China: What is Common Prosperity and What Does it Mean for Investors?

China, and more specifically, its Common Prosperity initiative have clearly been in the headlines of late but, what is not clear is how the initiative will impact investors. Will it lead to real policy moves and implications for Chinese companies, or is it just a catchy political slogan? Global Investment Strategist Kevin Hebner joins the podcast to discuss the macro backdrop of Common Prosperity and Emerging Markets Portfolio Manager Tim Sledge explores the potential implications for Chinese companies. (December 13, 2021)

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Transcript

Speaker 1: 0:02

Hello, and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.

Speaker 2: 0:15

Hello everyone. Welcome back to another episode of Actively Speaking. Uh , today I'm joined by two guests. Uh, we're gonna be talking about China and what's been going on there in recent months. It's been in the news quite a bit. Fair amount of activity in the markets around , uh, around some of that news. So anyway, I'm joined by , uh, Kevin Hebner, our global investment strategist. Hi, Kevin. Hey

Speaker 3: 0:35

Steve.

Speaker 2: 0:36

And , uh, Tim Sledge , who is a portfolio manager on our emerging markets team, and is involved in , uh, investing in in China. Hi, Tim.

Speaker 4: 0:44

Hi , Steve. Thanks for having me.

Speaker 2: 0:46

So , uh, Kevin, let's start with you. There . There's been a lot of news about what's going on in China, and it , it's goes under this rubric of quote , common prosperity. Before we get into what that term means , uh, or doesn't mean , uh, can you set the historical context for us? Uh, I, I have spent most of the last 30 years , uh, wondering how it is that China was still referred to as a communist country. It had made such a sharp turn after several, you know, after the first few decades after the communist takeover in 1949. It was a very doctrinated communist country. And then , uh, you know, in the 1980s made a turn towards , uh, market reforms and became , uh, seemingly a much more capitalist economy. As I say, I was sort of puzzled how it was , how it was that we still called it a communist country. So how does what we're seeing today fit into that historical context? How significant is this turn ?

Speaker 3: 1:39

Okay, thanks Steve. So it , it certainly is , uh, a Leninist party structure, and , and I think that's what people refer to when they're trying to be careful about , um, where China fits in the political spectrum. And , and we , we can sort of think of, you know, the period, you know, from our careers as having three distinct epics , I guess, or eras. The, the first beginning with Mao, and this is referred to as the, the standing up period , um, where China became united. They defeated or expelled the , uh, imperious powers and certainly successful doing that. But , um, CCP dogma admits there were some practical and theoretical mistakes. Um, so you could think of some pretty enormous center planning errors that mal made . And so this , this led to the, the second period , uh, under Dang , um, in which, and this is referred as the growing prosperous period where China , um, embraced markets to some extent opened up to the world economy. And , and the popular slogans were things like, it, it's glorious to get rich , or it doesn't matter what color the cat is , as long as it catches mice . And the idea was to market to catch up . Um , but this resulted in a number of excesses or imbalance , um, sometimes unrestrained capitalism. And so this led directly to the , the third period, so under President Xi, and this is referred to as the becoming stronger period. So we went from standing up to growing prosperous to becoming stronger. And, and the idea here is to, to balance the power, the , the londonist power of the CCP and market forces to tame some of the excesses of the , the dang errors era. So inequality, corruption, rapid speculation , different centers of power, for example , um, with Alibaba. And , and ultimately the goal under, you know, this period under President Xi is for China to regain its former glory before the imperialist period to become a , a preeminent world power. Uh, officially the goal is to reach that by 2049 , the , the hundred anniversary of the ccp. Um, but , uh, at least in terms of CCP dogma, that's how the , the three different periods are , are viewed.

Speaker 2: 4:09

Okay . Okay. So what we've heard in in the press in recent months is this idea of a quote , common, a new policy called quote common prosperity. So how well defined is that term? Or , you know , what does it mean and and what specific , uh, specifics can you point to in terms of changes in policy that have taken place?

