China – A Contrarian Hunting Ground

This week in Shanghai we visited 15 companies in the wealth management, tourism, recruitment, and e-commerce sectors. They are mostly listed on NASDAQ, have fallen up to 30% in the past month, and some have up to 50% of their share price in cash.

On the ground, nothing much has changed. Yes, the ‘New Normal’ for China is to grow about 5%, not 7 to 10% as in past decade but then China is now a middle class country with average income US$8,000 per capita like Europe, Japan, Korea or Taiwan. Shanghai is a world class sophisticated urban centre of 20 million comparable to New York or Tokyo in style and wealth. The economy’s theme is no longer exports, infrastructure, or heavy industry: it is domestic consumption, tourism, and financial reform.

The sudden end to the Shanghai A share ‘bubble’ market is a healthy development for China’s long term evolution, towards a ‘western’ savings and investment culture, of mutual funds, pension funds, and rational long term investing, as opposed to the ‘Casino’ gambling culture of Macao, or Shenzhen. What we observed, was the rapidly growing seeds of a fund management industry, with ‘wealth management products’ producing fixed income returns of 6 to 8% p.a., real estate trusts (a form of REITS), venture capital and PE funds, hedge funds and long only equity products.

The largest private, non-bank, wealth manager controls about US$10 billion AUM, and smaller competitors growing at 50% p.a. can be found for 10 times P.E.

One of the best managed businesses is Hua Zhu (or China Lodging), which controls about 2100 mid-level hotels in China, and will sign a deal with the French group Accor, to manage 100 higher priced hotels, with an on-line booking link, for China’s estimated 120 million outbound tourists. This company and others we interviewed, are managed by US Ivy League educated ‘returnees’ an impressive group of top notch managers – mostly women.

The online e-cmmerce business is booming while ‘offline’ retail brand name sales are in recession (one can see this in the Hong Kong shopping centres of empty shops with luxury brands). China seems more advanced, than Western nations in this respect, with Alibaba’s sales of over US$550 billion, now dwarfing Amazon, or E Bay. Tencent and Baidu and their affiliates make up the core galaxy of competition, (nearly 600 million Chinese have smart phones).

The Shanghai Stock Exchange now has US$5 trillion of listed companies, and an average US$100 billion daily trading volume (larger than New York). They will now relax listing procedures to allow internet start-ups to list on a ‘new industry board’ (akin of Nasdaq). Clearly the government intervention has had mixed results especially the many suspended listings, which backfired badly: but Chinese officials learn quickly from experience, and we expect that by the end of 2015, the market will become more open and tradable with RMB convertibility (and the IMF’s imprimatur of the Yuan as a reserve currency), and the Shenzhen-HK Connect opening.

In summary, China’s ‘miracle economy’ era is over. The ‘new normal’ is lower growth: but GDP growth and share prices are not always correlated (ie. Japan 1975-1990). We believe this summer’s sharp correction is an extraordinary opportunity to accumulate patiently long term positions, in some great businesses, at reasonable valuations. We have positioned our Bamboo Fund for a strong recovery with all engines firing – not only in China but also Japan, India and South East Asia. The ongoing correction in commodities led by oil, gold, and metals is a positive ‘tax cut’ for Asian consumers.

Deflation is beneficial, and will spur inventions and discoveries, as it always has done historically in the 1870s and the 1930s.

Robert Lloyd George
August 2015

Deflationary Bull Market (continued)

History will decide whether the agreement reached today between Iran and the Western nations contributes to peace in the Middle East over the next decade or not. One thing is certain, that if the accord is implemented, and approved by the US Congress, among other parties, the immediate effect would be an increase in oil supplies of between one and two million barrels a day. With the continuing slowdown in China, and some other developing nations, this means that the over-supply in the energy market will be exacerbated, and we may see the oil price decline further below US$50 and perhaps as low as US$30 per barrel by the end of the year. Along with the fall in other commodity prices such as iron ore, food and soft commodities, this has very positive implications for China, India, Japan, South Korea and all the Asian nations which import most of their energy and raw material needs. (Indonesia and Malaysia are negatively impacted because of their energy exports.)

We believe, therefore, that the growth background for Asian equities in 2015 continues to be positive, as it has been in the first half of the year. In addition, the continuing cuts in interest rates, which most Asian nations have seen and which will continue, especially in India (where wholesale prices are now negative) and in China recently, provides a positive backdrop for shares.

The extraordinary volatility experienced in the Shanghai A-Share market, which fell over 30% in June, is a unique and contained phenomenon, which has not had a broader impact. It will also not have a significant impact on China’s economic growth, which will be maintained at 6% to 7% GDP per annum. The Renminbi has remained extremely stable, some capital has flowed back from Hong Kong to China in the short term, because Hong Kong shares offer much better liquidity for sellers than A-Shares, almost 40% of which were suspended in the last week. (This has now begun to ease and we expect that trading will resume normally). It is, therefore, reasonable to see this as a natural sharp correction in an ongoing bull market in China, which may still be in its early stages. It is a healthy correction in the sense that margin trading will be reduced, trading controls and listing procedures will be improved, and the Shanghai and Shenzhen markets will continue to grow, but at a less hectic pace, in order to achieve a broader acceptability for international investors.

