Macro

Value traps or deep value? Often it’s hard to tell, especially when analysing Chinese stocks. One thing that will always be a good investment in Hong Kong though is a bowl of wonton noodles. My favourite is served in a tiny restaurant not far from the city’s financial district. In a recent week-long trip with colleague Jeffrey Tse, we ate there every day. While dining options are many, I have been to Hong Kong enough times to know that this restaurant is by far the best. Our investment approach with local stocks has been similar – stick to what you know, keep it simple and avoid unnecessary risks.

Most of the companies we visited have easy to understand businesses, little or no debt, a history of paying large dividends and significant insider ownership. These desirable characteristics mean that their stocks usually trade at high valuations. But the recent local market meltdown has seen the prices of even these above-average quality businesses fall. The Hang Seng index is down about 20% over the past year. It’s too early to write about any specific stock, but there are three anecdotal observations from the trip worth sharing.

Young generation on the rise

The Hong-Kong stock market is well known for its large number of family businesses still run by founders. In recent years the second generation has been taking over. This new breed of entrepreneurs often studied overseas and, while they still want to grow the original business, they’re also keen to improve it. For example, they are trying to move away from simple contract manufacturing to develop their own brands and exploit direct-to-consumer distribution channels.

These strategies should help their businesses become more profitable and less susceptible to competition. Strong brands take time to develop. But the internet and widespread adoption of smartphones across Asia is fast-tracking the process. While Chinese consumption is growing, the market is already big enough that there is a lot of room to pursue niche strategies without competing with cashed-up multinationals.

Improving corporate governance

Many investors avoid Asian companies due to the lack of respect for minority shareholders. For the first generation, listing the business on the stock exchange was often the culmination of an arduous career rather than a way to finance growth. Historically, these patriarchs have put little effort into building relationships with minority shareholders and the wider finance community.

This is changing. Not because of corporate governance consultants, but because of old fashioned self-interest. The second generation is more interested in their shares trading at a fair price. This can help to finance further growth and deal with family succession issues.

While recent share price collapses might also be playing a part here, for the first time in five years, executives of the companies we visited asked for suggestions on how to improve their relationship with the market. Time will tell if any of our recommendations will be put into action. We remain sceptical, but at least they are asking.

Not about cheap labour

Over the years Chinese manufacturers, largely thanks to generous government subsidies and tax cuts, have been investing in automation. They are now the lowest cost producers in many industries. And making inroads into industries that require greater levels of technological know-how. Sometimes, as discussed in this previous post, they are also becoming the innovators.

While trade tensions between the US and China have continued to make headlines over 2018, none of the international businesses we have been talking to are considering relocating production to other countries. Producing in China is no longer about accessing cheap labour. It’s about supply chain management. Supply chains are costly to reorganise and Chinese production is still the most efficient. With this in mind, many of the Hong-Kong listed manufacturers look attractively priced.

This was our best trip to Hong Kong yet. We have built on the hard work of previous years and expanded our watchlist of potential investments. We are also looking forward to welcoming Forager’s new Senior Analyst, Paul Quah, in February. He brings a lot of investing experience in the region.

While in Hong Kong we met with the managers of our current local investments too. You can read about their recent developments in our December quarterly report which is available on our website.

Further Insight

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