Over the past few years I've featured several articles on the favorable investment opportunity set in emerging market (EM) equities. I've written about the attractive relative valuations and longer-term fundamental economic and demographic growth rates, particularly as compared to domestic equity markets that have garnered the lion's share of capital flow and investor attention. Last December, 2016 just before the holidays I was with a group of investment professionals with an emerging market real estate focused private equity firm. The group was in general agreement about the prospects for emerging market investments relative to developed market alternatives in the aftermath of corrections in EM public equity markets and currencies. We debated the best investment opportunities for 2017 across the EM landscape. We eventually white-boarded each individual's top EM investment idea as an official record and for group accountability.
My emerging market "pick to click" was the Chinese consumer. This selection was primarily driven by the favorable underlying trends I was seeing in certain Chinese consumer focused businesses within private equity funds I manage for a family office client. The consumption data from these funds greatly contradicted the media coverage and conventional wisdom on China. The contrarian nature of the selection was also evident in its stark contrast to the generally unfavorable consensus economic view of China for 2017 by the "experts." Many brilliant hedge fund managers had been calling for a economic hard-landing for China and its currency, the renminbi. This feature article will provide an overview of the Chinese economic performance so far in 2017 and an in-depth discussion on the rapidly expanding Chinese consumer class from a couple of different bodies of research followed by short cameos on two Chinese consumer focused private equity companies.
At a macro level, China’s gross domestic product (GDP) growth in the first quarter of 2017 was 6.9%, compared to 6.7% in the first quarter of 2016. This growth rate was higher than market expectations and signaled that the Chinese economy was off to a good start in 2017.
Retail sales grew by 10.0% in the first quarter of 2017 while online retail sales grew by 32.1%, accounting for 12.4% of China’s total retail value, indicative of increasingly deeper penetration by online channels.
Real per capita disposable income, a key driver of personal consumption trends, maintained its high growth of 7.0% during 2016, with income of rural residents growing at 7.2% compared to urban resident’s growth rate of 6.3%, narrowing the gap between rural and urban populations.
These data elements suggest that China’s economy is off to strong start to 2017 with most major macro metrics meeting or exceeding expectations. I view the macro environment in China as very favorable for long-term secular trends in increased consumer discretionary spending (consumerization) and a move towards more expensive premium products (premiumization). These secular trends in China were expounded upon by reputable researchers at McKinsey and Goldman Sachs.
In a March, 2015 excerpt entitled "Why China’s consumers will continue to surprise the world" from the book One Hour China - Five Stories That Explain The Brutal Fight for One Billion Chinese Consumers authors Jeffrey Towson, a managing partner of the investment firm Towson Capital, and Jonathan Wetzel, a director in McKinsey’s Shanghai office, highlight that the most exciting aspect of Chinese consumption is the trend in rising discretionary spending. The author's relay that "Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off. Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of “semi-necessities.” Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth." Please see the chart below from this article (click on image to a link to the article and a larger image).
So too in Goldman Sachs’ latest macroeconomic insight report titled “The Rise of China’s New Consumer Class” wherein Goldman reports that "Across Asia, rising incomes are creating an enormous new class of consumers. Much of that growth is coming from China, whose working population is larger than those of the U.S. and Europe combined. As more Chinese consumers gain purchasing power, their needs and preferences will have a powerful effect on the global economy." As the chart below depicts, China’s 770.4 million working population is a multiple of total workers of 146 million in the U.S. Only 11% of China's population is considered middle class. Rising incomes from the industrialization and urbanization of China are contributing significantly to the expansion of the middle class and the formation of a new hierarchy of consumer classes in China.
The middle market bulge in China's working population is comprised of the Urban Middle and Urban Mass. The Urban Middle class, defined by Goldman Sachs as families having an annual income of $11,733 per a capita, is depicted in the chart below. This growing demographic of 146 million people (equivalent to total U.S. working population) consists of financially comfortable corporate office workers and those with government jobs on the public payroll. This is the main focus of marketers as the middle class consumer tastes develop and incomes rise.
The Urban Mass is made up of 236 million blue-collared workers and migrant workers with average annual income per capita of $5,858. Income for this group has the biggest potential to rise in the next few years enabling them to incorporate discretionary spending into the mix along with basic non-discretionary consumption.
Goldman concluded that even today nearly half of China’s consumption goes to more discretionary “needs” like clothing (looking more beautiful) and food (eating better). The chart below shows the clear differences between China’s middle market consumption patterns with those of the US. The comparison of an emerging working class with that of a developed economy shows that with rising wealth and income spending will shift over time from pure necessities to more discretionary items.
My oversight role of a portfolio of private equity funds includes a few with Chinese consumer focused portfolio companies where I was able to see the rise in China's consumer class beginning to play out in a big way in 2016. Through attendance at fund advisory board and annual meetings and review of fund quarterly investor reports over the course of the year, my conviction increased that these Chinese consumer businesses were doing quite well and earning the high risk-adjusted returns an emerging market investor should expect to receive. Many of the general partners involved in these Chinese companies have been consistently advising their investors that Western conventional wisdom on China was mostly wrong. The Western view throughout 2016 was that all Chinese of means were anxiously seeking to get their money out of renminbi. Admittedly wealthy Chinese were prudently diversifying their investments, but these funds saw firsthand important bullish indicators of Chinese company operating metrics. Secondly, they took great comfort that their local Chinese partners were displaying longer term conviction by investing in China's future through increased investment in these businesses. Let me highlight a couple of private company on a no names basis as examples of the rise of Chinese consumption for you.
