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Investors shift to China’s domestic sectors

07:12 AM   Source:FTChinese

Both economic data and the stock market in China offer little cheer to investors still spooked by the events of the summer. But a visit to the portfolio companies of Citic Capital, a local private equity firm, suggests the gloom is overdone.

Citic Capital believes China is indeed making the desired shift to a more service-oriented, consumption-driven economy, a view that has become its principal investment theme today. That shift, though, does not appear in much of the data, which still focus on such measures as industrial production and deflation in producer prices. Moreover, since the whole point of the stock market from the beginning was to raise capital for (often profit-free) state-owned enterprises, the market itself is hardly a reflection of the state of the overall economy.

Consider, for example, the circumstances of the Chinese unit of King Koil Mattress, which Citic Capital bought in 2014. While it is not immediately obvious, a mattress company is a good indicator of consumption. A King Koil showroom on the outskirts of Shanghai displays mattresses that sell for up to Rmb970,000 ($160,000), with its best-selling models priced at Rmb16,000 and its lowest end mattress Rmb10,800.

Meanwhile, King Koil’s revenues have grown 40 per cent per year for the past three years, with profits up 110 per cent for the period on a compound annual basis. One reason for this is the fact that raw material costs are not rising. Labour costs, though, are up between 10 and 15 per cent on average, according to staff in the showroom — but that is a good thing, not a bad thing.

If the shift is to take hold, China needs to create jobs beyond low end manufacturing, and wages and incomes need to rise to support consumption. And that is happening on the mainland (in contrast to much of both the developing and developed world where wages remain essentially flat). China created 13m jobs last year and more than 7m in the first half of this year, while in most provinces wages have been rising 13 per cent on average.

“Jobs are the silver lining,” says Haibin Zhu, chief China economist for JPMorgan in Hong Kong. “There is underemployment in manufacturing and slower income growth, but services mean more income and more consumption.”

At the same time, productivity continues to improve both at King Koil and generally across the mainland. The factories in China produce better quality mattresses than those in the US — still at a lower price.

Meanwhile, a visit to one of OC Early Education’s kindergartens on the outskirts of Beijing tells a similar story, of rising tuition charges in a growing market. OC Education teaches English as well as Chinese from the time its students are three, while their increasingly affluent parents have enough money to afford a doubling of tuition fees in later years.

Moreover, a combination of demographic and regulatory changes provides further tailwinds. China is about to let virtually all urban residents have more than one child, which will create far more demand for schools, especially those that will give the children of so-called “tiger” parents an advantage later in life.

Both companies are in fields that are highly fragmented, suggesting they can grow by acquisition, and that Citic can easily find an exit through a trade sale at some point.

The so-called Li Keqiang index, which measures the increase in bank credit, electricity usage and railway freight transport, does not capture any of this. Most service companies lack the hard assets banks require as collateral for loans, and they are not energy intensive. (Given the logistics for King Koil, and the challenge of so-called last mile delivery, trucks transport mattresses to customers from the factory.)

Indeed, Citic Capital’s portfolio is dominated by service companies that barely existed 10 years ago, in sectors including education, media, finance and logistics — and Alibaba (on which Citic expects to make five times its money). And while many of its portfolio companies cannot get bank financing, ironically Citic Capital itself has no problem doing so.

At some point, of course, private equity firms will be able to float these service companies, and the stock market will provide a less distorted view of what is happening in the economy and offer investors more interesting opportunities. If that is the lesson regulators draw from the debacle of the summer sell-off, both sides will be better off.