Our team is now scouring the battlefield for oversold and undervalued quality Chinese and Hong Kong businesses, including some online companies which have Nasdaq listings, and may still be privatised and repatriated to China. In the other Asian markets, we also see some emerging value, especially in sectors and areas which benefit from cheaper energy, including airlines, hotels, restaurant, transport, logistics, plastics and chemical companies.

We are increasing our exposure to Japan, especially in the domestic sectors, and in those companies which have substantial export sales to China (which have been unduly marked down). The yen is exceptionally weak and corporate governance is improving. For the time being, we remain cautious on South Korea, because of corporate governance issues, which have particularly affected the valuation of the Samsung group this year.

India looks especially attractive, with corporate earnings growth expected to be above 16% in the next two years. The Monsoon is proving better than average despite its tardy arrival, and inflation is declining for the seventh consecutive month. This will continue with the fall in oil prices in the next few months. The Indian Rupee has also shown remarkable resilience in the year to date with the improving balance of payments situation, and the rapid increase in foreign exchange reserve from US$77 billion two years ago to US$352 billion today. This has greatly reduced the Indian stock market’s vulnerability to global capital flows, which affected it in the past. Indian GDP is also growing faster than that of China, (at a 7.5% rate in the first quarter of the year) and is expected to be maintained. We see special opportunities in the private sector banks, cement, automobile and mortgage finance companies, and there is also particular interest in pharmaceutical companies which are supplying generic drugs to the US market as patents for many important drugs expire.

Although we are mainly focused on the Asian region in our Bamboo Fund, we continuously screen for value opportunities around the Emerging Markets. The major issue for Africa and Latin America today, as well as Russia, is the fall in commodity prices which is having a significant impact on those countries’ purchasing power parity, and therefore on the valuation of many of their major exporters. What we appreciate most about Asia is that the management of many of our core businesses have been through tough times, in terms of the Asian crisis, (from which they have restored their balance sheets), an oil price increase to nearly US$150 a barrel, (maintaining their profit margins), and the global financial crisis which dried up much of the credit in the South East Asian region. Many local banks have now stepped into the vacuum created by the retreat of Western banks, and are achieving good return on assets. We look particularly to the financial sector in Asia, both banking and insurance, as the leading indicator of middle class growth and savings. Our focus continues to be cash flow and dividend payments as a major component of total return to our investors.

We want to emphasise to all our clients that we have maintained a very conservative philosophy in our regional investment portfolio, avoiding the excesses of the Chinese markets, so that at the worst point our fund fell no more than 3% during the steep fall in both China and Hong Kong. It has since recovered most of these losses and we are looking to add undervalued positions in the aftermath of the correction in China.

Robert Lloyd George
18th July, 2015

Where Will Chinese Wealth Go?

Today it was announced by the Boston Consulting Group that there are now four million millionaires in China (up from three million in 2014) compared to seven million in the USA. This was mainly attributed to the rise in the Chinese stock market last year, as it only includes cash, shares, and financial investments not real estate, art or businesses. In the Asia-Pacific region as a whole, private wealth rose nearly 30% last year to US$47 trillion, out of a global total of US$164 trillion.

The question that comes to mind, as the Renminbi becomes convertible by the end of 2015, and China liberalises both its financial system and its capital account, is – where will all this wealth flow? In our view, real estate has always been the primary destination of Chinese family savings, but this hunger has already been assuaged in cities such as Beijing, Shanghai, and Hong Kong, which now has the highest values per square foot in the world (HK$32,500 per sq. ft. or US$8.3 million for a 2,000 sq. ft. flat).

The new wealth will, in our view, be directed to liquid securities, such as shares, bonds, and mutual funds. With the “Shanghai-Hong Kong Connect” being swiftly followed by a parallel Shenzhen-HK capital link, the money will be flowing mainly one way, into Hong Kong, where there are over 600 listed Chinese securities, and the average multiple is 11x compared to 25x on the Shanghai market and almost a 74x compared on Shenzhen. We expect that the greater China market will harmonise into a single capital market like Europe did after 1992, with Hong Kong being the centre as London became the financial centre of the EU. We are therefore very much focused on the liberalisation of the Chinese financial sector, banking, insurance and broking as it adapts rapidly to the imminent possibility of full convertibility for the Renminbi. We have received confirmation that the IMF will officially accept the Renminbi as an international reserve currency by September, and China may move to open its capital account by the end of 2015.

China is moving rapidly from heavy industry and infrastructure development to the service and consumer sector. It is also moving from energy intensive GNP growth to a lighter model where alternative energy sources (nuclear, solar, wind and electric vehicles) assume a much greater importance. By 2030, China has pledged to reduce its carbon emissions, which is a major undertaking considering that China depends for 70% of its energy on coal, and is now the largest importer on oil in the world at 6 million barrels a day. The pressure of public opinion on the Communist Party leaders has increased in recent months, since over 20 million people viewed the video “under the dome” about the worsening problem of pollution in Beijing and its health consequences. Nothing will be more significant to the world energy balance and to the oil price than if China reduces its use of fossil fuels (this also effects geopolitics, as China moves to build base in the South China Sea and to protect its sea lanes, especially for oil tankers coming from the Middle East.

