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The state of the world’s largest emerging economy is inscrutable from afar, obscured by geopolitical dark clouds and a tightly controlled local media. China re-opened from the pandemic only last November after prolonged sweeping lockdowns and extreme—albeit intermittent—deprivation. Since then, China has become even more opaque, as government authorities have stopped publishing some economic and industry data. Public mention of the pandemic and lockdowns have triggered the censors. As fundamental research analysts, we believe in-person conversations can shed light on today’s China, including its expansive private sector and unique market risks. To aid in this primary research, we have a local presence in China, via our Shanghai-based research subsidiary.
This September, we conducted an intensive research trip across Shenzhen, Hong Kong, Beijing, Jiaxing, and Shanghai, joined for parts of our journey by analysts from Causeway’s US and Shanghai offices. We met with executives of about twenty-five companies across the technology, consumer, communications, and industrials sectors. We spoke with industry titans and upstart innovators alike, constructing a bottom-up view of China’s investment landscape from their business experiences and insights.
- China is facing economic opacity with strict media control and censorship, intensified after the pandemic, requiring in-depth, local research to understand the economic landscape.
- Despite a weakened property market and consumer confidence, certain sectors like EVs and green energy are prospering, signaling the private sector's resilience.
- Chinese private sector firms are focusing on self-reliance and local talent development but are proceeding cautiously in global markets due to geopolitical concerns.
- The private sector, pivotal in employment and innovation, is navigating regulatory and economic hurdles with a focus on growth and profitability, suggesting potential for China's economic recovery—and no turning back to a planned economy.
What did we learn? China certainly has its problems, a distressed property market and anemic consumer confidence topping the list. Yet many private sector companies in nationally favored industries such as electric vehicles, battery technology, green energy, semiconductors, high-end materials, and artificial intelligence are thriving. We do not see a return to the past twenty years’ robust economic growth. Further currency weakness? We think so. Liquidity trap? Probably not, as demand for credit, according to companies we interviewed, appears evident across most industries. Banks, chastened by devalued property collateral, reportedly have been lending instead on cash flow. After more property pain, we expect a gradual recovery from the economic devastation of the pandemic period. If successful, continued anti-corruption campaigns should squeeze more income from state-owned assets and return funds to public coffers. Headwinds include a multi-year drag from property deflation. We believe China’s engine for gross domestic product recovery and growth resides—as it has historically—in the country’s resilient private sector.
China has an estimated 40-50 million private sector companies, 30 million of which are sizable enough to have multiple employees (for comparison, the US has approximately 6 million multi-employee small businesses). Overall, our most interesting meetings occurred with companies who have survived intense domestic private sector competition to become successful in their respective industries. A specialty chemical scientist entrepreneur told us she and colleagues built an innovative resins business largely free of government intervention. The company’s technology has become successful in an array of industries such as pharmaceutical manufacturing and direct lithium extraction. With orders booming, they have expanded overseas, aided by an acquisition in Europe. She has a very profitable business with the competitive moat of high customer switching costs. She and her husband (and co-founder) control the company, and do not currently intend to sell their shares. Like so many Chinese entrepreneurs Causeway has met over the years, these founders seem determined to succeed even in a country with tight controls.
Our research indicates the localization trend is real, displacing foreign incumbents in favor of homegrown companies. A board secretary of a mid-cap power semiconductor firm told us that global chip shortages gave his company a chance to win Chinese customers that otherwise might not have risked using his company’s products in areas such as industrial automation and clean energy. His employer and local competitors have built an ecosystem of suppliers and customers. Management of a semiconductor etching and deposition equipment company told us they expect China to become self-sufficient in the semiconductor supply chain over the next three to five years. That timeframe seems optimistic to us. Yet the race has started, and private and public sectors appear aligned in this goal. Ten years ago, said management of an analog integrated circuit semiconductor company, China had few university graduates with semiconductor concentrations and had to rely upon “returnees” educated abroad. They do now, thanks to increased funding for Chinese university curriculums. We heard how many SOEs (state owned enterprises) are focused on domestic substitution, facilitated by improved localized customer support. And, as Western competitors shutter their Chinese facilities, their trained talent becomes available to local firms. A software developer executive shared that when a foreign competitor closed its China division, his company hired many of their engineers.
Our research indicates the localization trend is real, displacing foreign incumbents in favor of homegrown companies.