Speaker 3: 4:30

Yeah , so it's, it's a catchy political slogan as politicians like, and , and in particular it's been adopted ahead of the , the 19th Party Congress, which occurs next October. And that's, that's very important. So we we're never really exactly sure what these slogans mean. Um, under President Biden, we have build back better under President Trump . We had Make America Great again to some extent. These things are always old wine and new bottles, but, but there , there's some things we can point to sort of concrete policy actions or focus , um, that they have. And certainly with President Xi, one is , um, a focus on inequality, reducing inequality, which, which on some metrics is as extreme as , um, it's in the us . Uh, a second to tame property market speculation. And , and we've talked about this previously, but , um, China's definitely on the off the chart in these measures. A third, which, which really began almost a decade ago, so around 2012 when President Xi , uh, ascended to his current position is to, to reduce or reign in corruption , uh, associated with the party. And then the fourth one , um, and this is more of a reversal of d is self-sufficiency, where we're Dan was focused on opening to the rest the world under president and more important be self-sufficient and things like tech hardware , particularly semis , uh, energy food . And , and we even saw this , um, in the last week or two at Cop 26 , where China does have a pledge , um, to their sort of objective to be net zero by 2060 . Um, but it's very much something that they're doing on their own and sort of a self-sufficient perspective rather than working with , um, other countries . So it's, it's sort of a broad vague slogan like they typically are, but there , there are some concrete policy actions or , or areas of focus that do come out of it.

Speaker 2: 6:29

And , and do we know what's, what's next? You , you talked about some of the things we've already seen. Do we know what's coming ?

Speaker 3: 6:36

Well, you know , a big part of this we're seeing through regulatory changes that have occurred , um, and this , this really has accelerated, so of started last October , um, particular after some comments by the , um, the founder of Alan Baba , Jack Ma , but has been accelerating through the summer. Um, so there's been a lot of regulatory changes affecting the real estate sector, and that made a lot of sense because it did exacerbate inequality, extremely expensive, and , um, lots of signs of rapid speculation. Um, certainly the tech sector is another area , um, referred to an area of unstrained capitalism. Uh , in particular, it became quite powerful. It was challenging some policies of the ccp , um, often referred to within the party as the wild west. Um, and there were real issues with data privacy with , um, the crazy hours that people were working and so on. So regulatory changes of attack , that private education got a lot of attention this summer , uh, putting too much pressure on kids, and it was expensive exacerbating inequality , uh, gaming , um, which was referred to by the party as spiritual opium, and they successfully restricted the hours of access for children areas like gambling. So there's been a number of regulatory changes and there's also been , um, a lot of areas in which the , the parties becoming much more involved in the corporate sector. And so we're going to some type of hybrid model where maybe on paper companies are privately owned, but certainly the, the party is very involved in making sure it isn't just a profit motive , but also the policies of the , the party , um, that are adhered to . So I think going ahead , um, that seems to be one of the most interesting areas to pay attention to .

Speaker 2: 8:26

Okay . Well , let's , let's turn to Tim , uh, to get a perspective of , uh, what's been going on in the markets. How have markets reacted to all of this? So, so Tim, what have we seen in the Chinese stock market , uh, over the last few months?

Speaker 4: 8:39

I , I agree with everything Kevin said. Uh , I think it puts a very good context around a lot of the different fronts we've seen under this common prosperity umbrella , and not surprisingly , uh, the quite volatil bit . And if we just think , uh, about China as a whole , the market's down about 12% year to date , and that's greatly underperforming. A broader emerging markets benchmark, which is about flattish for the year. And , uh, within that, the performance of different sectors and industries is quite , quite , uh, broad. And , um, and the , with the companies and the , the sectors that are most affected by those elements that Kevin just said, they're down quite considerably. Um, and so we would say, you know , uh, consumer discretionary , uh, has been the , the worst performing sector down almost 20% in China. And that reflects the movements of big cap stocks like Alibaba, like jd.com and the education stocks, and to a lesser extent , uh, the staples tech and communications communications where Tencent is on the opposite side, you have a couple of sectors that have done fabulously well. Uh, and no surprise, those are the commodity led , uh, sectors. Energy's up quite considerably. PetroChina and the coal companies , uh, the utilities are up and , uh, the materials, but the leadership is very narrow and it tends to be with the rare earths and the lithium miners companies , uh, leading the charge there. So the , the broad answer is the , the Chinese market is , is has been very difficult this year , uh, to be certain. And , um, the job of every analyst and every portfolio managers to figure out where we're going next with these , uh, common prosperity , uh, elements .

