A longtime fund manager reflects on the state of China’s economy and market and what the future might hold.
Our guest this week is Martin Lau. This is his second appearance on The Long View, the first being in August 2021. Lau is a managing partner of FSSA Investment Managers, part of First Sentier Investors. He has been at the firm since 2002 and is the lead fund manager of various FSSA strategies, including FSSA Asian Equity Plus, FSSA China Growth, and FSSA Hong Kong Growth. Lau has been in the investment business for nearly three decades and is based in Hong Kong. He earned a Bachelor of Arts degree from Cambridge University, a master’s degree in engineering from Cambridge, and holds the Chartered Financial Analyst® designation.
Background
“Martin Lau: Now Is a Better Time to Buy China,” The Long View podcast, Morningstar.com, Aug. 3, 2021.
Morningstar Global Fund Report: FSSA Asian Equity Plus
Morningstar Global Fund Report: FSSA China Growth
Morningstar Global Fund Report: FSSA Hong Kong Growth
China Market and Foreign Investments
“FSSA Martin Lau’s Lessons Learnt From 30 Years of Investing in China,” by Kate Lin, Morningstar.com, April 18, 2023.
“Meeting Companies Amid China’s Post-Covid Rebound,” Fund Manager Q&A With Martin Lau, Winston Ke, and Helen Chen, FSSA Investment Managers, April 2023.
“Client Update: A Fast Thaw After a Long Winter,” by Martin Lau, FSSA Investment Managers, March 2023.
“China Equities: Keeping a Long-Term View,” by Martin Lau, FSSA Investment Managers, March 2023.
“Three Themes and Companies to Play China’s Rise,” by Martin Lau, Firstlinks, March 22, 2023.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Martin Lau. This is Martin’s second appearance on The Long View, his first being in August 2021. Martin is a managing partner of FSSA Investment Managers, part of First Sentier Investors. He has been at the firm since 2002 and is the lead fund manager of various FSSA strategies, including the FSSA Asian Equity Plus Fund, the FSSA China Growth Fund, and the FSSA Hong Kong Growth Fund. Martin has been in the investment business for nearly three decades and is based in Hong Kong. He earned a Bachelor of Arts degree from Cambridge University, a master’s degree in engineering from Cambridge, and is a CFA charterholder.
Martin, welcome back to The Long View.
Martin Lau: Thank you, Jeff.
Ptak: Thank you. We really appreciate your time and are looking forward to this conversation. When we spoke to you back in August 2021, you were optimistic about Chinese stocks, yet they performed poorly since then, losing some ground. In your opinion, what’s gone wrong since we last spoke to you?
Lau: Yes. Thank you, Jeff, for the question, and thank you for having me today. That’s a very good question to start. I recall when we had a conversation in 2021, when COVID was very bad, and China had this huge lockdown, as you know. Evergrande, the developer, was having problems and a lot of our investors were concerned about common prosperity, the new government, what that means, and so on. You’re right. At that time, we were actually quite optimistic from the point of view that we did believe COVID is not a permanent phenomenon. So, we believed at that time that a lot of the control measures would be gone. And of course, as of today, they’re all gone.
We are also of the view that, being a bottom-up investor, you tend to focus on the companies, and you would want to buy them when they are attractively valued. So, we were quite optimistic at that time because people were already reasonably negative. At that time, people were talking about COVID control, and all the ships being locked down in Shanghai port, and so on. I guess what we have been surprised and related to your question is how far that negative sentiment has gone. And I think as of today, now that COVID measures are all gone, people have been surprised by the lack of recovery or the slow economic growth in China and also the lack of policy response. I think that has been one of the disappointments, is that despite the slower economic growth, it seems the government is quite content or quite happy for that to happen. And I think that has been a surprise as in the even without the COVID control I think it does happen that the Chinese economy has been growing more slowly maybe than we anticipated.
Benz: You just outlined some reasons for pessimism. I’m curious to find out how optimistic you are today. Are you as optimistic as you were when we spoke with you in 2021?
Lau: Yes, we are. I think there need to be a few things that—when an investor decides to invest into China today, I think they need to accept—and that has always been our view that China is no longer the kind of high-growth country that we talked about 10, 15 years ago, maybe 20 years ago. If you look at China today, it’s actually already the second-largest economy in the world. And if you think about why people are concerned about China, let’s say if you have your Evergrande and your Country Garden and some of the developers having liquidity problems, it does reflect certain structural issues in China. In this case, the leverage in the system is actually quite high. So, if you have the second-largest economy and already reasonably leveraged, I think one should really expect the slow growth to be the norm.
