15th April 2023
Chinese State Owned Enterprises
Dear Investor,
Today we will discuss the additions to the thematic portfolio in April which were the Chinese banks and Chinese railway construction companies.
As we said at the time, this is in line with one of the major pronouncements out of the March NPC which gave us the impression that there would be continued support for the SOEs and that they would be pushed to have a higher return on capital then purely growth for growth’s sake. In our view, this is not just lip service to attract back foreign investors but an understanding from the Chinese leadership that the old model of debt fuelled growth is not sustainable.
In fact, they already know this, and this is why during Covid lockdowns they didn’t follow the rest of the world’s playbook in giving mass handouts to consumers and breaks to businesses. This is a double-edged sword as it meant that their sovereign debt levels didn’t balloon like a lot of the world, especially the US, UK and the EU, but on the other hand, consumer sentiment is much more depressed in China which also makes the recovery slower than in those regions. Slower, but more sustainable in our opinion.
We have added two sectors to the thematic portfolio, one more of a “trade” and one a more longer-term investment. Now, this newsletter is more about longer-term themes, but I believe the first of these sectors will play out over the near term and this is a function of our experience of the Hong Kong market (and other markets with a large retail participation rate), where stocks get rerated very quickly if they capture the retail “zeitgeist.”
The shorter-term trade is the construction and related companies. These have started moving already after the NPC announcement and while I can list out a bunch of narratives for their performance, that would simply be rationalising a move which I can see coming and is happening.
The narrative could include the following
- They are extremely cheap on an earnings and cash flow basis 3-5X PE and CF (with the caveat that they have average returns on capital and 10-12% ROEs).
- Dividend Yields of 4-6% with a relatively low payout ratio of ~20%.
- Most recent results show big operating cash inflows so they are getting paid by their customers.
- They are SOEs and so will benefit from Beijing’s push to both support, streamline and make this sector more profitable, especially as they are not fully related to property or the tech sector.
- They are also part of the Belt and Road initiative – I will go into more detail below- but it is essentially a series of massive infrastructure projects which binds countries to China.
- From the previous China bull market/One Belt One Road peak in 2015 they are down between 60 and 80% and “only” up 20% from the November 2022 lows in the HK market until the NPC put a fire underneath them.
Some charts for reference.
One year chart of China Railway Construction showing the bounce off the bottom in November 2022:
15-year chart showing the longer-term picture:
Source: Eikon
While China Railway Construction Group and China Railway Group 1186 HK and 390 HK both have railway in the name, they have expanded beyond that into a wide range of engineering contracting. This includes the construction of railways, highways, urban tracks, water conservancy and hydropower projects, buildings, municipal projects, bridges, tunnels, airports and marine ports.
China Communications (552 HK) is effectively a service provider for the big three telecom companies in China, both in network construction but a more recent growth driver is their investments in digital infrastructure such as data centres (not a business to be given to non SOEs). This has been included to give some diversification to the SOE theme. It has similar valuations, net cash and a steady business.
What is One Belt One Road?
Well depending on your point of view it is either:
China trying to recreate the old Silk Road trading routes and build ties with countries initially close (East Asia, Russia, the “Stans”) and expanded further afield (Africa, Latin America), by providing low-interest loans for those countries to build infrastructure to enable easier trade.
Or the more cynical view is that it is essentially tying these nations into debt slavery and the infrastructure story is a cover for that goal. If the latter is the correct interpretation, then it is equivalent to what the IMF and World Bank do – making loans to nations and enforcing austerity measures which squeeze the general population. Ask anyone in Asia or Latin America what they think of those institutions and you won’t get a glowing review. As an example, in Korea the Asian Financial Crisis is called the IMF crisis! As an aside, what is good for the goose is not good for the gander as when you had the GFC in the West in 2008/2009, no such austerity was preached at home.
Either way the result is that China is funding massive infrastructure projects across the globe and these companies are a beneficiary of that. This combined with the new alliances being made means there are more countries that want to work with China in this way. These companies are also the tip of the spear as regards investment into “new Infrastructure” which is all things environmental and energy related, which will be a growth driver for them in the coming years.
China Rail Construction, at its recent results announcements, reiterated the party line as regards shareholder returns (dividends and buybacks), as well as managing projects for cash. In China, if the management of an SOE says something publicly like that, they will make it happen as the alternative is not usually being fired but something worse. This, for us, makes it more likely that this whole “managing for profitability rather than growth,” is not just lip service.
With the low payout ratios and reduction in debt, there is scope for dividends to be raised increasing the already healthy yields.
