Tips for Choosing a Quality Company

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Although each investor may have a different definition of a quality company, research has shown that several quality factors have a greater impact on stock performance. These quality factors can mostly be found in a company’s annual report, such as return on invested capital, return on equity, debt to equity ratio, accounting quality, gross profitability, and EPS growth. In summary, companies with high barriers to entry (reflected in higher return on invested capital and return on equity) and the ability to generate cash flow (reflected in good accounting quality, lower debt to equity ratios, higher gross profitability and EPS growth) typically have better stock performance.

Of course, the above research is based on statistical correlations and is not a definite or unchanging rule. During times of quantitative easing by central banks, even poor-quality companies may have the best stock performance, as seen with the surge of meme stocks in 2021 and early 2022. Additionally, investors may be willing to tolerate negative cash flow for a relatively longer period of time when emerging technology companies are building their own competitive strengths in new industries, such as with Amazon.

Currently, global central banks are tightening liquidity, and investors exhibit lower tolerance for risk. As a result, companies that do not conform to the abovementioned quality factors may experience significant price pressure.

This was evident in the recent targeting of an Indian conglomerate by short-sellers in early February. Despite its highly diversified portfolio, which includes a range of businesses from airports and data centers to mining and national defense, the company’s primary focus is on traditional industries. Nevertheless, over the past five years, the company’s stock price has skyrocketed from just over 100 rupees to more than 4,000 rupees, making its founder one of the richest men in the world.

The short-sellers accuse the company of manipulating its stock price through complex structures. The veracity of these allegations is difficult to confirm, but we can try to analyze the company’s annual reports with the abovementioned quality factor framework to get more informed on the issue.

While profit inflation is common in annual reports, manipulating cash flows is more challenging. Therefore, we can start with looking into the company’s cash flows. Over the past two years, the company’s operating cash flow was only 54 billion rupees, far below its investment cash requirements of 250 billion rupees. Most of the required funds came from bank loans, resulting in the company’s borrowing amount soaring to over 400 billion rupees, approximately 1.5 times its capital, which is relatively high. However, the company’s shareholder return rate is only 2.9%, which is exceptionally low, and the annual return rate is insufficient to support the company’s rapid expansion.

From a valuation perspective, the company’s stock price has skyrocketed over the past five years. Unless there are significant changes in its business, it is generally difficult to support such rapid growth in stock prices. Despite a decline of more than 50% in its stock since the beginning of January, the company’s price-to-earnings ratio (based on its earnings in 2022) remained over 200 times by mid-February, far higher than other traditional industry companies. At the same time, the company’s price-to-book ratio was 9.3 times, while the Hang Seng Index’s price-to-book ratio was only 1.2 times by then.

We primarily invest in Chinese stocks and are not experts on India. Our research on Indian companies is limited to analyzing their annual reports. Relying solely on annual report data has its drawbacks, as other competitive advantages of the company may not necessarily be reflected in the numbers over one or two years, such as their execution capabilities and political-business relationships. However, analyzing these quality factors along with the current performance should also provide insights for investment.

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, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class 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 any industry, asset or asset class described herein.

Two Reasons China Outperformed the Global Market in COVID-19 Recession

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When a pneumonia of unknown cause was first detected in central China’s city of Wuhan in November 2019, no one expected that this virus, later named COVID-19, would become a global pandemic that infected as much as four million people and caused over 300,000 deaths in half a year[1]. The deadly coronavirus not only posed a big threat to the world public health system, but also grinded entire economies to a virtual standstill. To prevent the spread of human-to-human infections, world leaders locked down counties and cities, closed the factories and restaurants, and issued travel bans and social distancing policies, which in turn, brought the global economy to a recession.

As the initial epicenter of COVID-19, China paid a heavy price for the strict containment measures, suggested by the GDP readings of -6.8% YoY contractions in Q1, a historical low since the figure started publishing in 1992[2]. Fortunately, with the initial success in containing the virus, China is now getting back on its feet while much of the rest of the world is struggling with soaring death tolls and floundering economies.

We see signs indicating that China is the first major economy to emerge from the disruption. Though challenges remain as the strong interconnection between China and the shrinking world economy makes it impossible to stand alone, we believe two drivers, namely China’s lead in virus containment and substantial, targeted, but more measured supportive policies, are propping up an umbrella for China under the global economic downpour, while the US economy probably would not fully recover until Q4, 2021[3].