I think whether it’s 5% or 4%, 3%, we never quite pay attention to the official number anyway, because we believe that’s only an official number. But then, the other thing, I think for the optimism. As a bottom-up investor, which we are, it’s really about the growth opportunities or the exciting companies, which might happen even with a slower economic growth. In fact, I would probably go even further as in, let’s hypothetically say, if China does have, let’s say, 3% to 4% or 5% growth for the next five years, in my view, it’s actually quite good. It’s definitely not the end of the world. And the reason for that is that only if … For many, many years, whenever we travel in China—and this is a real story—we have a company telling us, “By the way, there’s really no point of innovating.” And we said, “Why?” And they say, “No matter how much you’ve tried hard, the profit is not sufficient to buy a property in Shenzhen.” So, when the property price is not going up and the economic growth is more sluggish, in a way it forces companies to think differently. And I think this is one of the things that we are really watching out for in China as in how companies’ behavior with regards to their efficiency, cost management, mentality, balance sheet management, how you return cash to shareholders possibly. And these things matter. I think if you look at, let’s say, the U.S. or U.K. or even Japan, I think a lot of companies have done well not because the economy has done well. It’s really the way that they do things have gradually evolved. And this is what we want to find out, which companies do have those characteristics in China rather than taking a view as whether GDP growth is going to recover from 4%, 5% to maybe 6%, 7%. If it happens, it’s great. But that’s what we look for from companies.
Ptak: You raised a number of really interesting ideas in that last response. Before we get to that, I did want to ask you about something that I’m starting to hear more of, which is this notion that China might be the next Japan, so to speak. Chinese stocks have lost about 1% per year since just before the global financial crisis. I think I walked off from Oct. 20, 2007. So, it’s not just a lost decade, but a lost decade-and-a-half-plus at this point. So, what would you say to those, to dispel doubts that China is the next Japan, maybe differences that you might see between China and what we saw in Japan decades ago?
Lau: That’s a very interesting question, Jeff. We do cover Japan. We do invest in Japan. By the way, I’ve actually been learning Japanese for the last four or five years. I think there are lots of similarities between China and Japan, and I’m going to tell you the similarities first, and I’m probably going to talk about the differences later. I think there are lots of similarities. And the reason why people think they are the same is, one is, for both countries, people are getting old. I think the birthrate in China or the marriage rate in China, they’re both record low. So, people are not having kids. And if you look at other countries, it’s actually very difficult to reverse this trend. So, people are getting old, as in, people are getting old in Japan and the same in China. Both went through a bubble. I think Japan had a huge property bubble in 1989. In China, it’s difficult to defend that there wasn’t or there isn’t a property bubble. And therefore, some of these developers are having issues. So, it’s the same. So, if Japan has gone through very little economic growth for the last 35 years, the bubble burst in 1989, I think there’s a fair chance that China would have a slow growth for next, let’s say, five, 10 years, or 15 years or something. So, we won’t even defend that China is centering into more a mature phase, as in Japan.
The debt level is high for both countries. Even before China went into the current situation, we always like to highlight—if you look at the ‘80s and ‘90s, the largest banks in the world were Japanese. And even today, the largest banks in the world are Chinese. So, I think eight out of the 10 largest banks in the world are Chinese. So, whenever your banks become the largest in the world, you just need to be careful about the economy. So, there are indeed a lot of similarities between Japan and China.
There are some differences, and I would probably relate it to your comment about basically the market has not returned anything for the last 10 years or something. I think in Japan, you have, first of all, a number of policy misjudgment or mismanagement. It’s too early to say whether the same is going to be true for China. So, I think that’s the one I would say question rather than the difference. I think the other major difference between Japan and China, when Japan had the property bubble, Japan was pretty much a developed economy. So, wealth level was high, property price was extremely high. Whereas in China, I think the good and bad thing about China is I think China is having these issues when the middle class is still being formed and the income level in China is no longer low but is by no means comparable to, let’s say, the U.S. and U.K.
And then, I think more importantly, and that relates to your point about negative 1%, I probably want to elaborate on that one. The reason why the index has not returned you anything is more about the index itself. In fact, if you look at the Hang Seng Index, MSCI China, the Shanghai Index return, and so on, they have all underperformed significantly the GDP growth in China. However, if you look at individual stocks—let’s say, if you look at Tencent and we’ve been shareholders of Tencent since 2005—Tencent since 2005 has recorded a profit growth of roughly 30% to 40% compound. We don’t believe this is sustainable, but they have grown enormously since 2005. And then if you look at the 10 years, I think the profit growth would have been maybe 25%. When that happens, the share price has also compounded quite healthily for the last 10 years.
So, the reason why the index has not performed, and this is the reason why we as a team have never believed we should look at the benchmark and try to follow it. So, our active share ratio has always been 85% or more. It’s because the index keeps putting stocks into it at the wrong time. So, three years ago, when everyone was positive about China and China technology in particular, China tech was like 60%, 70% of the index. When everyone was positive about Chinese banks, Chinese financials were 60% of the index. When everyone was positive about PetroChina, when oil price was very high, PetroChina was a big part of the index. So, I think a large part of the index performance is related to the issues with index itself.
