China’s Property Market Shows Sooner Than Expected Recovery

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With Hang Seng Mainland Properties Index down -8.04%1, the valuation of China’s real estate sector was extremely compressed in 2018, as most market participants worried about a continued decline in China’s real estate market. China saw a spike in the number of failed land auctions in the third quarter of 2018 as developers have turned cautious on the growth outlook of housing market against the backdrop of a tougher fundraising environment and tightening property policy. September and October are usually believed to be the high season for new home sales, but from January to October last year, nation-wide property transaction growth, measured by floor area, slowed to 2.2%2 vs. 8.2%3 in the same period of 2017.

Since last December, we’ve accumulated long positions in some select leading developers with low debt ratios and sound fundamentals as we expected to see a valuation recovery for them. When we invested in these companies, their valuations were extremely cheap, while some other investors seemed too pessimistic about the property market and the developers’ earnings. The Enterprise Valuation of some name that got hit the hardest was even up to 80% discount to its land cost4. We thought  the downside risk in China’s housing market would be well contained. Real estate contributed 9.4% to China’s GDP in 2017 and we didn’t think the government would like real estate to go down the drain5. At the end of 2018, although crackdowns on speculation continued, we saw some loosening policies starting to take place. Beijing was likely to give local governments more flexibility to fine-tune property polices depending on the market demand. Heze, a city in Shandong province, cancelled the three-year reselling ban imposed in 2017 and allowed developers to use more of the capital from pre-completion sales. Guangzhou, one of China’s largest cities, followed Heze to ease curbs on apartment sales, aiming to improve the liquidity of properties.

In 1Q19, Real Estate sector contributed substantially to our fund performance. High-frequency data show signs of property market acceleration. March property transaction picked up in larger cities. From March 1 to 29, 30-medium/large-cities property transaction growth accelerated to 24.1% YoY vs. -4.7% YoY in Jan-Feb6. We think the following three main factors drove the real estate market.

First, the housing policy was moderately eased, as no curbing measures were introduced at the National People’s Congress annual session in March. Also, local governments now enjoy a high level of discretion to adjust their property policies, including restrictions on home purchasing, resale and pricing.

Second, overall financing conditions for property developers have improved after the government’s continuous liquidity boost. The financing costs for real estate companies have declined, on the back of the market’s greater risk appetite which in turn is a function of the more dovish FED and ECB stances. As such, developers have been able to secure financing from various channels, e.g. offshore USD bonds, onshore RMB bonds and real estate development loans, which effectively alleviated the market’s fear that developers might turn aggressive in selling their inventory on tight cash flow and financing.

Third, the transaction data shows the property sales in 1Q19 was slightly better than expected and most of the company results indicate that 2018 earnings remained resilient, which restored market confidence.  After all, the low inventory level of residential real estates in most cities in China should have boded well for a sooner than expected recovery.

2019 earnings per share (EPS) estimates for state-owned and private enterprises combined are likely to reach 8%-10%, with real estate sector contributing to nearly 25% of the growth7. We still favor quality real estate names with high visibility and we expect these industry leaders to continue gaining more market share in the coming years.

[1] Source: Bloomberg, as of Dec 2018

[2] Source: National Bureau of Statistics, as of Jan 2019

[3] Source: National Bureau of Statistics, as of Jan 2018

[4] Source: iMoney, as of April 2019

[5] Source: Citi Research, as of April 2019; NBS, Citi Research estimates, REI Driving factor= 1.5-1.7X

[6] Source: CICC Research, as of April 2019

[7] Source: Goldman Sachs, as of Jan 2019; Factset, Goldman Sachs Global Investment Research

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry discussed. Any reference or inference to a specific industry listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry. Please be advised that any estimates of future performance of any industry discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in the industry described herein.

Why are Beer Sales Falling in China?

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As the largest consumer of beer in the world, China consumed double the amount of beer than the United States (18 billion liters) in 20151. However, the market for domestic mass-production beer is trending towards saturation, as beer consumption has shown a continued decline since 20141.