All this rapid change in China is having consequences on other countries, especially on the emerging markets in South East Asia, Africa and Latin America. We do not expect there to be a recovery in commodity prices. If Islamic State invades Saudi Arabia, the oil price would certainly jump in the short term, but there is no visible bounce in gold or other mineral prices. The world is awash with oversupply for most of these products, which Chinese demand has driven for the last decade or more.

We are still in a deflationary world, which is beneficial for consumers especially in Asia. As retail activity moves more and more onto the internet, this is also going to effect the demand for commercial space and we see a significant downturn in property values coming over the next few years. We are currently researching all of the Chinese internet stocks to find the new winners in e-commerce and other high growth sectors.

In conclusion, although the market is expecting a summer correction, because of Greece or rising US interest rates, we are looking beyond these factors, to see that China is still moving ahead fast, and liberalising. China has learnt a valuable lesson from the USA in paper wealth creation, which is now coming from stock market more quickly than from trade and manufacturing. Over 4,000 new Chinese hedge and private equity funds have started up in the past three months and assets under management rose by US$75 billion to US$433 billion. In our view the Shanghai boom is just beginning and we will be going to Shanghai next month to try to assess the foundations, and the sustainability of this important development, of the financial sector, of the world’s largest second economy.

Robert Lloyd George
June 2015


Oil has rallied 25% from the bottom and, according to Fibonacci, needs to retrace 38% of its decline to break the cycle, i.e., $67 a barrel. This is now quite probable and would imply (given the extent of monetary easing and reflation in past 6 years) that from January’s deflation scare, we are now moving towards slightly higher inflation and higher interest rates. The relatively sharp upward move in bond yields (from their 30-year low) is also signalling this change.

We do not believe that this indicates an upward move in commodities generally, (thermal coal, for example, is nearly 60% below its 2011 price). Oil is a separate and special situation, still driven by Middle East political tensions. If Iran gains control of Iraq, they control almost 50% of oil supplies in the “Persian” Gulf; if they can block Saudi oil tankers (i.e., by controlling the port of Aden), this rises to about 70%. In the words of one astute European investor aged 80, this is “the most dangerous geopolitical situation since 1939,” including Russia’s revanchism, again on display during the May 9th  Moscow commemoration of victory over the Nazis.

Another potential “discontinuity” is if the cost of solar power falls and the advance of electric battery technology proceeds rapidly enough, then the use of gasoline and diesel in the world’s vehicle population (around 1 billion cars and trucks) will rapidly decline; and the oil age will end within 20 years. Supply will, in any case, be plentiful (as the Arctic and other areas are opened for exploration), and the oil price would be nearer $20 than $100. All of this is good news for energy consumers such as China, Japan, Korea and the Philippines.

In the short term, we continue to be optimistic on stocks and, more specifically, on China/Hong Kong, Japan, and India, also South Korea. Earnings growth this year will be better than expected in the region, and there is generally political and currency stability; and average GDP growth in the Asia-Pacific region is expected to average 6.3%.

How do we reconcile our bearish view on Chinese real estate values with our bullish stance in Chinese equities? Kenneth Rogoff in his notable 2009 book, This Time is Different, noted that the peak in US real estate prices occurred in 1925; but the stock market did not peak until October 1929, four years later. Although we may have actually seen the peak of Chinese property (both residential and commercial), it is a slow-moving cycle; and the massive shift of savings from ‘hard assets’ into shares (evidenced by millions of new share trading accounts opened in Shanghai and Shenzhen) will propel the share market up for several more years. A parallel was made in the Financial Times two weeks ago between the growth in GDP in Japan from 10% from 1950 up to 1970, when it slowed down to 4% in 1970s, and at that point, the Tokyo stock market began its 20 times move up, until 1989. So far, Shanghai has only doubled and is still on a reasonable P.E. ratio of 22. We expect both Shanghai and, more especially, Hong Kong, on a P.E. of 13 and 40% discount to Shanghai, will make a much more significant move in the next 2 or 3 years.

The Bamboo Fund is currently invested 40% in Hong Kong, 10% in China, 10% in India, 10% in Japan, and the balance in Singapore, South East Asia and cash. We continue to screen vigorously our potential investee companies for valuation, management quality, and product and price sustainability as well as E.S.G. We are rigorous in our research because a public listing does not certify long-term honesty or respectability. Despite our enthusiasm for solar power, we are proud not to have invested in Hanergy, a former market darling (up 400% in seven months). We did not trust management, and when their Chairman did not turn up to a meeting, their stock fell by 47% in a morning. We earn our living by finding value-for-money companies that are managed to the highest standards. Our major themes and sectors continue to be financials (banks and insurance stocks with high consumer penetration potential, for example, HDFC in India), Internet and mobile applications (especially in China, gaming and on-line shopping), power and water utilities, and healthcare. We have recently made company

visits in Taiwan, confirming the pre-eminence of our major holding, TSMC. The Taiwan market still trades 22% below 1989 levels. In India, where we have been analyzing the durability of the IT sector as reflected in space demands (Ascendas REIT, listed in Singapore) and in Japan, where we are focused on earnings growth among hi-tech exporters (Fanuc, Omron).