And back to the Japan-difference argument. We do look at Japan and we do look at China. Let’s say, if you look at Japan, many companies, you’re talking about the third-, fourth-, fifth- or sixth-generation companies in terms of management or family ownership. But then in China, we are really talking about still pretty much the founders who basically founded the company, whether you’re talking about Anta Sports, Tencent, or Alibaba, or (indecipherable) almost all the Chinese companies or private companies you’re talking about. We’re still talking about the first-generation entrepreneurs. So, I guess, the one difference—and there’s actually some negative with this comment—is that the companies are still very driven. They want to do something different. And that’s something I guess exciting that we find whenever we see the company, it’s just the excitement. They try to do something different. If you look at TikTok, if you look at Tencent or even Alibaba, forget about the sentiment and forget about valuation, and so on. If you look at what they’ve achieved in the past 10 years, it’s been quite incredible.
I think this is what matters. I think in simplistic form is, if China is going to repeat what it has done in the last 10 years, let’s say, stock market return, let’s say negative 1% or not very high. If GDP growth remains low—and by the way, GDP growth for the last 10 years has never been that high anyway—our job is really to find, in our view, the next Tencent, the next company which managed some successful innovation, expand the market, and grow the profit. We believe ultimately it is the profit growth which drives share prices, it’s not GDP growth.
Benz: We wanted to talk about the role of the stock market in China. It plays a particular role in capitalistic societies like the U.S. where it’s viewed as an engine for building wealth and achieving prosperity. I’m curious, how is the stock market viewed in China, and how has that changed in the last decade?
Lau: Yes, that’s very interesting. Thanks for this, Christine. I think for many years—and we heard the comment that even China was a communist or a socialist country. In fact, China was the most capitalist in the world and also compared with the U.S. and U.K. Of course, there was the period when China emerged from poverty. So, Deng Xiaoping, which is the first liberal leader in China, he once said that no matter whether it’s a white cat or a black cat, as long as it catches a mouse, it’s a good cat. So, effectively, from an extreme ideological communism, China actually developed from it, had a lot of reforms. And alongside with that, there have been a lot of successful stories of how people got rich and how companies became successful in the stock market.
If you look at Tencent, as of today, the owner, Pony Ma, has become a multibillionaire because he was successful in founding this company. So, I think that has been the case for a long time. I think increasingly there’s a question mark on—I guess that’s the background of your question is, whether China has changed or whether China has become more communist or socialist. I think the whole world is becoming more socialist, but let’s forget about that—but I think whether China has changed. Our short answer to that is yes. I think there was a period when the Chinese government was really looking for economic development. And after that period, if you look at how serious China has been in ESG, and if you look at electric vehicles, solar, and so on, China has really been serious about the environment. And the reason for that is China went through a period of very bad pollution. So, for them, the environment to a large extent is more important than GDP growth. So, I think in our last conversation, I mentioned about the Chinese government is more focused on the quality of growth rather than the quantity of growth. And that’s still true.
And of course, what also happened in China is a number of people have already become rich or super rich. The government also mentioned this terminology, which scared a lot of investors globally: common prosperity. So, it’s not about a small number of people getting rich. It’s about how you take care of the rest of the public. And I don’t think this is just China. I think this is the same in the U.S. This is the same in the West. Basically, the diversion of wealth has led to the government becoming more focused on this. So, I think, if you mentioned you focus on this—and that’s before you go into presidencies—more ideological kind of thinking. I think it is probably less capitalist than before. So, it’s not like growth at all costs. And it’s probably become more socialist at the margin. However, I think it’s kind of like your stock market question is, whereas I think in China, the stock market may not be as important as the U.S. and I think for the simple reason—in the U.S., let’s say, Biden would probably want the stock market to go up before the election. There’s no election in China. So, the same kind of interest is not there. But then, no government or leader would not want economic growth or income growth. But they probably prefer to see a more balanced income growth or economic growth. But every government would want to see a better stock market, a better economy. But it’s probably in a different context compared with the U.S.
The final point I want to maybe mention is also as in capitalists and socialists, or how the economists think, and so on. If we take a step back from GDP growth and politics, which is getting increasingly complicated … I’m a parent of three kids. I’m a tiger parent, a Chinese parent. So, if you think about the parents, Chinese parents or Asian parents are known to be spending whatever they can to provide them with the best education, ask them to work hard and study hard, and so on. And if you think about that mentality, it’s still pretty much that. It’s not like parents wanting their kids not to succeed. So, if you think about innovation being driven by people and Tencent, if you look at the management, they all—not all, many of them actually—studied overseas and returned to China. That trend is still ongoing. So, it’s not like all the people giving up and let’s forget about tomorrow. So, I think as long as that continues, I think the entrepreneurial spirit and the innovation going on, I think there will still be opportunities.
Ptak: I wanted to go back to an earlier comment that you made, which to paraphrase, I think what you were saying is that price should follow profit share per growth, give or take, right?
Lau: Yes.