So we have cheap stocks and a good narrative. We like these kinds of investments/trades as, (famous last words) the downside is limited but there is a lot of blue sky available. Another asymmetric opportunity.
The second, longer-term investment are the Chinese banks.
Now, who would be crazy enough to buy a Chinese bank while the rest of the world’s banking system is having serious problems! Let’s dig in…
Now they are cheap on the numbers, and yes cheap things can get cheaper or they can stay cheap or the numbers can be wrong. Having looked at Asian markets for 25 years, we are well aware of this!
So what are the stated numbers?
Source: Eikon
These banks look extremely cheap. Why? Well, no one believes the numbers and investors think the books contain a lot more bad debts than is stated especially with the property market issues that have been well publicised over the last couple of years as well as Covid. Many high-profile US fund managers each year call for the demise of the whole Chinese economy and the whole “house of cards” to come crashing down. Well it hasn’t happened yet (not that it cannot happen), but as we said, the Chinese economy probably had the worst 3 years out of the last 50 years, and it didn’t implode, so we have to give them the benefit of the doubt.
Their margins have contracted as evidenced by the lower level of EPS growth than revenue growth (Remember most Asian companies don’t buy back their own shares to flatter EPS growth when profits are down – a distinctly US market phenomenon).
If you don’t believe the numbers, you should believe in cash. Let’s look at how dividends have grown over those last three years:
During these 3 terrible years, their dividends have grown around 10% a year. Not bad compared to many other sectors and regions in the world. Now the latest dividend, just announced was lower and similar to 2 years ago but it was expected by the market and there was no negative movement in the stocks.
So we have some boring stocks which will pay out 8-9% in dividends per year at the beginning of a credit cycle (as opposed to the end of the cycle in the West) with the opportunity to grow dividends as earnings grow. Now at some point, our educated guess is that some pension funds, once they decide to get back into China will like these numbers. With sovereign debt markets in the West looking very precarious and a not very good store of value, these types of alternatives will become increasingly attractive.
Now, they are not sexy, dynamic tech stocks that the hedge fund crowd like to trade and that is precisely why we like them. They don’t have a lot of Western institutional ownership and so are not subject to the whims of those investors going hot and cold on China. They have a low beta so that you can sleep at night holding them. These are not short-term plays but longer-term in nature and if we have to wait and collect 8% a year while waiting, then that is ok.
Having addressed the issue of them staying cheap and getting paid while you wait, can they get cheaper? Let’s look at some charts:
Below is the chart of Bank of China since listing in 2007. Excluding the Great Financial Crisis, the lowest the bank has been is $2.40-$2.50 during the sovereign debt crisis in Europe (2011), and in November 2022 at the low of the Hong Kong market.
Looking at a shorter time frame, the 1-year chart is below. You can see that while banks were dropping in every other major market in March due to the banking issues in the US and Europe, Bank of China was actually up. In addition, it is still below where it was just in July of last year. To its low of the last 11 years, there is 16% downside. To us this is a very good risk-reward for a sector which is at the beginning of a credit cycle, has government support as these banks are a major tool for government policy (which we understand is unattractive to some investors).
The banks all have very similar looking charts and so there is no need to repeat.
We believe Western and Japanese sovereign bonds are not a good place for your money going forward giving our macro view of the world and the continued mass issuance we see going forward. As we have said, the end game given the debt situation in the West will be a cut in interest rates and continued bond issuance to fund ongoing public works, fiscal deficits, and pay-outs to the public. Some elements of financial repression will be used whereby debt yields less than inflation so that the debt can be inflated away. The alternative is a breakdown in the current monetary system as higher interest rates bankrupt governments.
We view these banks as a substitute for bonds, given their low beta/volatility, high dividends. They have some potential upside in that if they trade at 0.75x Book Value, this is 50% upside and at 1 x Book, will give us a 100% return.
As a reference point, JP Morgan trades at 11x earnings, 1.6X book value and a 3% dividend yield. Its Return on Equity is 13.7%, versus Bank of China at 10.3%. This is just to illustrate that there is no reason that Bank of China cannot trade at 0.75-1x Book.
Moving on to recent events, we would like to go back to a few important points we highlighted in the last commentary.
While discussing the banking issues we explained that even insuring depositors fully and allowing banks to borrow at par against bonds which were trading below par, wouldn’t take away the core issue. That is the return offered by safe money market funds of >4% versus the 0.1-0.5% offered by most banks.