Speaker 2: 10:30

And , and so yeah. What, what have you concluded from that? Where are you, where do you think there are opportunities for companies that might actually benefit from, from what's happening?

Speaker 4: 10:39

The way we at Epic emerging markets approach the asset class, we approach it with a very differentiated type of model, and it starts with the epic core model , which our clients will know, as you know, we describe as the , uh, the digital expression of our epic free cash flow philosophy. And we've , uh, coupled that with a number of proprietary quant tools that my colleagues have built, not the least of, which is a , uh, multifactor risk, country risk model designed specifically for emerging markets. And then we take the output of these tools and the fundamental analysts of which I'm one, you know, our job is to go in there , uh, to look at the , uh, the , the opportunity set and find out what are the best stocks to invest in . So we really think of ourselves more as a bottom up type of , uh, uh, of strategy. Mm-hmm , <affirmative> . But within that framework, there's, there's definitely things that we see when we look at China. And I would broadly say, rather than trying to , to pick a sector over another sector, really has to do with what are the pockets, what are the sub industries and groups that have been overly punished or unfairly punished by the market? And here we see a couple of interesting things, which I , I'm happy to highlight within consumer discretionary , um, which again, has been a group that's been down quite a bit, led by the big internet names. You know, we, we , we , we see some other o opportunities that , uh, that, that appeal to us. And one of them, for instance, would be online travel agencies. So think the analogs like booking.com or , uh, Expedia , uh, a company we , we look at is to , along Tong Chang is a , uh, one of the market leaders in China. And this is a market that is already narrowed to a rational, a oligopoly, but there's an element to this, to the thesis around these stocks that's a reopening post covid as travel starts to get back to normal. But even more so for a company like Chang , uh, there is , uh, a long term secular tailwind for them because they happen to be the market leader in lower tier cities, tier three, four, and five, where you're seeing the greater population growth, the greater economic activity, and these submergence of a middle class that now has travel open to it , uh, particularly domestic travel, which we see as a long-term tailwind for a company that's already mature in terms of its margins, but growing at 25% , uh, or more on , on the top line and a strong take rate. So we see , uh, we , we see a company like this unfairly penalized just by association with other internet based names, even while we have , uh, a very secure market position. And even, interestingly enough, the backing by the market leader seat Tripp or , uh, trip.com, which is the leader in the larger tier cities. So a so a company like this is, is very interesting to us . And I'll go a step further. Uh, Kevin mentioned China's desire to be self-sufficient. You know, one of the areas that I think , uh, it's been maligned , uh, it has to do with decarbonization. Uh, president Xi was famously not attending the Cop 26 , uh, uh, um, summit a few weeks ago and missed an opportunity for China to show leadership in raising mistakes on , uh, greenhouse gas emission cuts. But that's not to say that China's not dedicated to this. We have seen a number of different , uh, efforts by the country to curb greenhouse gases. We've even seen , uh, rolling power outages as a result of, of curbs on coal. But , uh, never forget that China's the leader in EV technology. A lot of the technology that goes into Teslas and , and , and batteries goes through China and the populations very much behind it. So as we look at, you know , green tech , uh, decarbonization and electric vehicles, you know, a name like Yia , uh, jumps out at us. Uh, and this is , may not be a household name, but it's actually the market leader in two wheeled electric vehicles, e-bikes and scooters. And it has a number of different advantages to recommend it . Uh , first of all , it's the solution for a very highly urbanized and congested society. It is helped by the long term tailwind of the , the emergence of, of , of , of delivery services. And , uh, and it appeals to the young generation in particular , uh, millennials , uh, particularly like their products. And they're very consciously moving their portfolio of brands up market , uh, to try to take a premium space and then go overseas . And so you ask yourself, you know, what does this mean? This is 25% grower on the top line that we think has been overlooked by the market and , and , uh, and , and , uh, and mistaken within all the , the , uh, the volatility that's out there. And it's a company that's still putting one and a half to two times more of its revenues back into r and d and , and reinvestment than its near term peers and secured a lot of , uh, ventures with the leading battery technology makers in China. We see a company like this with a very long-term tailwind of growth , uh, and could be a global brand eventually. So those are some of the, the , the , the interesting ideas we see coming out of consumer discretionary staples has been a very difficult place, as I mentioned. And, you know, one of the things coming down the pike in terms of, of , uh, uh, uh, common prosperity is tax reform reform . And this is one of the things that have really hit this sector pretty particularly hard. The, the , the central government is clearly toying with higher property taxes, as Kevin mentioned, consumption tax, capital gains tax , and it's piloting higher income taxes in select cities. So the implications are, are a hit to discretionary income. And you've seen luxury type products hurt particularly hard in staples. Uh, and that includes what we would see as , uh, the liquor companies. Uh, the liquor in China is baiju and the premium brands there are Ma , Tai , and w uh , and they have been , uh, they , these, these stocks have come down quite considerably in price on this sphere , but also because , uh, there's, there's evidence that regulators are looking at the , the industry in terms of reregulating price, particularly in the wholesale level. So where do we see opportunities? We think the opportunities are in more basic staples. And , um, you know, in the midst of all this confusion around China, we think one of the things we can probably safely predict is that the Chinese will still want their soy sauce. Um, and so when we look at that particular end of the market, it's actually quite fragmented, but the , there's market leaders there that have some very interesting elements to it. So the one that we look at, Foshan Han one of the market leaders with a nationwide presence , uh, this is a category, the condiment category, growing, you know, high single digits slightly better than China, GDP . But what's special about this particular company is , uh, its focus , uh, on the commercial end and from a distribution standpoint , uh, and ties to restaurants, restaurant chains , uh, which is growing better than category. And then the ability, as we perceive for pricing, we think they can add more 2% through pricing because of their, their market position and , uh, and an ability to upsell with other condiments as well. And again, a good company with stable growth at the top line and free cash flowing, which is the kind of things we look for and I think everybody knows in terms of the epic ethos and approach to , uh, to investing.