Ptak: And I think that speaks to the basic arithmetic of stocks’ real returns. We probably break it up into earnings per share growth, dividend yield and growth, and then multiple expansion. So, reflecting on your answer to the previous question about how things have maybe evolved in the Chinese market, but there are still some things that are constant, do you think investors can still feel confident in this basic arithmetic that it continues to hold in China amid some of the government interventions that we’ve seen? And also, in view of the fact that the reporting that we see coming out of China may be boasts the same sort of robustness and veracity as it would in other parts of the world. What’s your take on whether that basic arithmetic still holds?
Lau: Yes. I think the arithmetic that you just mentioned would always hold. So, mathematically speaking, your capital return will either come from earnings-per-share growth or dividend and the growth of dividends as well as the P/E or the rating of the market. So, it is always true. And with that equation, there’s also an equation of your return on capital employed, meaning that unless your return on capital is healthy enough, you cannot sustain growth and dividend payout at the same time. And this is how we do our investment process. We want to find companies with high return on capital employed, high return on equity. In fact, a lot of the companies that you would hear us talking about are those companies with high return on capital employed, whether it was in the Tencent or Anta Sports, and so on. They tend to have high return. So, we like that. And the reason for that is we believe this equation is still true.
And the rerating we are probably less focused on, because one of the things about this rerating and derating is quite cyclical. So, unless you believe a company can derate or rerate forever, we tend to do the reverse. Actually, by the time they got derated a lot, you should actually feel more excited about it, and so on. And I guess this is the reason why we’ve been wrong, since the last time we spoke is, we underestimated the derating. But we don’t think derating or rerating is as important as earnings growth and dividend income and growth.
I think if you look at China’s stock market or the economy, it’s not a very sophisticated stock market economy. The first China stock was listed in Hong Kong in 1992. So, it’s been like 30 years. And then for a large part of these 30 years, China was actually high growth. Only we are talking about the last maybe five, 10 years that we are starting to see lower growth. So, indeed, one of the frustrations, or in a positive way, one of the engagements that we have been with the companies that we invest into is to basically give them some comments and feedback. One feedback that we’ve been trying to give to management is that it is OK to be lower growth. So, when lower growth happens, you focus on cost management. When lower growth happens, you return more cash to shareholders. When lower growth happens, you basically focus on your return capital or try to think about capital allocation rather than just thinking about building another factory, expand in another country, and so on.
That is happening. I mentioned a lot of companies you’re really talking about, first-generation entrepreneurs—there are good and bad things about first-generation entrepreneurs. They’re probably at the margin still focused a lot about growth. In fact, if you think about why people have been concerned about China—this is beyond regulation—is that competition in China is actually quite severe. You have Tencent, you have Alibaba, and before you know it, there’s another TikTok, and before you know it, there’s another one, the Shein and all these companies. You can say it’s good because companies are reasonably aggressive and competitive, but on the other hand, it seems companies are still pretty much looking forward to competing aggressively with each other in order to generate growth.
So, you’re right. I think the mindset in terms of capital allocation and dividends is developing, is still not there yet. But we are seeing a lot of changes. For example, recently a lot of our companies have been announcing interim results, first-half results. As a general rule of thumb, if you look at all the companies which have reported, by and large, quite a number of companies have actually increased their dividend payout. So, they acknowledge growth is not going to be as high as before. They also acknowledge stock prices have come off. Share prices are cheaper than before. So, there have been more buybacks and there have been more dividends being returned to shareholders. So, I think this is happening. I don’t think the equation is broken. And yeah, I think this is an evolving process.
Benz: When we spoke to you last time, you said, and I’m quoting, “China has never been as great as you think, and China is probably not as bad as you think also,” meaning that China is misunderstood at times by foreign investors, and yet their alarm can confer good future returns. How does that apply to the present situation?
Lau: I think that comment is still pretty much true. I’ve been looking at China for 30 years. And I think that pattern is still pretty much true. I think once every five years, there will be a reason why people are super-bullish about China. And once every five years, there’s a reason why people are super-bearish about China. And that has been the case for the last 10, 20 years at least. For now, I think we are more to the negative side. And the reason for that is property, economy, regulation, government, and many of the things that we discussed about.
I’ve been following Goldman Sachs CIO survey. I participated in it because I wanted to get the results. About four or five years ago, there was this question about what’s your favorite market and what’s your favorite stock, and what’s your least favorite market and what’s your least favorite stock. For three, four years ago, and for the three, four years before, three, four years ago, basically China was the most favorite market. And then what’s your most favorite sector? China tech. And what’s your most favorite stock? Alibaba and Meituan, and all those. Last year, the favorite market—this is a survey in Asia—the most favorite market is actually Southeast Asia. And what’s your least favorite market? China. What’s your least favorite stock? China tech. I think that tells you the cyclicality of the sentiment. Has Tencent really changed that much since four or five years ago? I would argue that it hasn’t really changed. The management is the same, the business is the same, earnings are higher. It’s mainly the sentiment has changed.