In conclusion, we are convinced that we are in the early stages of a long Chinese bull market in Shanghai, Shenzhen and Hong Kong shares (like New York 1925 or Tokyo 1985). There are now more than 81 million private trading accounts in China: up 12% since the start of 2015. Many people have more than one account, so this means that despite a stampede of growth, equities ownership among 1.4 billion Chinese remains very low and with plenty of room to grow.

Source: CLSA

My vision of Asia in the next few years is that, as China’s economy matures and liberalises (especially in the financial sector and the international use of the Renminbi), a single capital market will emerge, as it did in the European Union after 1992. Hong Kong will likely perform the role of central financial hub, as London did for Europe. The Hong Kong dollar may be repegged to the RMB instead of the US dollar. This is a positive for Hong Kong, because the internationalisation of the mainland Chinese currency is good for China and what is good for China is good for Hong Kong, her shop window. Both the Hong Kong and Taipei share markets will be revalued as they continue to become more visibly linked to China.

Robert Lloyd George
May 2015

Additional Note

We believe that the success of the Shanghai-Hong Kong Stock Connect program in the past two weeks is a significant event which will lead to a steady appreciation and revaluation of Hong Kong stock market, and possibly of the Hong Kong dollar, in the next few years.

The Chinese Government wants to make it easier for funds to flow in and out of China with the gradual strategy of making the Chinese Yuan an official “reserve currency” by the end of 2015, joining the US Dollar, the Euro and the Yen. In the meantime, the People’s Bank of China has instituted a policy, to expand the daily range of the Chinese currency from 1% to 2%, putting pressure on the exchange rate, and increasing potential volatility and flexibility.

Hong Kong is likely to be the principal beneficiary of this political and financial goal for China. In the past two weeks, we have seen the daily inflow from China into Hong Kong shares reach US$1.6 billion daily (and over US$2 billion into Shanghai.) As the premium of A shares over H shares listed in Hong Kong has been over 30%, we expect that the arbitrage activity will rapidly narrow this premium, and Hong Kong listed shares will be the main beneficiary. In addition, a further trading link between the Shenzhen and Hong Kong Exchanges will be launched imminently. The authorities have already indicated that they would make it easier for mainland investors to open trading accounts under 500,000 Chinese Yuan (US$80,700) in size.

The upward pressure on the Hong Kong dollar is already causing the Hong Kong Monetary Authority to intervene heavily, and the fixed peg, which has held steady since October 1983, may become subject to increased pressure.

In the Bamboo Fund, we have already assembled a portfolio of blue-chip Hong Kong and China shares with average dividends of c.3%. We expect that this pressure on the market and the currency, will benefit undervalued Hong Kong blue-chips. In addition, there are hundreds of Chinese companies, in the consumer, internet, healthcare and tourism sectors, which are listed on the Hong Kong Stock Exchange, and we are conducting company visits every day to try to identify the most promising small cap and mid cap names.

Although the Chinese economy in the first quarter of 2015 has shown a slowdown to GDP growth levels under 7%, the service and consumer sectors continue to grow at a steady pace, and are much more attractive area to invest in than government SOEs, infrastructure or property. For the next 10 years, we continue to see growth in the Chinese middle class, and as they improve their living standards, their demand for many products will expand, including travel and tourism, insurance and banking, and healthcare and consumer products.

The focus of our China team, based in Hong Kong is very much to identify the next generation of corporate winners who will be able to benefit from these trends.

Robert Lloyd George
April 2015

After Harry Lee

About 20 years ago, I met Lee Kuan Yew and his wife, Kwa Geok Choo, at a small dinner party in London. I was seated next to Mrs Lee (who was clearly the power behind the throne). I exerted myself to make a good impression; and at the end of the dinner, she told her husband “We must get Mr Lloyd George to come to Singapore” – equivalent to a royal command. We applied to open an office for our fund management business and were told to route the application through Lee & Lee, the family law business. Once set up, we received important mandates from GIC (Government of Singapore Investment Corporation), Temasek (now run by Lee’s daughter-in-law) and MAS (Monetary Authority of Singapore), the central bank.

Everything was clean and above board, efficiently managed. Singapore is a marvellous place to do business, one of the only places in Asia with little corruption (although it helps to know the right people). It is extraordinary to think that when Lee Kuan Yew took over in 1959, per capita income was US$500 and, despite the vision of Sir Stamford Raffles that it was geographically the pivot of Asia’s trade, Singapore was a sleepy run-down port. Today it is a gleaming cityscape with US$56,000 average income and a modern financial centre; long-term planning has built up “centres of excellence” in science, technology, and education as well as in finance and wealth management. Such is the result of Lee’s “benevolent dictatorship,” which was much admired by Chinese leaders, such  as Deng  Xiaoping, seeking to modernize China’s economy whilst retaining central control. Corporate governance is a national sport in Singapore.

