China’s Covid-19 lockdowns have lasted longer than expected, affecting the economy and investor confidence. Despite this, we continued to buy high-conviction companies at more attractive valuations, as we viewed the near-term weakness as temporary.
The country’s structural drivers remain intact, even if we don’t return to the heady growth of 10 to 20 years ago. The companies we invest in should benefit from trends such as rising incomes and wealth, increasing demand for premium goods and services, and growing sophistication in technology and manufacturing. See chart 1 for an illustration of how a long-term trend can endure.
Since the 1990s economic reforms, China’s role in global trade has increased beyond Japan’s peak in the mid-1980s. This bodes well for exports and consumption, partly due to China becoming wealthier from selling to other countries. But as the availability of cheap labour fades, there is a growing need for Chinese companies to innovate and move up the value curve.
Growth runaway
To give us an idea of the growth runway for Chinese companies, we compared the revenue of a few of our holdings with their global peers. For example, Nike is considered the best sportswear company globally. In China, we believe Anta Sports is the best sportswear company domestically. As seen in Chart 2, a side-by-side comparison implies plenty of room for Anta to grow.
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Likewise, the best pharmaceutical company in China is Jiangsu Hengrui, the best automation company in China is Shenzhen Inovance; and the best medical equipment company in China is Shenzhen Mindray. We like these companies for fundamental reasons. It has nothing to do with government policies, property measures, interest rates, the state of the economy, or GDP growth. Rather, it’s based on their ability to gain market share, earn higher margins, create more valuable brands, and have strong management and alignment.
We will discuss these companies in more detail and why they will likely remain our long-term holdings.
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Industrial automation aims to offset a shrinking workforce. Given labour shortages and the government’s goal to become self-sufficient in “hard technologies”, China’s automation market enjoys strong secular tailwinds. China’s working-age population is declining due to the earlier one-child policy.
From 2022 to 2050, China’s workforce — people aged between 15 and 64 — will contract by 22% or 217 million people, according to United Nations (UN) projections. There is increasing demand for robotic equipment and components that can improve efficiencies or the production process. With this in mind, we have followed industrial and general automation companies closely for several years.
We own Shenzhen Inovance, an industrial automation company with leading positions in inverters, servo motors and new energy vehicle (NEV) controllers. The ownership and alignment are strong, with a dedicated founder team that has grown Inovance from a small inverter maker into China’s most successful automation company.
Inovance has repeatedly proven its capability in developing new products and entering new markets, where it can compete with multinational peers. The company has generated 28% per annum shareholder returns since its IPO in 2010, with a 40% CAGR in sales and 35% net profit CAGR. Despite its size, we think Inovance can continue to generate attractive growth over the next five to 10 years as it gains market share and innovates.
Another example is Airtac, China’s second-largest pneumatic components supplier, with around 25% market share. Demand for pneumatic components is also driven by industrial automation. Airtac is a rare Taiwanese company that has built its channels and brands to compete with global companies like SMC rather than focus on manufacturing for third-party companies.
The chairman seems clear in his goals, treats employees well and positions for long-term growth by identifying attractive markets. Airtac is also moving into linear guides, which he believes are a stepping stone to larger, high-end pneumatic customers, as there is a big customer overlap between the two businesses. Over the longer term, we expect 10% to 15% growth annually.
Leading healthcare firms gain market share
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Healthcare spending in China is much lower than in developed countries and should continue to grow with the ageing population. According to UN estimates, the 65-plus population will increase from 14% in 2022 to 30% in 2050. In the healthcare sector, we own pharmacy businesses, independent contract laboratory (ICL) companies, and medical device manufacturers.
The pharmacy sector is highly fragmented, but consolidation is likely, and the industry leaders would benefit. There are 1,200 pharmaceutical companies in China, and the largest two, Jiangsu Hengrui and Sino Biopharm, have a 3.1% market share each, followed by a 2.7% share for CSPC (we own all three companies).
By comparison, the global pharmaceutical sector is also fragmented, but leaders tend to hold a 5% to 6% market share.
We also hold Shenzhen Mindray, China’s largest domestic medical devices company and a market leader in patient monitors and life support systems. The company has gained market share from global leaders as it expands its presence overseas, with more than 40% of its sales through exports.
Meanwhile, the penetration level of medical devices in China is still low, and there is a growing preference for import substitutions.
Domestic brands may benefit from premium consumption
China’s easing of Covid-19 restrictions is gathering momentum. This should enable a return to structural growth in consumption and tourism.
Amid the weak consumer demand over the past two years, we have focused on buying higher-quality franchises and market leaders. This means companies with above-average margins and returns and the ability to upscale and raise selling prices.
For example, China’s beer market differs from most, as beer volumes have declined since 2014. But as the economy and middle class have grown, so has the opportunity to upscale and improve unit economics.
China Resources Beer (CRB) is the largest beer company in China, with around 30% market share. The Chinese beer market is highly consolidated, with the top three companies (CRB, Tsingtao and Anheuser-Busch Inbev) sharing 75% of the market. As a result, competition is rational and measured.
Despite tepid sales, margins and profitability have improved as beer companies consolidated their breweries. CRB’s share of premium sales has grown with help from a 2019 merger with Heineken China, resulting in higher average selling prices (ASP).
Although the company is a state-owned enterprise (SOE), China Resources businesses have typically been well run, with returns comparable to private enterprises.
Building stronger brands
As China’s reopening gathers momentum, we expect people to return to a more active and sporty lifestyle. This should benefit Anta, China’s most successful sportswear company and one of the few Chinese companies that have proven its ability to build and run multiple strong consumer brands.
In the longer term, sportswear consumption in China can increase as incomes rise, judging from the per capita spending on this segment in Japan and South Korea.
Few companies know Chinese consumers better than Anta, as its direct retail sales and data- and survey-driven consumer analytics bring the company much closer to its customers.
We believe the “Anta System” that enabled Fila’s success can also be replicated across its other brands. As long as Anta can attract new customers (with Kids, Fusion and its performance sportswear range, and more efforts to target the underrepresented female customer segment), we believe it can prolong its brand life-cycle and continue to grow sales.
The key is quality
While much about China has changed over the last 30 years, our investment process remains unchanged. The key for us has always been the quality of the business and management, backed by structural growth drivers.
So what will the next 30 years look like for China? Drawing upon the parallels in Japan, Olympus, Komatsu and Sony have become world-class companies; we would expect some of China’s domestic champions to reach similar levels of competence and acclaim.
Meanwhile, the median age in Japan is now 49 years, compared with 38 in China, and Japan’s average life expectancy is 85 years, compared with 78 years in China. As China’s economy matures and its people grow older, it could heed a few other lessons from Japan’s experience — like age gracefully with growing wealth, wisdom and happiness.
Martin Lau is the managing partner and lead portfolio manager of the FSSA China Growth