I think the opportunity and the risk—and maybe you asked, can this go on further? We basically have no idea. But then the basic principle and the lesson learned for us for many years is try to shy away from macro as much as possible because China is a little bit of a black box because of information and many reasons. The more you get closer to the macro numbers, the more you would get confused and maybe you will probably become positive and negative at the wrong time. We want to focus on the earnings and management and that’s what we do.
The other thing—and I think you can actually debate on this one, and you might quote this actually next time I’m invited for this podcast again. I do have a strong feeling—there are two feelings. One is the best time to buy into a stock market or market is when the economy is bad. So, the best time to buy the U.S. was when the U.S. economy was on its knees. And the same with U.K. By the way, Japan—people think Japan is now great, but Japan economy has been very bad. So, that’s the first point. The second point, which I’m increasingly of the view is a poor economy is not necessarily bad for a company. It, of course, depends on what business you are in. But when the economy is sluggish or weak, it makes the management to think of changes. And I think a company with good management, strong management, it forces you to think differently, to differentiate from your competitors and think about return a bit more, and so on.
So, I think, in a way, the fact that China is not doing as well could be a blessing in disguise. And I’m going to tell you another one final example before the next question. If you think about, let’s say, property. Right now, if you look at Chinese developers, I think, let’s say, 40% of the developers have already defaulted on their bond, so it’s really bad. But if you believe in capital return, capital cycle, and so on, in a way, if you manage to survive, if you are a property company in China, if you manage to survive this downturn, imagine the lack of capacity or lack of competition in three to four years’ time. I think that could be a blessing in disguise. So, usually, a tough economy would take out capacity from different industries. And again, I do think the best time to buy a market is when the economy is tough.
Ptak: I think you’ve stated previously you don’t expect recent problems in the Chinese property sector, which you’ve mentioned a few times during this conversation. You don’t expect that to spill over into Chinese banks in the same way the real estate sector caused a contagion during the global financial crisis. Why is that?
Lau: Yeah. So, I think there are a few differences between China and let’s say, the U.S. And these differences could be good and could be bad. I’m going to talk about the good things and I’m going to talk about the bad things. In China, the government has a strong control on many things, or most things. They’ve introduced so many measures on property so that the property market started to turn down. And of course, recently, they’ve been trying to reverse some of the policies. In China, all the banks are owned by the government. Foreign banks or foreign capital is a tiny percentage of the Chinese economy. So, in a way, if the bank continued to lend, let’s say to Evergrande, it would not have the issues. So, I think there’s a certain degree of control which you can have on the economies. So, that’s why we say the contagion is unlikely to do the same.
If you look at the U.S. and the more developed world, the reason why there could be a banking crisis is when there’s a problem and the bank pulled the plug on, let’s say, WorldCom. And whether WorldCom is seriously a problem or not, it would go bust. And the same with Silicon Valley Bank. By the time people lose confidence on that bank, mathematically speaking, it would have issues. Whereas in China, all the banks are basically owned by the government. This is the reason why we don’t think you have get-out-of-control contagion to every bank and things like that. The negative part of this—and you mentioned about the lower return from China over the last, say, 10, 15 years—is the lack of market mechanism. So, imagine if you are a zombie company. Many newspapers have written about the zombie companies and the ghost towns in China in the past. Basically, the bank may not pull the plug as they should, and therefore from a supply perspective, basically a lot of the excess or useless capacities would not be taken out from the system immediately and therefore resulting in lower returns for investors. But I do think because of that control on the banks and also China as a whole—and this is a bit similar to Japan. And you might argue China may ultimately become more like Japan. The same. Japan has kind of dragged on and on, but Japan is not very dependent on foreign debt. So, it would just stay like this for a bit longer.
Benz: You also wrote that you think some of the tumult in the Chinese property sector is by design, reflecting the government’s desire to create defaults and in the process, combat moral hazard. But with the Chinese government controlling the banks that have made these bad loans, is it realistic to think that this will lead to more disciplined lending and borrowing?
Lau: Yes, that’s an interesting question. If you look at the human history, whether it’s China or U.S., there are moral hazards for companies and people take risk and people take risk at the wrong time. So, I’m sure, even if, let’s say, the Chinese government, they try to avoid moral hazard by not bailing out Evergrande, but you’re almost guaranteed there will be another company doing some stupid things in maybe 10 years down the road, because I think it’s human nature for being greedy or maybe taking excessive risks at the wrong time, and so on.
I think the Chinese government—and this is one of the reasons why the market has been disappointed and why this market sentiment has been more negative recently—is that I think there was an expectation that the Chinese government may bail out either the economy or certain developers in China, because if you want a better economy, you really don’t want developers to default. I cannot think about a situation whereby a U.S., let’s say, developer defaults and then the economy would be booming. This simply doesn’t happen. So, the fact that the government has not introduced more aggressive policy response and the fact that Chinese government has allowed, the recent one being Country Garden, to default—the market is concerned when that happens, which means the economy is not going to be very strong and therefore there’s a good reason why you’re concerned.