The question today is, whether Lee’s successors – and particularly his son, Lee Hsien Loong – will feel confident enough to loosen the straitjacket, especially in the social and political arenas. Taiwan and Korea are two reasonably successful examples of “Confucian,” previously military-run states, which have adapted to multi-party democratic rule. Lee Kuan Yew came from a generation of ‘streetfighters,’ who had lived under British rule, under Japanese occupation for 3 years, and then fought for independence in the 1950s. There is a tough, paternalist streak in Chinese family tradition. Lee was a Hakka Chinese: Hakka means ‘guest family’ and the Hakka are a people known to be frugal, pioneering merchants. The younger generation in Singapore have had it easy: will they prove as tough as their parents and grandparents? Certainly, they have had the best education available, many in top US colleges; and capital is plentiful for new endeavours. But their objectives and values in life may be different. Lee often wondered whether the younger generation had gone soft.

The global impact of a deflationary slowdown, and following the 2014 collapse of oil and mineral prices, is being reflected in slowing profits in the US and elsewhere. This is why we believe Asia will shine in terms of relatively strong growth, especially in the “young” consumer markets of India, Indonesia, Philippines, and ASEAN (Singapore is at the heart of this dynamic region), for which investors will pay a premium.

We have made a series of company visits this week in Japan, where shareholder activism has begun to produce results at strong companies, such as FANUC and Nintendo, Kyocera and Canon. Dividends are being increased, and share buybacks are beginning. The Japanese market will be further re-rated in the next two years. Corporate governance is improving as a market theme; last year’s launch of the Nikkei 400 index has proved a great success in increasing payouts to shareholders. The Tokyo Exchange has long required companies to “strive” to hire an external non-executive director; this new index requires at least two.

In China, we are looking at the healthcare sector, which, given the ageing population, is bound to be a growth area. For corporate governance and property exposure reasons, we generally prefer not to invest in private hospitals in Asia, but rather in medical equipment and services as well as pharmaceuticals. We see growth surpassing every other sector in the next 20 years. Among companies we are looking at today are Fosun Pharma, Sinopharm, Mindray, China Biologic, and companies in the ‘biosimilar” area.

It is very interesting to watch the long-term strategy of China’s leadership to internationalise the Renminbi, and to liberalise their financial system (this week introducing deposit insurance). The launch of the US$100 billion Asian Infrastructure Investment Bank, in which Britain has become a founding member, will rival the Japan- led Asian Development Bank in Manila. China’s currency is not yet a “freely traded” currency, such as the IMF requires for reserve currencies; but it is quickly evolving in that direction, and investor confidence in the financial leadership and opening-up policy of Beijing is reflected in the exceptionally strong performance of the Shanghai A Share Market, notwithstanding our long-term caution about China’s property market and industrial overcapacity. The overwhelming view from China-watchers is that the current growth contraction is being well-handled in favour of long-term stability. The retail investor market is starting to assert itself.

The week following Easter saw exceptional advancement in the Hong Kong market; a new ‘Connect’ system has been opened between the Shanghai and Hong Kong stock exchanges. This allows limited, bilateral flows of unrestricted capital between these markets for the first time in modern history. The Hang Seng Index rose 7.9% in the week and Hong Kong Stock Exchange turnover on 9th April was triple the usual figure. Shares in the Stock Exchange itself were up 27% in the week.  The Hong Kong Monetary Authority injected US$3.5 billion to maintain the currency peg. There is still an arbitrage, presently averaging more than twenty percent, between shares listed in both Hong Kong and Shanghai. Hong Kong blue chips hardly moved because new investors from mainland China do not yet have brand awareness, whereas Chinese brand names such as Tencent rose 20%. The Hong Kong market was subdued in the second half of 2014 because of political uncertainty and it is now catching up with the rest of China. Despite last week’s surge, we remain optimistic on prospects for Hong Kong. There is clearly tremendous Chinese enthusiasm to invest in Hong Kong, and the quotas for this are widely expected to be expanded in the coming months. The gradual opening of the Shanghai market is a start; Shenzhen, with its trillion dollar market, is next. There will inevitably be profit-taking but the advent of millions of new investors is not yet priced into the market.

There is some concern among professional investors about the potential lack of liquidity in E.T.F.s, particularly those in Emerging Markets with less turnover. We are, therefore, cautious on entering more illiquid frontier and emerging markets at this time, though there may be buying opportunities later. The financial stress on companies with high US dollar debt ratios (Petrobras is a prime example) will continue.

We are continuing to emphasize capital conservation and good sustainable dividend income, as well as reducing currency risk. Although we believe the US dollar’s ascent has been too rapid and may easily reverse this summer, we expect corrections in the Asian markets (we have seen India fall 6% in US dollars in the past month) and anticipate better entry levels.

The essential philosophy in our Bamboo Fund is to select great Asian companies with consistent and growing dividends over the years and hold these positions for up to 5 years so that the fund has a tax efficient 20% maximum annual turnover.

We have visited all the companies we intend to invest in, and we monitor them closely, but the selection is also based on the experience we have had in the Asian markets since 1982. It is possible that about 10% of the fund may be invested in similar high-grade corporate names in Latin America. In terms of sectors, we avoid oil and gas, mining, and property. We focus on healthcare, consumer, telecom, and utilities.