The decline in beer sales is largely attributed to the decrease in the size of the main customer group. The blue collars used to be the main contributor of beer sales for a considerably long time. China’s rate of growth in fixed asset investment2 and value-added of the construction industry3 has been declining since 2015. In addition, with many low end manufacturing jobs moving from Pearl River Delta and Yangtze River Delta regions to Southeast Asia where production costs are lower, brands in categories that traditionally cater to blue-collar workers, such as instant noodle and beer, have been suffering from consumer demand falling off4. Nevertheless, Chinese Baijiu market has shown a strong growth momentum amidst a waning beer market. Enterprises above designated size (i.e. enterprises with an annual revenue of RMB20m and above) in the baijiu market have recorded sales revenue of RMB 565 billion in 2017, a 14.4% YoY increase, with profits soaring by 35.8% to RMB 102 billion5.

Mid to high-end Baijiu saw strong sales growth in the past two years, mainly driven by domestic consumption upgrade. The supply side reform started from 2015 pushed the price of cyclical goods upward and hence supported the recovery of cyclical industries. With these companies’ abilities to pay off debt improving, banks are reducing bad debts, which leads to a virtuous reflation cycle. While China’s manufacturing sector has been upgrading , consumer market has been undergoing an overall consumption upgrade at the same time. As there’s a close correlation between Baijiu consumption and economic prosperity, China’s economic growth are boosting high-end baijiu consumption.

From the second half of 2012 to 2015, Chinese Baijiu industry has undergone an adjustment period which lasted for around three-and-a-half years. Besides constraints from the macroeconomic environment, the central government’s crackdown on “three public consumptions” also played a role in Baijiu sales slump. Government consumption currently accounts for only 5% of the total Baijiu market, compared to 40% in 20126. Though government spending on Baijiu consumption declines significantly, personal consumption growth has driven the Baijiu industry’s recovery since 2016 as per capita disposable income keeps increasing.

Against the backdrop of consumption upgrades, we continue to remain bullish on premium Baijiu market. First, Baijiu has a high irreplaceability. It plays a pivotal role in China’s social culture and can only be replaced by few alternatives such as red/white wine. Second, premium Baijiu brands have high customer loyalty and rising Chinese cultural confidence will also contribute to promoting Baijiu consumption. Third, with a lot of weaker Baijiu brands and those with poor distribution going out of business, premium brands are faced with less competition. Fourth, tight supply due to capacity constraints drives average selling prices up, which will help improve profit margins.

In 2017, per capita disposable income in China rose 9% YoY to RMB 25,9747, compared to RMB 18,311 in 20138, with a cumulative growth of 41.8%. Despite the gains, China’s per capita disposable income only accounted for around 10% of the US’ ($39,155, about 255,000 yuan)9. We expect that there is still much room for growth in disposable income. Continuing consumption upgrade will further drive demands for high-end consumer goods, benefiting Baijiu market.

Akin to Baijiu industry, Macau gaming revenue used to rely on VIP segment and government consumption was a main source, but now mainland tourists are becoming the main consumer group and per capita gaming spending has also increased with an increase in their disposable income. We have noticed that casinos have raised the minimum bets in some mass-market tables, catering to tourists from mainland. The development of the Premium Mass Market may become the driving force for growth in gaming going forward.

[1] Source: Research and Markets, as of March 2017
[2] Source: National Bureau of Statistics of the People’s Republic of China, as of Jan 2018
[3] Source: National Bureau of Statistics of the People’s Republic of China, as of February 2018
[4] Source: Bain & Company, as of November 2016
[5] Source: China News, as of March 2018
[6] Source: chyxx.com, as of August 2017
[7] Source: National Bureau of Statistics of the People’s Republic of China, as of January 2018
[8] Source: China News, as of February 2014
[9] Source: Statista, as of July 2018

Disclaimer:

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

There can be no assurance that any estimates of future performance of any industry discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry discussed. Any reference or inference to a specific industry listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry. Please be advised that any estimates of future performance of any industry discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in the industry described herein.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.