Opinion - From ‘made in China’ to ‘created in China’

01-Dec-2017

By Amit Lodha

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Having spent some time in China recently, I have come away with an overriding view: China is well on its way to morphing from the factory of the world to the laboratory of the world.

Starting with the big picture, the macro seems fine and the government seems to have so far managed a soft landing. There is tightening in the property sector but, in my view, China is still the factory of the rest of the world, and when economic growth is fine in Europe and US there is little to worry about.

Overall, the government and central bank seem to be in control of the bad debt issues though debt de-leveraging, although demographic challenges remain on the horizon.

So in this context, what do investors need to consider when investing in China?

There seems little doubt the government is serious about new environmental regulations, with anecdotes circulating of steel executives being jailed for not closing blast furnaces and 110 million tonnes of capacity being shut down over the past two years. This has significant implications across the materials and petrochemicals sectors as lower Chinese capacity growth would suggest better supply-demand equilibrium.

There is also significant over-capacity in the Chinese automotive industry, but if the government achieves its goals China will, in the next three to five years, become the largest electric vehicle market in the world. There is significant innovation and development in the supply chain and there are some exciting opportunities for stock picking.

The ‘Made in China’ concept is well known when it comes to manufacturing, but the rapid improvement in local Chinese quality continues to impress. On previous visits, I could easily tell the difference between a locally produced Chinese car and a Western automobile. It is getting tougher. Most local Chinese brands have recruited Western designers.

The same is true across the manufacturing chain more broadly, although there remain pockets where Western companies still lead the way.

This extends to Chinese brands. The younger generation is less likely to buy a Western brand blindly like his or her parents do, and loyalty is only as good as the latest innovation.

Further, localisation and personalisation continue to increase in importance among Chinese consumers. This trend of the rise of domestic Chinese brands is something we need to focus on in all the consumption segments.

What has been achieved in the past few years in China in technology and innovation is simply breathtaking. I used Chinese apps during the course of the week, including the easy Didi service app for transport, seamless payments through Alipay, and watched the locals exchange details through WeChat QR codes rather than business cards.

Technology permeates every corner. However, making the valuations work for any of these technology companies is difficult and there is significant froth in the technology and fintech IPO market.

So what does all this mean for investing in China? Overcapacity, poor capital allocation and questionable corporate governance have made it difficult for quality-biased investors to invest in Chinese stocks beyond the internet names.

We have therefore tried to play Chinese growth through Western companies. At the margin, I think this is changing.

Environmental control and debt issues have reduced capacity additions across a range of sectors. They have also led to consolidation in industries, the pace of which is only accelerating.

State-owned enterprise reforms have led to a number of companies putting in place stock option plans, leading to some semblance of corporate governance coming through. Destruction of wealth through expensive international acquisitions due to anti-trust concerns is also becoming less likely.

So it does seem that the world’s factory is morphing into the world’s laboratory. This points to some interesting stock picking ideas – and that certainly piques my interest!

Amit Lodha is portfolio manager for the Fidelity Global Equities Fund

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