Bloomberg April 7th
Money Fund Assets Hit New Record High, Although Inflows Slow
The cash pile parked at money-market funds hit a fresh record high in the past week, although inflows slowed from the recent breakneck pace. About $49.1 billion poured into US money-market funds in the week to April 5, bringing total assets to an unprecedented $5.25 trillion, according to data from the Investment Company Institute.
Money-market funds have been scooping up cash recently. Initially much of that flow was driven by more attractive rates, but concern about the steadiness of some smaller lenders helped turbocharge that within the past month.
This will lead to a contraction of credit in the US economy as banks pull bank lending and continue the liquidity squeeze there. This is another millstone around the neck of the US economy and the contraction of credit after a huge increase in credit (last 15 years and especially the last 3) usually spells disaster. As we have said repeatedly, the next set of issues will be in the “shadow” banking sector which encompasses the private credit markets, private equity etc. As they hold assets that are private, there is no “market” price for them and so they call it “mark to model” or as we like to call it “mark to make believe.” If those assets were marked down, you would see more collateral calls and selling down of those assets. The stress in these sectors will become public over the next few months as liquidity continues to tighten. As an example…
Reuters 4th April
Blackstone REIT limits investor redemptions again in March
Blackstone Inc (BX.N) said on Monday it had again blocked withdrawals from its $70 billion real estate income trust in March as the private equity firm faced a flurry of redemption requests.
Blackstone has been exercising its right to block investor withdrawals from BREIT since November after requests exceeded a preset 5% of the net asset value of the fund.
BREIT fulfilled March withdrawal requests of $666 million, representing only 15% of the $4.5 billion in total redemption requests for the month, the firm said in a letter to investors.
Total redemption requests for March were 15% higher than the approximately $3.9 billion demanded by investors in February
In other developments, we had the below news which helped the oil price and related equities to rise. This is good news for the thematic portfolio but our worry is why they chose to cut production. The benchmark WTI Oil contract had already fallen to around $65 and then risen in the month before the announcement took place so my sense is that OPEC is more worried about future demand falling and so are being pre-emptive in the cuts. In addition, you have natural gas at an extremely depressed price, while uranium is down around 25% over the last 12 months. It is unusual for one type of energy to be diverging this way and those other markets don’t have a cartel to prop up the price. To reiterate, we are long-term bullish on many forms of energy but worry about the short term slowdown in the West due to recession. Oil and oil product transportation companies had a sell-off on the news as the view is that less oil produced means less oil transported. True, but irrelevant for the longer-term thesis.
Reuters 4th April
OPEC+ announces surprise oil output cuts
DUBAI, April 2 (Reuters) – Saudi Arabia and other OPEC+ oil producers on Sunday announced further oil output cuts of around 1.16 million barrels per day, in a surprise move that analysts said would cause an immediate rise in prices and the United States called inadvisable.
The pledges bring the total volume of cuts by OPEC+, which groups the Organization of the Petroleum Exporting Countries with Russia and other allies, to 3.66 million bpd according to Reuters calculations, equal to 3.7% of global demand.
We also found some data showing the extent of a few stocks on the performance of the big US indices. This reinforces our view on the narrow breadth of the rally in the US and how this will play out in the next few months.
NY Times 1st April
How Big Tech Camouflaged Wall Street’s Crisis
Trading in March offers a clear example. Even after the failures of two regional banks in the United States and the rescue of a global investment bank in Europe sent a jolt through the financial system and raised new fears about an already fragile global economy, the S&P 500 ended the month up 3.5 percent.
Apple and Microsoft accounted for about half of that gain, according to data from S&P. Both were seemingly immune to the banking crisis and boosted by fervor over artificial intelligence, with Apple rising 11.4 percent during the month and Microsoft 15.6 percent.
The S&P also produces an “equal weight” index, where each stock has the same effect on the wider group. In March, that index fell 2.6 percent.
In other good news for the thematic portfolio, gold continues to do well, in fact close to going to new nominal highs. We repeat: Buy more if there is a correction to USD1900-1930 and you do not have your required weighting.
Japanese trading companies, of which we have a couple in the thematic portfolio were highlighted by Warren Buffett after a recent visit to Japan. We like this as he is a long term investor, not someone who publicises his holdings in order to sell into any rise due to the publicity.
CNBC April 12th
The Berkshire Hathaway chairman and CEO revealed this week that he had raised his stakes in each of the five major Japanese firms to 7.4%, and added that he may consider further investments. Buffett’s trip to Japan is intended to show support for the companies.