So, I think the government, it seems that even though they clearly don’t want the property market to spiral down significantly, they’re still quite determined to let these companies—and by the way, if you look at the background of all these property companies in China, the reason why they are having problems now is that they are taking huge, huge risks by leveraging and we never invested in any of these developers, by the way. But if you look at five years ago, if you look at the balance sheet, you think they are really, really brave. And this goes back to the first-generation entrepreneurs that I’m talking about. If you look at the histories, backgrounds of these property entrepreneurs, they started off being farmers and they took a lot of risk and became super rich. So, I think the in a way it’s good, but it is bad for the economy.
Ptak: I think I might know the answer to this question I’m about to ask you, but I was curious whether you think the Chinese market is maybe less hospitable to quality investing, given that higher-quality firms boast more defensible businesses, they tend to earn higher economic profits, possess pricing power and all in ways that might draw attention and invite government intervention. Or do you think that’s too simplistic a way to think about quality investing in China?
Lau: I think it is probably a little bit too simplistic. I think to put it the other way around, I don’t think China is about buying unsustainable profitability and companies with low pricing power or no pricing power and bad management, and so on. I think the key is probably sustainable. We like to look at companies in a slightly different way compared with the market. We always like to look at, let’s say, tax rate and margins and basically questioning why a company is profitable and not paying tax. We also like to look at the average salaries. So, when margin is high, you want to look at, oh, by the way, how much of the profit actually goes to employees? Are they good to employees? We also want to look at margin and see whether it’s too high.
I think the concern would be if you buy into a company—and this is your question about the government regulation. If you’re making a lot of profit, I think it does arouse the attention from the government. I think it’s not a Chinese phenomenon. It’s a global phenomenon. That’s one. But then I think what you’ll be concerned about is that profit is not sustainable. If the profit is on the back of not paying tax or not paying the employees properly or being bad to the environment, these are really bad. If the high profit is due to overdominance or monopoly of a certain industry, which I guess is one of the reasons why the concern on China internet and things like that happened, then it is a concern. But then, if the profitability is based upon a strong brand, if the profitability is based upon your ability, especially if that ability is based on some kind of building up certain products, which people want or building up some products which you can sell overseas, let’s say, BYD, or let’s say, Huawei, or we invest into a company called Shenzhen Mindray, which does medical equipment. If you make good profit by innovating, by exporting those better products to overseas to earn more foreign exchange or by helping to replace imports, which the government actually wants to see, I cannot see why it’s against the government’s will. So, it’s really about how you make those profits and whether it’s sustainable.
I think whenever profit become too high, one should be concerned because, one, you have the regulation, second is because of competition. If it is because of a brand—your point about pricing power is interesting because for many years Apple has been very successful with the largest company in the world, and so on. Apple has a phenomenal pricing power and the brand, and so on. We don’t have Apple in China. But then, if there’s a company which managed to establish a brand, let’s say, we are shareholders of Anta Sports. If Anta Sports, it’s making more profit because they’re coming up with a better product, people prefer to buy Anta rather than Nike and Adidas, I cannot see the reason why it may not be sustainable or why the government would come to you and say you should sell a cheaper pair of shoes or something. So, I think it really depends on the origin of that better profitability.
Benz: Are there other industries that you believe have grown too large too fast, like the Chinese tech platforms did and are therefore at greater risk of being reined in by the Chinese government?
Lau: Yes. If you think about what the Chinese government wants to achieve when they say common prosperity, the first one they did was on education. And I’m a parent of three kids, so I know how expensive education is. Basically, they want to reduce the burden on normal people, and they also believe it’s becoming more divisive. Those people who are wealthy can afford to put hours over hours of after-school tutoring onto the kids vis-à-vis those who are less well off. So, I think the government wants to reduce the burden. I think all governments want to reduce the burden on people.
So, if you follow the logic, it’s education, it is property. People in China complain about the expensive properties for many, many years. And then, they also try to focus on the drugs. They want cheaper drugs. I guess the U.S. government also wants cheaper drugs but hasn’t been as successful as the Chinese government. So, if you look at how much drug prices have fallen in the last, say, four to five years, I think easily you talk about 50%. So, basically, they really try to slash on the prices and say, by the way, you’re making too much profit, and so on. So, anything to do with the social side of things, necessity things, I think it is naturally more vulnerable. And of course, also utilities. If you are supplying necessity—power, gas, and so on—you’re probably more exposed to regulation or some kind of policies.
If you move to the industrial side of things, you tend to be less vulnerable. You’re actually alongside with the government. And the reason for that is, China keeps talking about whether it’s industrialized utilization 2.0 or 3.0 or 4.0. They really want China to move up the industrial development curve so that they can fend off politics and sanctions from the U.S., and so on. You’ll be more aligned with the government. If you’re more to the consumer side of things, there’s a likelihood that, if it’s too much of a necessity thing, then yes, you’re right, there could be more regulation.
