Local Knowledge in Hong Kong and Mainland China

Dilip Badlani in Hong Kong

When I left Hong Kong in August 1997 to come to the U.S. there was an air of uncertainty as the British had just handed Hong Kong over to China on July 1, 1997. Over the next two years, Hong Kong suffered like other Asian economies due to the Asian financial crisis. However, true to form, the people of Hong Kong successfully adapted the economy, and Hong Kong's unique position helped it to weather the global financial crisis. Today, Hong Kong is positioned as a service-based economy focused on growth in China.

Hong Kong has also become a key tourism destination for Mainland Chinese citizens, and it has built attractions such as Hong Kong Disneyland to cater to these tourists. In the first six months of 2010, Hong Kong received 16.9 million tourists, which was an increase of 23.1% over the same period in 2009. Mainland China continues to be the largest source of tourists, with 10.5 million visitors (+26.9%), accounting for 62.2% of all tourists who visit Hong Kong. It was also the first time a six-month period exceeded 10 million arrivals.¹

In Hong Kong, today, one is able to meet with the CEOs and CFOs of Chinese companies as a large number of them have their headquarters in Hong Kong. These companies typically prefer to use Hong Kong as their base of financial operations because of the high degree of transparency required and Hong Kong's well-established capital markets.

Its stock market is comprised of companies whose businesses are largely in Mainland China. For example, four of the top five weighted members of the Hong Kong stock exchange are Mainland Chinese companies.² Public companies in Mainland China are listed on the A share market on the Shanghai and Shenzhen stock exchanges; A shares are traded in Renminbi, the currency of Mainland China.

Some shares on the two Mainland Chinese stock exchanges, known as B shares, are traded in foreign currencies. In general, foreign individuals cannot directly invest in A shares due to government restrictions. Therefore, a large number of Chinese companies use the Hong Kong Stock exchange as a vehicle to list their shares and to communicate to the global investor base looking to invest in China.

In Hong Kong, we have been looking for companies that meet our value standards—those with high returns on invested capital and strong balance sheets. We have also been focusing on businesses that seem likely to benefit from the domestic consumption growth that should occur in China as many of its 1.3 billion people grow wealthier. While China's economy is still export-driven, there is an emerging middle class that is demanding goods for local consumption.

• China's GDP per capita has increased from $314 (U.S.) per person in 1990 to $3,774 (U.S.) in 2009.³
• China had the world's fastest growing group of millionaires in 2009, rising 31% from 2008 to encompass 477,000 people.⁴
• In terms of the number of automobiles produced, China overtook the U.S. as the world's largest automobile market in November 2009. In 2010, China produced 18 million cars, up from 5 million in 2004 and 1 million in 1992. The number of registered cars, buses, vans, and trucks on the road in China reached 62 million in 2009.⁵
• China's retail sales rose 18.4% year over year to $2.34 (U.S.) trillion in 2010.⁶
• The People's Daily reported in 2009 that China had already become the world's second largest luxury market behind Japan, despite being in the early stages of consumer and retail development. In 2009, the country contributed 27% to global luxury sales.
• Prada opened its first store on Mainland China in 1995. In 2010 Prada's turnover in China increased by 75%. Including Hong Kong, it is twice the size of the Prada's U.S. market, and that's with only 14 stores on the mainland. There are nine Prada stores in Hong Kong alone.⁷ (To see the queues of Mainland Chinese tourists outside the Louis Vuitton and Chanel stores in Tsim Sha Tsui, Kowloon is amazing.)
• On December 28, 2010, Beijing City announced that it will raise its minimum wage by 21% in 2011. The monthly minimum wage will increase to Rmb1,160 ($175 U.S.) and the hourly wage to Rmb6.7 ($1.01 U.S.).⁸

From an investment perspective, we are trying to identify local companies likely to benefit from this increase in wages, paying particularly close attention to companies that have created brands which are priced at significant discounts to Western names yet are similar in quality and have a local flavor that's attractive to the Chinese consumer. Many of these companies have been operating in China for a long time and have gone through the expense of putting in place a sales and distribution network across the country.

• A shoe and apparel manufacturer whose urban sporting clothing rivals those of its Western competitors has close to 7,000 locations in China. Its products are priced at a discount to foreign competitors in order to meet the burgeoning demand from China's working class.
• The largest apparel retailer in China has a network of 3,800 retail stores. The average ticket at its stores is $15 (U.S.), which allows Chinese workers to purchase Western-style clothing at lower prices.

On the negative side, inflation in China is definitely an issue, with the wealth gap increasing significantly and food prices rapidly rising. For example:

• China's broadly measured money supply has surged in the last two years, soaring 54%. As of December 2010 the overall inflation rate in China was 4.8% after reaching 5.1% in November. The food inflation rate dropped to 9.6% after hitting 11.7% in November 2010.⁹

When I am in Hong Kong, I read the South China Morning Post, which is the leading English language newspaper in Hong Kong. On my most recent trip, there were several front-page articles highlighting the inflation problems that people are facing. However, the government has implemented measures to help address this issue. China's central bank has raised the reserve requirements for lenders four times in slightly more than two months.

Additionally, there are concerns whether China will be able to sustain its high growth rate going forward. The proportion of China's urban population significantly increased over the last two decades. At the end of 2009, 47% of China's population was urbanized compared to 36% in 2001 and 26% in 1990. Due to China's one-child policy, the annual population growth rate is estimated at less than 1%.¹⁰ Therefore, due to the law of numbers, the growth rate of China's consumer market will not be as significant as it was over the past two decades.

However, our view is that the country's domestic consumer markets should still grow, as China continues to slowly rebalance to a more internally driven economy. The largest companies in the Chinese market have gone to great lengths to establish significant barriers to entry in the form of sales outlets, distribution networks and, most importantly, brand recognition, putting them in position to become the primary beneficiaries of this growth.

¹ http://www.tourism.gov.hk/english/statistics/statistics_perform.html
² China Mobile, China Construction Bank, CNOOC and Industrial & Commercial Bank of China
³ http://data.worldbank.org/data-catalog/world-development-indicators?cid=GPD_WDI
⁴ http://www.digitaljournal.com/article/293790
⁵ ChinaAutoWeb.com
⁶ Chinese National Bureau of Statistics (NBS)
⁷ http://www.theaustralian.com.au/news/executive-lifestyle/pradas-beijing-show-awakens-the-chinese-fashion-tiger/story-e6frg8k6-1225995008025
⁸ http://www.ft.com/cms/s/0/30f7f9e0-1277-11e0-b4c8-00144feabdc0.html
⁹ http://www.nytimes.com/2010/11/18/world/asia/18china.html
¹⁰ http://www.stats.gov.cn/english/