Are Food Stocks a Defensive Play Amid Uncertainties?

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Just as emperor penguins huddle together for warmth during cold weathers in Antarctica, investor communities tend to invest in similar themes to make up for the lack of confidence during harsh conditions. Amid uncertainty in the Chinese onshore and offshore markets, we noticed that investors are inclined to buy relatively macro-insensitive stocks that are perceived by them to have high degrees of certainty, such as food and beverage and other consumer staples. For example, one of food seasoning manufacturers was up almost +60% YTD and one of hot pot restaurants soared more than +100% YTD1. We understand the rationale of this behavior. However, are these food stocks really a defensive play at this juncture?　

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Chinese people spent 4.27 trillion yuan (USD 597 billion) on dining out in 20182, which is even higher than Sweden’s GDP (USD 551 billion3) and one type of cuisine dominates China’s restaurant industry – hotpot, eating almost 14% of the total market share1. With consumer sentiment weakening amid a sluggish economy, investors have been loading up on their perceived safe stocks, including the above-mentioned hotpot stock, as an old Chinese saying goes “Eating means the world to people” and they believe the company’s aggressive store expansion will increase revenue significantly.

In 1H19, the hotpot chain generated 11.7 billion yuan in revenue, up 59.3% from a year earlier4. Nevertheless, the company’s valuation, in our view, has been pushed to an expensive level, which could lead to the risk of a collective sell-off once risk appetite returns.

We think the current stock price has already baked in the scenario of rapid earnings growth in next three years, which may not turn out as the market expects. The current high valuation is based on the market’s hope that the chain will constantly break the ceiling on the number of restaurants locations and per store profitability maintains momentum. Notwithstanding, from its interim results for the first half of 2019, average income for single store slipped -8.89% YoY4 and  table turns for restaurants in Tier 1 cities declined from 4.9X in 1H18 to 4.8X in 1H194, indicating that new stores may cannibalize sales of existing stores. The stock is trading on a 12-month forward P/E ratio of 54.2x at the time of writing, an increase of 81% YTD, while its peers have much lower forward P/E ratios of 23.5x and 16.1x1.

In addition, some of its peers’ profit margin is catching up with this hot stock (see chart below5), with the valuation remaining at a reasonable level.

Despite that the hotpot chain’s strong brand and execution will support its earnings growth, we don’t think it provides a decent margin of safety.

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With the fear of missing out on a market rally, some investors may forget about disciplines and rush into an expensive investment. Instead of crowding to this space, we tend to focus more on companies that become undervalued during this round of market volatility. Although they might be perceived as more risky than defensive stocks at this moment, we believe that accumulating them at attractive valuations will drive medium to long term returns when the dust settles.

[1] Source: Bloomberg, as of August 2019

[2] Source: People.cn, as of July 2019

[3] Source: World Development Indicators database, World Bank, as of July 2019

[4] Source: Company Interim Report 2019, as of June 2019

[5] Source: Zeal Asset Management Limited, as of July 2019

 

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.

In the Face of the Tech War, This Chinese Tech Company Thrives

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In recent years, China has advanced rapidly in tech developments and has even developed into a leader in mobile 5G technology. As China catches up and even surpasses the world on some technology fronts, the US has been suppressing China’s tech development by curtailing the country’s access to American technology, putting Chinese tech companies’ businesses at risk. Under these circumstances, it might come as a surprise to some that the stock of a Chinese tech company has risen almost 40% so far this year1, and there are others who are also thriving. Are there really companies that would benefit from the tech cold war?

This company that we speak of is an analog integrated circuit (“analog IC”) design company (“Company A”) that is likely to become a beneficiary of the tech war, since the US government’s export ban is forcing China to speed up semiconductor localization.

China’s semiconductor localization to accelerate domestic demand for power management chips

Company A specializes in power management chip design for industrial, consumer, computer and network communication devices. An example of application would be a cell phone, which consists of many chips for different functions in one place. Since the chips work at different voltages, a power management circuit is needed to adjust the power going into each of these components. Although the technology involved isn’t rocket science, it is essential to all electronic devices and production of these components requires skilled analog designers and engineers. Nine of the top 10 suppliers that held 60% of analog market are all from western countries2 and Company A is one of the very few companies in Greater China that have gained significant market share in Asia.

Chinese electronic manufacturers used to choose US power management chips because of their sound quality and there wasn’t much incentive to switch to other analog IC suppliers, since it wouldn’t deliver significant cost savings. Until recently, the US banned their semiconductor makers from cooperating with Huawei, which prompted these Chinese companies to develop their own semiconductors and use domestic products. We think this trend will increase the demand for non-U.S.-made power management circuits, benefiting Company A as an analog IC design company founded by Chinese experts. Besides that, most of its sales come from Asia, so the business that it would lose during the trade war would be manageable.

Core competitiveness of the analogy IC design company

We first researched Company A back in 2015 and we believed that, as an analog IC design company, it would become an industry leader in Asia and a high quality but lower cost import substitute for the current incumbent suppliers in the US and Europe. Currently, China takes up 40% of the global analog market while Company A has less than 50% of revenue from China3 – we see there is still ample room for growth and the company will benefit from China’s ambition to localize its semiconductor supply in the long run.

The core competitiveness of Company A lies with its four founders who are analog IC veterans from the US, leveraging the massive supply of low-cost engineering talent in China to build the only local analog IC design company with in-house Intellectual Property capable to rival big global competitors like Texas Instruments and Maxim. With its strong Research & Development (R&D) capability and lower selling price, even before the relationships between China and the US soured, the company had already been gaining market share. Another factor that makes the company competitive is its private status. Unlike many state-owned semiconductor players that rely on subsidies from the government, Company A has been staying on top of their business to increase profitability by constantly developing independent R&D capabilities.

We believe that neither China nor the US could come out of a tech cold war unscathed. Not only is China still one of the best places in the world to manufacture large-scale electronic products, it is also an important consumer market for most of the US tech brands. Although the Sino-US conflict inevitably slows down the technological advancement of China in the short run, China is set to further develop its independent R&D capabilities with the government’s policy push and the nation’s growing talent pool in STEM. And it would do well for investors to remember that even under the current conditions, some companies will continue to evolve and thrive.

[1] Source: Bloomberg, as of July 2019

[2] Source: IC Insights, as of May 2019

[3] Source: CLSA, as of March 2019

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.