Of course, localization cuts both ways, and many Chinese companies are pursuing global expansion with caution: an executive at an automotive original equipment manufacturer told us they are cautiously pricing in-line with European competitors to avoid being perceived in European markets as a “price killer.” Management of a testing services firm admitted difficulty making acquisitions overseas as geopolitical tensions mount.
China’s demographic challenges—an aging population and declining birthrate—and real estate woes invite comparisons to Japan’s economic stagnation of three decades ago. Yet unlike Japan, China hasn’t yet emerged, and individual incomes have room to grow. China currently has a GDP per capita of approximately $12,700, according to the World Bank, about half of Japan’s GDP per capita in 1990. Japanese companies spent the first two decades after the Tokyo real estate bust reducing debt. In the two decades post property bubble collapse, Japanese management key performance indicators tended to focus on market share and profitability, but rarely included returns on shareholder capital. In contrast, competitive private sector companies in China, especially those with significant founder ownership stakes, are keenly aware of how they deploy capital and the returns that shareholders expect, given the risk.
Both Japan and China prioritize societal stability and full employment. We found evidence of Chinese internet companies with large employee numbers hiring recent college graduates to soak up the excess supply. Given the relatively low-cost of these young workers versus older labor, this “national service” seems rather benign. Wisely, Beijing’s “common prosperity” agenda does not appear to involve further taxation or redistribution of private sector profits. We heard examples of the Chinese government supporting small businesses: setting price floors for leading companies, awarding contracts to smaller players, and providing land and facilitating financing for new ventures. But most of the companies we met had progressed through the crucible of blistering domestic competition and currently receive negligible government subsidies. The leadership of these companies is sharply focused on growing revenues, achieving scale, and carefully investing capital for expansion. That’s usually a formula for success.
Most of the companies we met had progressed through the crucible of blistering domestic competition and currently receive negligible government subsidies.
Emerging markets have risks; China is no exception. Unique to a country of this size, China has a closed capital account. This creates challenges for its companies, such as the largest in communications services and consumer discretionary, listed on the US and/or Hong Kong stock exchanges. With poorly performing share prices since early 2021, many extremely profitable and cash generative companies must deploy cash generated and kept abroad to facilitate share buybacks offshore. The central government tightly controls the export of Chinese yuan, allowing external transfers mainly for strategic acquisitions.
Overregulation remains a risk for most industries, although we did not find signs of creeping communist party representation on private company boards or material interference in normal operations. Technology industry executives engaged in building generative AI models told us they have spent considerable time educating senior government officials on how China can compete globally in AI. The best of cloud compute and AI research, not to mention consumer data collection, generally belongs to China’s massive internet and gaming companies, not to the state-owned companies. China will not be at the forefront of computing without the innovation, motivation, and participation of its largest internet companies. Nor can China afford to materially handicap its private enterprise, which provides much of the nation’s employment and vitality. According to a CFO at a large online job recruitment platform, the private sector hires over 80% of the country’s workforce. We believe any threat to the private sector imperils the entire economy, thereby debilitating the central government. National security equates to healthy private sector companies boosting employment and wages. Said one executive reflecting on China’s private sector development since the 1980’s, “We will never go back.” He was referring to the pre-economic reform planned economy, where the state set production goals, controlled prices, and allocated resources.
China will not be at the forefront of computing without the innovation, motivation, and participation of its largest internet companies.
All in, this research trip into the enigmatic Chinese economy and private sector underscored the importance of primary research to reveal how macro policies interact with business fundamentals. China is too important a market for a global investment manager to ignore. As Causeway quantitative portfolio manager Arjun Jayaraman notes, “China is the largest of the emerging markets (currently a roughly 30% weight in the MSCI Emerging Markets Index), along with Taiwan and India (each about a 15% weight). Events in China echo throughout the emerging countries, especially in Asia. We must understand what is happening in China to inform all of our strategies.” Through our research, a generation of tenacious business leaders emerged in relief against a gloomy macroeconomic backdrop. These professionals have demonstrated a commitment to growing their businesses profitably. And we are following their progress.
 State Administration for Market Regulation (China), U.S. Small Business Administration Office of Advocacy
This market commentary expresses Causeway’s views as of September 2023 and should not be relied on as research or investment advice regarding any stock. These views and any portfolio holdings and characteristics are subject to change. There is no guarantee that any forecasts made will come to pass. Forecasts are subject to numerous assumptions, risks, and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented has been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy, or completeness of such information.
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