Known as “sogo shosha,” Japan’s trading houses are akin to conglomerates and trade in a wide range of products and materials. With the import of metals, textiles, food and other goods, they helped vaunt the Japan’s economy to the global stage.
They have been criticized by some investors for their complex operations, as well as for their growing exposure to risks overseas as they expanded internationally. However, for Buffett, those diversified operations could be part of the draw. They also boast high dividend yields and free cash flow.
Until Next Time,
Source: Eikon
Why China attaches importance to railway projects it funds across the world – Asian News International
26-Jan-2023 10:54:33 PM
Successful completion of these and other rail construction projects would significantly deepen connectivity between China and its neighbors, potentially boosting Beijing’s geopolitical and geoeconomic clout while shoring up China’s domestic economy.
Beijing [China], January 26 (ANI): China attaches great importance to the railway projects it funds across the world under the Belt and Road Initiative in order to strengthen its economic, political, and cultural linkages with partner countries, reported ChinaPower.
As of 2020, the BRI includes 138 countries with a combined GDP of some USD 29 trillion and 4.6 billion people and of the 34 countries that signed rail construction contracts with China, 29 are involved in the BRI.
Middle-income countries have attracted most of China’s rail construction contracts since 2013. Lower middle-income countries took in 41.7 per cent (or USD 25.7 billion) of all contracts, while upper middle-income countries took in 29.1 per cent (or USD 17.9 billion). The remainder was split among other economies, reported ChinaPower.
Disaggregated by regions, about 46.9 per cent (USD 28.8 billion) of China’s rail construction contracts were concentrated in Asia. Within the region, the lion’s share (61.1 per cent) of contracts went to nine Southeast Asian countries.
In Malaysia, the top recipient in the region, China is constructing the East Coast Rail Link, which will stretch some 640 km and cost a total of USD 10.6 billion, reported ChinaPower.
Africa received the second-highest amount of rail contracts from 2013-2019. At USD 20.8 billion, this accounted for 33.8 percent of the total. Similar to Asia, the largest contracts in Africa are concentrated in a few countries.
About USD 7.5 billion worth of rail-related construction contracts (36.1 per cent of the amount in Africa) were signed with Nigeria, where China is constructing a series of lines that comprise the 1,300 km-long Lagos-Kano Railway Modernization Project. This massive undertaking has made Nigeria the world’s top recipient of Chinese rail construction contracts during the 2013-2019 period, reported ChinaPower.
Chinese leaders have made rail projects an important element of the BRI. In a 2014 speech, Chinese President Xi Jinping stated, “China attaches great importance to the railway and highway projects linking China to… neighboring countries,” and added, “These projects will enjoy priority consideration in the planning and implementation of the ‘Belt and Road’ Initiative.”
In Pakistan, under CPEC, China will be part of USD 6.8 billion project to upgrade 2,655 km of the country’s existing railway lines. In Southeast Asia, China is pursuing one of its most ambitious BRI projects, the Kunming-Singapore Railway (also known as the Pan-Asian Railway). If completed, the railway would consist of three major corridors extending some 3,000 km from the southern Chinese province of Kunming down to Singapore, passing through Laos, Thailand, and Malaysia, reported ChinaPower.
Successful completion of these and other rail construction projects would significantly deepen connectivity between China and its neighbors, potentially boosting Beijing’s geopolitical and geoeconomic clout while shoring up China’s domestic economy.
For example, once completed, the Kunming-Singapore line is expected to increase two-way trade and tourism flows between southern China and mainland Southeast Asia. This would leave Southeast Asian countries more economically reliant on China, providing Beijing with additional leverage in the region. At the same time, the increased cross-border activity would promote economic growth in China’s less-developed border regions – a key goal of the BRI, reported ChinaPower.
Importantly, railway construction projects also help to open up new markets for Chinese companies. According to CGIT data, two Chinese SOEs in particular have benefited from rail construction projects abroad.
China Railway Construction Corporation signed 21 rail construction contracts worth USD 19.3 billion, accounting for nearly one-third of the global total during the 2013-2019 period. China Railway Engineering Corporation signed 19 contracts worth USD 12.9 billion, amounting to roughly one-fifth of the value of all contracts, reported ChinaPower.
While rail construction projects could benefit Beijing politically and economically, some projects have faced setbacks and criticism. Surveys indicate that rail and other infrastructure projects have had mixed impacts on China’s international image.
Several rail projects have also been criticized as instruments of “debt-trap diplomacy,” wherein China purportedly seeks to gain leverage over developing countries by burdening them with unsustainable debt. (ANI)