Speaker 2: 18:13

Thanks for that. That's a very good bottom up perspective. It sounds , you know, so there are certainly, even in this environment, you know, sounds like there's certainly plenty of opportunities, but I wanna now sort of jump back up to a higher level view again and , and go back to what you've both been talking about with China wanting to be more self-reliant. Which kind of leads to the question of, you know, things have changed a lot over the last few decades in terms of their need for and desire for foreign investment. You know, I would ask the question, does , does China really want foreigners , uh, investing in their companies , uh, going forward?

Speaker 4: 18:51

Well , I might take a stab at that first , uh, and Kevin, if you have some thoughts , uh, please join in. There was one , uh, chapter to this whole saga this year that was particularly striking , uh, and that was the education stocks that , uh, Kevin mentioned before. Uh, and I'm thinking of two in particular , uh, new China, excuse me , new Oriental education and t education, both of which were listed in the US and for years these were very high growth companies, very attractive with a lot of , uh, investment from North American investors. And , uh, it served a very important niche for, for a long time, Chinese families have put a very high importance on the value of education and furthering their children's , uh, education. But if you had invested on the assumption that that was , uh, something that would continue into the future and that the Chinese government would guard that you were very unhappily mistaken. Uh, it became increasingly clear through the year , uh, that the Chinese central government at the highest levels was very concerned about predatory practices within this industry. Uh, they were concerned about , uh, the burdens on middle class families, both in terms of the cost and the amount of time , uh, and stress put on the children. But to get to your point, and I think this is the , the important point, perhaps the most important concern of them was the fact that this industry , uh, was built on foreign capital, western capital, and the Chinese government felt that education was a particular service that the government provided for the people, and it wanted Western capital out. And so in July, there was a policy paper leaked from the highest levels in Beijing, which essentially required these companies to re-register as not-for-profits effectively wiping out capital. And it didn't make very explicitly clear, they did not like foreign capital involved in what it perceived as sensitive industries. And that was kind of a watershed moment. And we have been dealing with difficult times in China throughout the year, throughout the past few years, but this was a moment where I think a lot of investors really reevaluated the risk. Kevin, what are your thoughts?