Robert Lloyd George
April 2015

The Bamboo Bends with the Wind

It is difficult to form a clear conclusion of the direction about the Chinese economy at the present time, although exports and consumer spending to continue to be strong, the evidence of international commodity prices suggest that China’s demand for iron ore, copper, oil and other raw materials continue to be weak. There is clearly over capacity in steel, shipbuilding, automobiles and even in the supply of apartments and office buildings.

The Chinese Yuan has risen by 30% against the Japanese Yen and the Euro, in the past year, although it has weakened slightly against the US$ in recent weeks. China has become a more expensive location for manufacturers relative to its Asian competitors. Clearly the emphasis of the NPC (National People’s Congress), and the work report of the Premier, Li Keqiang, is on the shift from infrastructure spending to the consumer. We see many investment opportunities in the internet and consumer space, although we continue to be selective about our portfolio choices among Chinese companies, judged by corporate governance and transparency.

In Hong Kong, which benefits from the continuing US$ peg, we see good value in banks, telecoms and utilities with dividend yields of up to 5%. Even HSBC, now yielding 6%, seems to have weathered the storms and the threat of further US fines for past misdemeanors, and offers certainly a value “contrarian” bet. Other core positions that we have been analyzing are the newly reorganized Cheung Kong/Hutchison group where the non-property assets including telecom, water, retail and container ports remain an excellent long term investment. China Mobile, with a 4% yield, also offers good upside, with the rapid expansion of the smartphone market in China with nearly 800 million subscribers today.

I have just returned from a 4-day visit to Indonesia, which shares with India the characteristics of large human and natural resources, a new reforming government, and ambitious infrastructure plans over the next decade. Indonesia, however, is a large exporter of energy and minerals, especially to China, and does not benefit from the oil price cut in the same way. The Indonesian Rupiah has now weakened to over 13,000Rp to the US$ – the lowest since the financial crisis. What is impressive is the growth of the banking sector with groups such as Bank Mandiri, and some smaller Javanese banks, growing at 25% per annum. We also visited Indofood, part of the Salim family group with its large noodles subsidiary, ICBP, which has 75% of the large instant food market. With a population of 250 million people of whom 35% are under 25 years old, Indonesia represents a very exciting growth market. Another group we met was Lippo, which has expanded from its property base to encompass a listed hospital group, Siloam, with 20 private hospitals offering growth of 50% annually and benefitting from medical tourism. Finally, Kalbe Pharma, with 50% of its sales in nutrition of health drinks and good corporate governance, is an attractive play in the pharmaceutical sector. We remain cautious about timing investment in Indonesia given the weak currency and possible political uncertainty, but it remains a medium term target for ASEAN growth like the Philippines.

India held its budget on February 28th, and our colleagues at Val-Q share our optimism about the outlook for GDP at 7.5% this year, and possibly a current account surplus, (with the savings on oil), which will allow the Reserve Bank of India, (which already cut interest rates by 25 basis points in January, and again in March), to make a further 100 basis points interest rate cut in the next 12 months. With strong leadership at the RBI, we expect the Rupee to be stable at round 62 to the US$ with less volatility than other Asian currencies. We are encouraged by the Budget, and intend to overweight the information technology and pharmaceutical sectors, but underweight telecom. We continue to like the Indian banks, especially private and smaller cap banks with strong growth in mortgage lending.

In fact, we have now seen rate cuts in the past 10 days by nearly all Asian Central banks, including Thailand, India, Indonesia, China, Korea and Malaysia. All this is happening while the world waits for the Federal Reserve to begin to lift its interest rates: so the US dollar will remain strong for some time.

As we prepare The Bamboo Fund for launch, and opening to subscribers, between now and 31st March, we are preparing our final model portfolio with the emphasis on Hong Kong and Singapore as well as India. We believe that, in a world where deflation has become visible in Japan, China and Europe, South East Asia will represent the real growth opportunity of the next 5 to 10 years. However we are very conscious of political and currency risk and we are proceeding cautiously with our objective of 3% dividend yield and 12% total annual return to insure carefully against downside risk, and establish good long term positions.

Robert Lloyd George
March 2015

What Does Deflation Mean for Investors?

The mood in Asia remains upbeat, we have had a series of meetings with companies in South East Asia, India, and Hong Kong which underline the strength of the consumer spending boom which continues to drive the region. Whether China’s headline GDP growth is really 7% or a lower figure matters less than the continued strength of the capital outflow from China both in investment flows into real estate  and international companies, and also the consumer spending reflected in the growth of tourism.

The crackdown on corruption in the Mainland has of course affected the Macau casino business and to some extend the retail sector in Hong Kong but we regard this as a short term blip in a long term growth pattern. We are now researching for internet and online businesses catering to the Chinese consumers. Although international investors have been transfixed by the recent US listing of Alibaba, there are plenty of other Chinese internet companies, which deserve investors’ attention.

The international background remains deflationary with the competitive devaluation of, first, the Yen, then the Euro, with the ECB program of quantitative easing. After the dramatic 50% fall in the oil price, and then the sudden revaluation of the Swiss Franc, the question that investors have to ask themselves today is – what else is unsustainable? One answer maybe the current exchange rate of the Renminbi. It has been extremely steady against the US dollar for some time but China may see its own interest in having a more competitive exchange rate, made more compelling by the competition from Japan and Europe.