The silver lining I would put to that is … So, we are invested into some medical-related companies, which have been subject to some kind of regulation or price cuts, and so on. If you look at China, one of the opportunities, but then you can also say it’s a risk, is that industries tend to be very fragmented. The largest drug company in China has got a market share of roughly 2%. There are like thousands of drug companies in China, medical equipment companies in China, and so on. So, we also believe as the industry is getting tougher, when you are not allowed to charge a supernormal kind of price or profit onto the patients or consumers, it will lead to industry consolidation. And this is what we believe. But yes, I think it depends on which industry you’re talking about. I think there is a regulation risk. I think it is a fact that China is still reasonably controlled by one government.
Ptak: Wanted to ask you a question about management. The last time we interviewed you, we asked you for an example of a stock whose management team you admired, but we didn’t own more of it because it wasn’t as cheap as you like. And you mentioned Anta Sports products, which is a name that you’ve mentioned a couple of times during the course of this conversation. It sold off a bit in the time since we spoke to you. Can you update us on your thinking about that business and the stock’s attractiveness in light of its recent performance?
Lau: Thanks, Jeff. You have a good memory. I think we still like Anta Sports. I think if we said it wasn’t cheap enough two years ago, it’s now our top 10 holdings. If you look at our China funds and greater China funds, you actually see Anta Sports. We actually just recently met with the chairman after the results. I will talk about the changes since two years ago and the reasons why we have become, let’s say, more positive or more negative on the company.
I think since two years ago, the economy has become tougher. There was a period when it was even tougher during COVID control, but I think, generally speaking, the economic growth has not been overly exciting, especially for this year. So, I think we have seen that. The reason why we like Anta is that we usually like companies which constantly think about ways to improve the business and not waiting for the economic growth to happen. If you look at what Anta has done over the last two or three years, first of all, they have something what they call the DTC initiative, direct-to-consumer initiative. They basically turn the stores from franchisee model to direct managed. So, as of today, basically all the stores in China are managed by themselves. Why they are doing that is because they want to control it better. They want to control inventory. They want to control the consumer experience. They also want to get better feedback from consumers because if your shops are run by a franchisee, you have another layer of another company and you’re never as close to your consumers as possible. So, we like that.
Another thing which we like about Anta is the ability to build brands. Anta is the original brand. If you look at the recent results and why share prices have gone up after results is, there is another brand called Fila, which they previously turned around and made a lot of profit. Then during COVID, they actually suffered, and in recent results, they actually showed a turnaround. So, if you look at Fila, for good and for bad, it’s actually 40%-50% of the profit. This number was zero five, 10 years ago. So, they managed to grow Fila into a profitable brand. By the way, I think apart from China, you can hardly find it in another country. I think Fila is actually quite a bad brand in the U.S., with all due respect. So, somehow, they managed to turn a brand, which nobody likes, into a popular brand in China, so I think to their credibility.
They also acquired a company called Amer Sports, which owns the brands like Salomon, the likes of Wilson. I’m going to pronounce this wrong. There’s a skiing brand called Arc’teryx. I don’t think it’s English, but I’m going to pronounce it in English: Arc’teryx. If you look at the growth of these brands since they were acquired, they’ve actually done pretty well. I think if you think about globally, there hasn’t really been—and you can debate on that one—there hasn’t really been one sportswear company which managed to become a multibrand company. Nike hasn’t been successful. Reebok and Adidas and Lululemon and Under Armour. They are one brand—Uniqlo—they tend to be one brand company. But this company has impressed us as their ability to grow different brands. So, in a way, their ability is more like a retailer to some extent. As I say, the DTC, knowing what the consumers want and trying to build an existing brand into something which the consumers would buy more of the products rather than creating brands. So, I think that part also impresses.
And of course, the stock has been derated because of the overall macro economy. If you compare to two years ago, when we last spoke, it was probably on 30 times P/E, and the profit has actually grown over the last two years by roughly, I would say, maybe 20% or 25%, 30% over two years. And the stock price is lower. So, as of today, it’s about 16, 17 times, depends on whether you look at this year or next year. So, we think it is more attractive. And as I say, we don’t control the GDP growth in China. We don’t control the sentiment. We only know companies. We hope companies’ value will go up with earnings. And in this case, the share price has actually fallen despite higher profit, which means it’s been derated. And I think when you see this and you still believe in the management, you own more of this company as compared with before. And this is what we’ve done.
Benz: You were just speaking about what consumers want. And you believe that there’s a long-term trend toward consumer upgrading, and that remains intact in China despite falling consumer confidence. What do you mean by upgrading? And what gives you confidence that that trend will endure even though consumer sentiment is fairly poor?