First In, First Out

Compared with the financial crisis in 2008, which started as a subprime mortgage crisis and eventually erupted into an all-out financial crisis, the coronavirus shock is more severe as the containment measures directly hit the real economy, including the global supply chain, oil consumption, company earnings, education systems, and people’s everyday life. Thus, the magnitude of the recession is not decided by the financial system but largely linked to the evolution of the virus and how long the containment measures need to be kept in place.

China has earned itself a high mark in the anti-coronavirus recession battle initially through virus containment. To curb the spread of the disease, China instituted unprecedented nationwide restrictions in late January and has only been eased in early March after President Xi Jinping visited Wuhan. 

For many other countries, in terms of containment policies, instead of employing China’s strict lockdown measures, softer social distancing measures were put in place. Admittedly, China’s strict measures pushed the economy to a halt in February, which is more punitive to near-term growth. However, it made China ahead of the world in getting out of the woods.

Substantial, Targeted, but Measured Policies                      

The frozen economy under the coronavirus prompted ever-increasing monetary policies and fiscal supports in major economies. The US took a lead to announce an interest rate cut, followed by unlimited, open-ended quantitative easing (QE), including the purchase of corporate and municipal bonds and a stimulus package with a $2.3 trillion price tag mainly to support the economy[4]. 

Although the generous supportive measures seem to bring some hopes of preventing an economic catastrophe, the trillions of dollars rescue package would push up budget deficits which is expected to widen to a historically high level. The rescue package approved by the US government so far is likely to increase the country’s fiscal deficit to 18% of GDP, the largest level since 1940s and could widen further to 24% of GDP if there is an additional $1.25 trillion stimulus[5]. While spending increase and tax cuts would further lead to a weaker government balance sheet, which becomes a heavy burden to serve its own population in the coming future.

China, on the other hand, is much more measured in launching supportive policies. Different from the intensive policies launched by the US policymakers shortly after the virus outbreak in March, China phased its policies into different stages, focusing on the specific major issues in each stage.

In the past few years, China issued special-purpose bonds dedicated to infrastructure spending. The quota for special purpose bonds was further expanded in March as part of a set of policies. Fiscal policies continue to be proactive to channel more affordable credit to the country’s 30 million small and medium-sized businesses (SMEs), which account for 60% of gross domestic product and half of tax revenue[6]. To help them withstand the financial hardships, the People’s Bank of China (PBOC) trimmed the reserve ratio for rural and small city commercial banks by one percentage point at the beginning of April, which freed up $56 billion of liquidity to SMEs[7].

In April, as the global spread of the virus negatively affected demand for Chinese exports, more stimulus, such as government-issued consumption vouchers, which can be redeemed at participating dinning, shopping, travel and recreational enterprises, is issued to trigger the domestic demand. There are signs of increased consumer confidence instilled by the massive issuance of government vouchers, suggested by the daily sales of major retailers rebound during Labor Day holidays, which witnessed a meaningful increase of 32% from Ching Ming Festival (A holiday in early April)[8].

Policymakers in China are more mindful to avoid deploying massive indiscriminate policies because of the negative consequences the world’s second-largest economy endured from the last round of stimulus during the 2008 Financial Crisis. With more targeted and disciplined policy supports this time around, we do not expect a rising tide lifts all boat phenomena in the Chinese equity markets. Given this case, investing in China requires careful and in-depth stock picking, as not everything in the market would bear a good return. For stock pickers like us, this would be a good backdrop to perform. We have concentrated our holdings in competitive and innovative companies led by experienced management teams, and so far this year, most have proven to possess a strong ability to weather the volatilities under economic uncertainties.

[1] Source: Johns Hopkins Coronavirus Research Center, as of May 2020

[2] Source: Business Insider, as of April 2020; China’s National Bureau of Statistics

[3] Source: Morgan Stanley Research, as of April 2020; Haver Analytics, NBS, Morgan Stanley Research estimates

[4] Source: CNBC, as of April 2020

[5] Source: Morgan Stanley Research, as of April 2020; BEA, Federal Reserve, Historical Statistics of the United States, Morgan Stanley Research estimates

[6] Source: South China Morning Post, as of May 2020

[7] Source: Bloomberg, as of April 2020

[8] Source: Credit Suisse, as of May 2020; Ministry of Commerce

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, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class 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 any industry, asset or asset class described herein.