article 11-05-2014

Hong Kong: Looking at Commercial Rental Prices and Automotive Demand

Hong Kong is a very important market to Royce's international efforts, though its economy has seen a significant slowdown over the past several years. Royce International Micro-Cap Fund Portfolio Manager Dilip Badlani discusses why he returned after having recently visited earlier in the year and what he learned from his meetings with company management teams. 

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In late August, Portfolio Manager Dilip Badlani made his second trip this year to Hong Kong, where he spent nine days meeting with company management teams. Hong Kong is a very important market for our international micro-cap effort. It is among our larger markets in terms of opportunities, and we believe making several visits a year to the country is a very productive use of our time.

Additionally, engaging with people on the ground and reading the local press give us a flavor—a more intimate perception—of what's going on in the region we're visiting, which ultimately adds perspective to what we hear from management teams. Qualitative analysis plays a big role in informing our investment decisions, giving us an advantage in our evaluation process.

Having grown up in Hong Kong, can you talk about what you observed on the ground there, describe how the country has changed, and how those events translate into investment ideas?

What was most surprising to me was seeing the protest rallies that were happening in Central, Hong Kong.

There definitely is a growing frustration over the wealth gap in Hong Kong today, which is not dissimilar to the feeling in some other cities around the world. Asset prices and rents are too high compared to incomes; the median housing price-to-income ratio in Hong Kong in just the past four years has increased from 11.4x in 2010 to 14.9x in 2013.1

Also, according to Savills—one of the world's largest global real estate firms—Hong Kong is the most costly city to live in after London. Growing up in Hong Kong, generally speaking, it would have been rare to see such protests. Hopefully cooler heads prevail and the protests are just a passing event.

An adjustment does appear to be beginning, as for the first time in probably three or four years you're starting to see rental pressures beginning to abate.

Today you're seeing prime street-front property in Central being empty. Eventually I think those vacant sites will be rented, but for that to happen rents need to come down.

At the same time, it's important to try and understand the reasons behind Hong Kong's high commercial rental costs.

As travel restrictions have loosened over the last two decades, tourism in Hong Kong has picked up markedly. This is partly because the city has served as the first port of entry for a lot of mainland Chinese tourists.

Recently, however, we're starting to see a large number of Chinese tourists visiting other destinations, such as the U.S. or Europe, as their visa restrictions have loosened further. While mainland tourism is still doing well, a lot of tourists are coming from second or third tier cities where spending power is lower than those tourists coming from Beijing, Shanghai, or Guangzhou.

While this hurts demand for some of our Hong Kong-listed investments, it also benefits them from a rental cost perspective. In addition, a lot of the Hong Kong companies that we own have operations in China, where it appears to us that demand is starting to stabilize after the slowdown last year.

A lot of the Hong Kong companies that we own have operations in China, where it appears to us that demand is starting to stabilize after the slowdown last year. The growth rate may not be what it was in the past, but the country is still growing in the high single digits. Now that there is growth visibility—albeit slower growth—companies should be able to rationalize their store base and generate profitable growth.

The growth rate may not be what it was in the past, but the country is still growing in the high single digits. Now that there is growth visibility—albeit slower growth—companies should be able to rationalize their store base and generate profitable growth.

Can you give us some examples?

Le Saunda Holdings Limited is a shoe retailer headquartered in Hong Kong that focuses on mid- to high-end shoes for women. It is a name I've known for a very long time.

The founder of the company did the right thing two-and-a-half years ago by stepping away from running the business and allowing an independent president to run the company, which only helped Le Saunda to further improve its corporate governance.

Unlike a lot of other companies in Hong Kong that seemed surprised by the slowdown in China, Le Saunda chose to undertake a restructuring plan beforehand, helping it to preempt the country's economic breather. It started to close down stores and build up its online business. Because of that, Le Saunda was able to generate positive sales growth through this entire downturn.

The company is still trading at a discount to its growth rate, paying a healthy dividend, and putting up good numbers. It also makes a quality product, so Le Saunda's brand is not going to be diluted by lower-end products that lack brand recognition.

At the same time, Le Saunda's products are affordable and will not be impacted by the campaign in China against graft. Ultimately, as consumer spending in China grows, you'll see women buying more of Le Saunda's shoes. 

I.T Limited is a fashion-forward company that we have owned in Royce International Micro-Cap Fund's portfolio for more than two years. It's a leading multi-brand retailer based in Hong Kong. It teams up with retail companies from the U.S., Europe, and Japan that have small, niche brands but aren't able to open up their own stores in Hong Kong because start-up costs are too high. By teaming up with I.T, these brands are able to bring their products to Hong Kong.

At the same time, I.T also has a portfolio of its own brands. Owning a blended portfolio of low-, mid-, and high-end products gives the company a sizable advantage in a place like Hong Kong because it's able to negotiate lower rents with landlords; when the company enters a mall, it's able to take up a lot more square footage than if it were a single-brand store.

Additionally, the company has been growing and increasing its presence in China. Unlike a lot of retailers that are pulling back, I.T has retained its commitment to China, as that is where the growth will come from in the long run. Management entered China when it saw customers ordering its products online to take back to China, which helped the company understand and capitalize on mainland demand.

We think longer term I.T is well positioned. It has a great portfolio suite, and as demand for fashion goes, this will be a good way to play the space. We're also starting to see improved data points; I.T's comparable store sales are growing and margins are increasing, which is a good sign for the company. 

Are there other areas of China's economy that you believe will see an eventual turnaround?

Industrial production in China also looks like it is starting to tick back up. There still is an emerging middle class in China that wants to embrace the culture of a developed country, which includes buying automotive products, a home, etc., so that's a theme we would like to continue to play.

Originally a Taiwanese-headquartered company with operations in China, China Metal International Holdings has now been operating China for two decades. It supplies some key automotive suppliers, such as TRW, and is a very well-run business.

I've followed this company for a long time and have a history with the firm going back about seven years. The company's balance sheet is conservative, and it has a culture of paying out good dividends. Management has historically executed very well and has done what it said it was going to do.

There's a large amount of insider ownership, there are some strategic shareholders in the company, and there have also been share buybacks when the stock price has fallen. We like to see these kinds of actions from management teams.

We're excited about the opportunity because the stock is trading at a 10x earnings multiple. The company is not really followed by anybody on the sell side. We think automotive growth will continue in China and over time you'll see more interest in the stock as the market cap grows and profitability increases.

Important Disclosure Information

Dilip Badlani is a Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. He is the portfolio manager of Royce International Micro-Cap Fund (RMI) and serves as an assistant portfolio manager for Royce International Smaller-Companies Fund (RIS) and Royce Global Dividend Value Fund (RGD). The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce International Micro-Cap Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund may invest a significant portion of its assets in securities of companies headquartered in foreign countries, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

Percentage of Fund Holdings as of 9/30/14 (%)

  RMI RIS RGD
Le Saunda Holdings Limited 0.89 0.00 0.61
I.T Limited 1.49 0.97 0.00
China Metal International Holdings 1.19 0.00 0.00

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

1 http://ecyyiu.wordpress.com/2014/06/06/an-international-comparison-of-housing-price-to-income-ratio/

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