The first noteworthy business is the master franchisee in mainland China (PRC) of a western market quick service restaurant (QSR). The company’s master franchise agreement grants it the exclusive right to develop, operate, and sub-franchise this brand's restaurants in the PRC until June 2032. At the time of investment, this business had about 60 system-wide restaurants. Consistent with the research outlined above, the private equity firm's original investment thesis in 2012 was to capitalize on growing middle-class demand for convenience foods with a proximate goal to open 600 restaurants over the next 5 years. Now five years into it, the QSR business has exceeded their store growth target while the profitability of the business is very strong and improving. The platform has capitalized on its operating leverage and has had excellent consumer response to its tailored, innovative menu offering. For 2016 the company exceeded its revenue and EBITDA budgets by wide margins by sustaining high comparable sales growth of over 15% for the past couple of years. The company has successfully grown system-wide restaurant count to over 650 stores, or more than 10 times the footprint at investment. Having clearly demonstrated successful execution in operations, the private equity firm has recently been able to secure increased borrowing capacity from local Chinese banks on favorable terms that will enable continued capital-efficient growth. The PE firm has begun exploring strategic options for the fund's holding.
The other highly successful Chinese consumer business owned by another private equity fund is a low cost producer and distributor of high end wallpaper for homeowners. The fund's thesis was that China's consumer markets will follow the same general market development pattern that occurred in the U.S. and other developed markets as they industrialized. The fund partnered with one of its longstanding Chinese partners with which the fund had invested earlier in a consumer paper products business - paper towels and toilet paper. With only a 3% penetration rate for wallpaper in China at the time of investment, the fund looked forward to successfully growing the business rapidly given its huge total potential addressable market. The fund's equity capital was primarily used to purchase capital equipment for the production of wallpaper which the PE firm believed established a reasonable downside for the venture at the liquidation value of the production equipment. The firm's high end wallpaper offering is highly similar to the best European wallpapers in design and quality but can be sold at a much lower price point given local labor rate savings and substantial shipping cost advantages. In just a couple of years, the wallpaper business has grown into the world's largest wallpaper producer. The private equity firm currently expects to sell the business to its Chinese partner now that the business is through its business development phase. Its founder would like to consolidate the profitable and rapidly growing wallpaper business with its other listed consumer paper products businesses.
Prompted by these insights on fundamental Chinese consumption trends, we endeavored to identify whether or not there was a liquid, publicly traded exchange traded fund (ETF) to ride the wave of rising consumption by China's massive middle and urban mass populations. We quickly identified the Global X China Consumer ETF (symbol: CHIQ) featured below. CHIQ has a price return through June 20, 2017 of 29.2% compared to 12.4% the broader iShares China Large-Cap ETF (FXI). Unfortunately, we have not yet added CHIQ to client portfolios because its assets under management (AUM) of $80 million does not yet meet our $100 million minimum threshold. However, we believe that we are in the early innings of this Chinese consumerization trend and will continue to monitor the performance and growth in AUM of CHIQ and expect to add the position to client portfolios at some point in the future.
The Global X China Consumer ETF (CHIQ) is based on the Solactive China Consumer Index. This index is designed to reflect the performance of the consumer sector in China. It is comprised of selected companies which have their main business operations in the consumer sector and are domiciled in China or are domiciled elsewhere but have their main business operations in China. The fund invests at least 80% of its total assets in the securities of the underlying index and in American Depositary Receipts ("ADRs") and Global Depositary Receipts ("GDRs") based on the securities in the underlying Solactive index. Sell side analysts' forecasts of the underlying companies roll-up to ETF level revenue and earnings growth projections of 12% and 20%, respectively, in 2017 followed by 16% and 19%, respectively, in 2018. The following table provides summary valuation metrics and historical view on CHIQ's price to earnings (P/E) ratio based on data compiled by the ETF Research Center (subscription required).
The chart below summarizes the consumer sub-sector exposure of CHIQ (click image to go to Fact Sheet and larger image). You can see that CHIQ is keenly focused on more on areas of consumer discretionary spending.
Barron's recently summarized a longer China research report by Morgan Stanley strategists Laura Wang, Jonathan Garner and Charles Clavel entitled, "What Morgan Stanley Expects for China Stocks." These strategist assessment was wholly consistent with the boots on the ground reports from the Chinese private equity firms. Morgan's principal conclusion reads: “We expect China to avoid a financial shock and achieve high income status by 2027. Our view is that moving to higher value-added activities will propel the economy forward and drive the continued medium-term outperformance of MSCI China versus MSCI EM, providing significant investment opportunities”. As relates CHIQ, the Morgan strategist recommended five thematic sectors for investment: a) Healthcare, b) Mass-market consumption; 3) Environmental protection; 4) Technology/High-end manufacturing; and 5) Defense/Aerospace.
Of note, The Wall Street Journal reported earlier today that MSCI agreed to include China A-Share locally traded shares to its indices. This decision follows three straight years of rejections and opens up the Chinese market to more foreign investment.