The impact of deflation around the Asia Pacific region will be uneven. In many cases  it is a “good” deflation in terms of falling energy and food prices, favouring the lowest cost producers, and stable cash flow businesses, which have strong brands, or strong market share. In other cases, deflation can be destructive, in terms of the value of property, or pressure on wages. This is the type of deflation we have seen in Japan since 1990, and to a lesser extent in Hong Kong, and some of the more high priced labour and property markets. We continue to be cautious on Australia, for example, which has not had a recession for 23 years, and where the combination of falling commodities prices, high property values and a rapidly devaluing Australian dollar could make for a steeper recession.

Both Indonesia, and the Philippines, appear to be in good shape, in terms of low debt ratios, young consumer populations and stable reforming governments.  However,  both countries, at a closer inspection, have fairly severe infrastructure problems. We have invested in the power, infrastructure, water and telecom sectors, believing that these will be an important areas, of steady growth and cash flow over the next decade.

Many of these factors are equally true of India. This week’s rapprochement between Prime Minster Modi and President Obama may be of geopolitical significance, but it  is as yet difficult to discern an investment thesis based on deregulation, or foreign investment and foreign trade (US has only US$93 billion of trade with India compared to over US$600 billion with China). There is no doubt about the potential for India, with a combination of a young population, and the economic reforms under Modi.

For India, the fall in oil prices coupled with very low wholesale price inflation has put pressure on the governor of the Reserve Bank of India to cut interest rates. Indian Rupee deposits still earn over 8%, and thus a fall in energy and food inflation, will give much more benefit to India, than to countries with zero rates. We expect more earnings upgrades for Indian companies.

While I was in Bombay last week, the Vodafone tax situation has been resolved sending a strong signal to foreign investors that India is now open for multinationals. This will probably include the large supermarket chains, such as Walmart and Carrefour. Retailing in India is still very disorganized, with less than 10% of food being sold in supermarkets. We also visited Tata Consulting Services (TCS), which is hiring 60,000 graduate software engineers this year, adding to an employee total of over 300,000. They are extremely competitive and are benefiting from the continued trend to outsourcing by US and European multinationals. (Indian software engineer salaries start at about US$6,000 per annum.)

Another example of rapid growth in the Indian consumer and financial sector is Yes Bank, which has come from a start-up in 2005 to a bank with nearly 600 branches and

$1.5 billion balance sheet today. The growth in bank accounts in India is astonishing, having added almost 100 million new customers to the total banking system in the  past year. Another area which is growing fast in India is e-commerce, and we visited Blue Dart, the logistics subsidiary of DHL, located near Bombay airport, which is also looking for 50% growth in the next year — but sells on a high P/E multiple.

The major change in the world is undoubtedly the drop in the price in energy and we are now trying to identify the secondary consequences of this huge transfer of purchasing power from producers to consumers, estimated by some analysts to be worth US$1.7 trillion. One example of a sector which should benefit is travel and tourism, airlines, hotels and also restaurants. In the Philippines last week, we visited two major fast food chains. Of all the countries in the world where McDonald’s operates, there is only one in which it has only not succeeded dominating the market, but it in fact soundly defeated by its competitor Jollibee, which has 80% of the fast food market.  With 10 million expatriate Filipinos working overseas, many of the  local chains, are taking their brands into the new markets such as Middle East, Hong Kong and North America.

We believe that 2015 could mark a new era in Asia with low oil prices, competitive currencies, lower interest rates, and new political leadership and policies in numerous countries including in India and Indonesia. We have studied the last two cycles when oil prices fell rapidly both in 1985/86 and 2008/09, and in both cases Asia  significantly outperformed the USA and Europe. Japan may be one of the main beneficiaries although it is important to measure energy prices in Yen, rather than in US dollars, to measure the true effect.

For the launch of our BAMBOO Fund at the end of February, we are now putting together a model portfolio of both blue chip Asian businesses with strong cash flow and good dividend yield as well as some small cap names that benefit from this consumer theme.

What we are going to experience in the next ten years is something akin to the 1870- 1900 period of deflationary boom — a Schumpeterian Cycle of creative destruction stemming from advances in technology, especially the spread of the Internet, which has already had a dramatic effect in pushing down prices. In our view, this process  still has a long way to go, with the cost of financial services being one example of further competitive deflation.

It becomes much more critical to be selective in sectors. Even in China, we have seen some manufacturing companies which are now moving from highly labor intensive production towards increased capital expenditure on automation. Wage costs in China have risen at 20% per annum, and it is now increasingly attractive for manufacturers  to replace people with robots, especially for highly-skilled and miniaturized production.

In conclusion we are now in a time of competitive devaluation, and deflating commodity prices, which will include not only oil and mineral prices (excepting gold which we believe will outperform as a result of falling confidence in central banks), but also, eventually, food prices. As use of ethanol in fuel declines, so the demand for corn will be affected. We expect corn, wheat, and soybean prices to fall; and this will, in turn, impact the value of farm land in Britain, America, and other developed countries which have seen a 10-year bull market in land prices and now probably a bubble.

