio of technology companies within financial and health services. With over 500 million users registered across its technology platforms, the company has only just started to convert these users to customers of all its banking and insurance services. With a valuation of just one times Embedded Value[1], none of this future cross selling is reflected in the current share price.
[1] The Embedded Value (EV) of a life insurance company is the present value of future profits plus adjusted net asset value.