Speaker 3: 21:13

Um, yeah , thanks Steve. And you know , Tim's mentioned that, you know , the equity markets in China have underperformed recently and , you know , for the last couple years, and in fact over the last decade, they've underperformed the s and p by over 50%. So, so it's not a new thing that they've underperformed. And even with that underperformance, they're still not cheap. They typically trade about a 35% discount to the s and p on a foreign PE basis. They're still there. And then in addition to the concerns we've had for a while , uh, we have a , a slower growth environment given demographics and different regulatory actions , slow down the real estate sector. Uh , there's lots of regulatory uncertainty outside of real estate, and Tim and I have been talking about that. Uh , third, we have lots of intervention by the, the state at the company level, making sure companies aren't operating just for profits, but are also taking into government priorities, common prosperity. Um, and Steve earlier mentioned the , the winner takes most issues. Um, in the United States, we have a small number of companies, 15 companies accounting for 50% of the gains in the s and p since 2015 . A lot of these are digital companies, and it , it , it seems very clear that with common prosperity , uh, we're not gonna get another Alibaba, we're not gonna have jack laws . So we we're sort of eliminating the, the top, the 10 beggars in the market. And, and ultimately I think this means, yeah , and this is a question we get asked , uh, a lot from , um, clients, is China investible? Um, I think it probably is, as Tim was mentioning, there's a lot of very interesting companies . Um , Tim was start talking about Green tech and , and China really is a leader of the world in green tech , and there's some other interesting sectors, but probably it makes sense to have a strategic underweight tactically, maybe some set times going to neutral overweight. But strategically everything we're looking at it says , um, this is a market that should be underway . Steve was wondering, do they in fact need our capital? Foreigners only represent about 5% of ownership, depending upon which market in China you look at, but overall around 5%. So they haven't been really important maybe in the education sector they've been , um, but outside that it's not really been important to China. And going forward , uh, given the priorities that President Xi <laugh> , I would think they're gonna be even less. So I , I do think these are , are deep questions that investors need to be thinking about when they're deciding how much to allocate into China.

Speaker 4: 23:53

Uh , I'll add one , uh, one point to what Kevin just said . You know , the question of whether China's investible , you know , being a proud member of Epic's emerging markets team , um, of course I'm gonna tell you it's investible, but it's important to recognize that, you know, for an emerging market investor, China and Hong Kong listed Chinese companies , uh, equates to about 34% a full third of the benchmark you throw in , um, Taiwan , uh, many of which whose companies are, are China facing , and you're on at almost exactly half of the benchmark. So we have to be there , uh, and we have to be engaged, and we have to be looking very carefully for the types of companies we want. But , uh, we can think about the risk and , uh, and that's what Kevin just alluded to. Uh, our team has taken , uh, an underweight position in China reflecting our view of the risks near term in that market.

Speaker 2: 24:48

Well, this is really all, you know, very interesting. And , uh, uh, to me it raises the question of , uh, and I'm sort of getting at this early on when I talked about the different eras in Chinese history with a sort going from Doctrinated communism to a much more market oriented economy. And , and now it seems like the pendulum is, is swinging back the other direction. And I think what I'm wondering, and I guess we'll all just have to keep our eyes on this over the coming years, is, you know, they've been very successful, they've generated a lot of growth, and yes, there's, you know, some people have gotten very rich just as is the case in the us uh, through entrepreneurship and creating, you know , companies that , uh, that created all sorts of value for the owners of the business. But I only did that by providing goods and services that people wanted, and they, they raised everybody's , uh, uh, you know, standard of living and the process. It , it's an open question to me. If, if China starts moving back in a sort of more collectivist, I think is the best way I can think of to put it direction , uh, will they still get that kind of entrepreneurial drive and, and innovation that they've seen over the last 20 years? So I don't think any of us has the answer to that, but it's, it's certainly something that we're gonna wanna watch. Uh , so I think we've , um, that's about all the time we have. So , uh, Tim, thank you for joining.

Speaker 4: 26:04

I enjoyed it. Thank you.

Speaker 2: 26:06

And , uh, Kevin, thank you.

Speaker 3: 26:08

Oh, thank you once Steve ,

Speaker 2: 26:09

And uh, again, if you've , uh, if you like what you've been hearing, please give us a good review wherever you get this podcast, and we'll be back with another episode soon.

Speaker 1: 26:22

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Speaker 5: 26:38

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