The growing tensions in the Eurozone, recently as a result of the Greek election and the split between northern and southern Europe, will eventually (and perhaps within a year) result in the breakdown of the single currency and the failed experiment of a centralized European financial structure. One possible result would be the collapse of the Common Agricultural Policy, which also will impact land prices and farming income around the European Union, including the UK.

We are bullish on equities in some of our key markets, despite these deflationary trends. Much of the money which has been invested in real estate, land, and urban property in the past ten years, as we pointed out in our last investment outlook, will now be redirected into equities. We have seen this trend in China in the last six months, and we believe that it will also result in higher share prices in other markets.

Robert Lloyd George
February 2015

The Demise of “Uncle House”

The inflation psychology which has characterized the last 30 years (even through inflation has been steadily falling) has led to a compulsive desire on the part of investors to acquire bricks and mortar, contrasted with the volatility of “paper assets” such as shares.

Nowhere has this compulsion been more extreme than in China where private citizens have only been able to own property (usually on 30 year leases) in the last 2 decades. The construction boom of the last IO years saw municipal officials, in particular, employing sometimes nefarious means to acquire properties: in one notorious example, in Guangdong province, an official owned more than 23 houses and (before being arrested for corruption) was aptly christened “Uncle House”. That property boom has now definitively ended, not only in China but probably in high priced global markets such as Hong Kong, Singapore, London and New York.

The combination of sky high prices, low rental yields, rising interest rates, and carrying costs (property taxes, maintenance) has finally punctured the bubble. The question for investors is, what’s next? and, what will be consequences of a possible 25% fall in real estate values in China and elsewhere? We have already seen a major correction in commodity prices, of iron ore, steel, copper and energy. The next stage may be a banking crisis (though, like Japan after 1990, there will be a period of “denial”, of putting off the recognition of a deflationary reality when prices fall but transactions dry up).

Much of the flight capital which has left not only China, but Russia, some European countries and the Middle East has been seeking “safe havens” in jurisdictions such as the UK, the US, Canada and Australia, has not been “price­ sensitive” – but what if a $1 million property turns out to be worth $600,000 and is costing $20,000 annually to service? There may be few buyers, and property is notoriously illiquid. Currency volatility is also a factor for investors.

We expect, therefore, a realignment of focus towards cash flow and liquidity as the leading criteria of investors: shares with steady dividends such as telecoms and utilities (and some internet providers) will be favored. The US dollar will (probably for a year or two) be favored over the Yen or the Euro. An era of competitive devaluation is developing, with the immediate source of deflation being Japan, which seems determined to drive the Yen down towards 150/$ (a rate last seen before the 1985 Plaza accord). This will put more pressure on China, the Renminbi will also fall, and trade tensions will increase. The beneficiaries may be some cheap labour nations in SE Asia as well as India and her neighbors.

The threat of deflation is a global one, but it will more deeply influence higher income nations with rigid labor markets (such as the European Union). A:flexible exchange rate is an essential tool to combat competitive trading pressure. It is easy to predict (but impossible to time) the collapse of the Euro, the end of the HK dollar peg, and the fall of the Renminbi: all may be expected within the next 5 years. Gold may rise out of the doldrums when paper currencies are so volatile and unpredictable.

Our focus is on companies. Recently even the most, stable and apparently predictable franchises (such as Tesco) have had unpleasant earnings surprises. So the successful past business model does not guarantee the future. The internet is undermining all pricing structures (even banks, during the next decade). The capabilities of management will be tested, but we are confident that certain consumer items and services have a constant appeal, and a strong brand, with pricing power.

In our Bamboo Fund, therefore, we are prepared for a deflationary era: we will own strong companies with good cash flow, and dividends (the only tried and tested means of rewarding shareholders). We will generally eschew property, mining, and energy in favor of utilities, telecoms, food and beverage, consumer finance, retail and logistics.

Of course a “Good Deflation” such as was seen in the 1870s rather than the 1930s involves productivity improvements (automation) as well falling commodity prices (food, energy, minerals). It will however impact high cost producers of manufactured goods in Europe and North America, and benefit lower cost providers of goods and services in Asia, for example, India IT services.

We have seen international meetings held in China and South-East Asia in the past week, and it is clear that China’s consumer economy is still the major factor especially driving tourism, and exports, from ASEAN (and Australia). The fall in commodity prices especially oil price is generally positive for consumer demand.

The agreement between the USA and China on “climate change” is also potentially important in switching energy demand from dirty coal to clean burning natural gas (hence Russia’s mega-deal to supply gas to China) – LNG will also become increasingly important in global energy trade (Japan is experimenting with fire ice, or methane hydrate, beneath the sea bed, which could be a game changer, too).

In conclusion, we believe that various elements are falling into place for a bull market in Asia beginning in 2015 with interest rates staying historically low and energy prices falling, both Asian economies and consumers will begin to feel a real boost in confidence for the first time in 6 years, after the financial crisis. Breakthroughs in Free Trade (TPP, APEC) will also be accompanied by free capital movements. The Renminbi has effectively been liberalized for offshore investors to buy this week: and the Hong Kong – Shanghai Stock Exchange deal allows international funds to buy A shares freely, and mainland investors to buy Hong Kong shares. There is the potential for a positive re-rating of risk, and de­ escalation of tensions in East Asia.

Robert Lloyd George
15th November 2014