Lau: Yes, that’s an interesting question, Christine. First of all, I think there’s a perspective of time horizon, meaning whether we talk about this year or whether you’re talking about 10 years from now. There’s also an element of structural versus cyclical. So, I think as of today, the economy is weak. As of today, the unemployment—and the Chinese government, by the way, has stopped announcing this number because it’s been so bad—is high. And therefore, when that happens, do you upgrade or not? You don’t. In fact, some consumers have actually downtraded. And this is, I think, also a phenomenon in the U.S. and U.K. when inflation is high. If you’re lower-income people, basically your spending power would be squeezed, so you don’t upgrade when that happens. So, I think there’s clearly some economic headwind.
Let’s say if you look at Anta Sports that we talked about. Last year, they increased the price by about 10% by introducing better products or something along the line. This year, they are not doing it. You’ll be quite lucky if they haven’t done more discounting. So, this is not going to happen. So, this is short term, and this is cyclical. In the long run, we still believe there will be upgrading demand, uptrend demand. First of all, it depends on your view on income. So, if your view on income in 10 years’ time is going to be Japan—we talked about Japan. If you think China is going to be like Japan, that probably would not happen or would not happen as significantly. If you look at Japan over the last 10, 20 years, the 100-yen shop has done very, very well because people just do not want to spend more.
But then, if your scenario is that the income would continue to grow—and of course, you may debate on this comment. The income in China is still not that high, but you may also argue the fact that it’s not high doesn’t mean that it needs to grow. So, a lot depends on the innovation, the economic development, and whether China can industrialize, and so on, providing income growth. If your scenario is that income would continue to grow—and this is what we believe, not this year, but over the next five to 10 years—consumers would aspire to be different. And also, when your income level is lower, you just aspire to live a different lifestyle than before. If you look at travel, travel demand has been very resilient in China. And the reason for that is people want to find out about the rest of the world when they can afford to do it, and likewise, people want to enjoy themselves when they can afford to do it. Branding, the same thing; quality healthcare, you feel more wealthy, you want to focus more on your health. Education, to some extent. When you have high income, you want to provide better education for your children. So, I think those trends, in my view, will still be valid if income growth continues to happen. But of course, if some of our clients or audience do take the view that income is not going to grow in China like Japan for the last 10, 20 years, such operating demand would not be there or would not be as significant.
Ptak: Last question we have for you is on ESG. Your team recently wrote that it considers ESG, I’m quoting, “synonymous with quality.” As you know, ESG has become highly controversial here and elsewhere with some criticizing it as a thinly veiled form of political activism. What do you think those critics perhaps get wrong? And by the same token, what can be done to build confidence in and acceptance of ESG recognizing that the concept is still a work in progress at this point?
Lau: Yes, that’s an interesting question. So, at FSSA, we do believe ESG equals quality. And the reason for that is to your point about sustainability of profit or how the government might come to you and haunt you is, unless you hold a positive or the constructive attitude toward the environment, toward the society, and of course as shareholders, unless I’m convinced that the company is actually focused on return of value for shareholders, why should it be a sustainable profit and why should it be a good quality company? We also believe that mindset, the more long-term you are, the more important it is. And it is really related to people. So, if a company doesn’t pay tax, I would argue that they would probably do something bad on their shareholders at some point. If they can do a shortcut on the employees, I would doubt whether they are actually genuinely good for shareholders in the long run. And the same thing, if they pollute the river outside the factory, I would doubt whether they’re genuinely returning value to shareholders over the long run. So, I think the longer term you are, the more important are the people side of things.
Numbers can only tell you your forecast are always wrong anyway. The people are important. So, often when we engage companies on ESG, it actually tells us more about what kind of people they are. All the presentations are excellent. And usually, they put up ESG reports and they’re all green in color. But only if we engage would they tell you what kind of person they are and that’s very important for long-term investments.
For China, it’s probably a bit different compared with the West because the West started off from a high base and you have all these—2030, 2035 and gender diversity and zero carbon, and so on. It probably went a little bit over, as in greenwashing and everything. China, you need to remember China is a much less-sophisticated economy and stock market. Many companies, even today, they still haven’t got a ESG report. Even today, they still haven’t got a zero-carbon target. Even today, if you ask them the question about gender diversity, they would look at you in the eyes and say, which planet are you from? So, I think it’s a process, and we do think it’s not as good as the Western world, but it is an evolving process and it’s also a function of your sophistication. And this is aside from the investment return. Of course, we would love to see very good return from our funds and for our clients, and so on. As a team, we also believe this is what we should do. It’s beyond—this might sound a little bit arrogant—but we do think it is important to do the right things for the society, and it tells you about the people, what type of people these companies are. So, ESG is indeed the most important. I would say this is much, much more important than your earnings growth because it’s going to be wrong anyway, the forecast.
Ptak: Well, Martin, this has been a very illuminating conversation. Thanks so much for returning to The Long View to share your insights.
Lau: Thank you, Jeff and Christine, for your time also.
Benz: Thanks so much, Martin.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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