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.

Notes From the Road: First-hand Insight into Consumer Cyclicals

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At Zeal, we practice value investing through buying shares of companies with strong business models and competent management teams at attractive valuations and we perform original bottom-up fundamental research. Every year, our investment team conducts about 1,000 regular and intensive management interviews.

Here we share some first-hand insight into Consumer Cyclicals gathered from a recent research trip in China.

Consumer Durables Demand Outlook hit by Housing Market Slowdown

China tech unicorns’ mass layoffs hit the headlines in recent months and traditional sectors are no exception. We talked to a leading furniture manufacturer and learned that they’ve been laying off a few hundred salespersons to cut costs as the company is faced with liquidity pressure amid lukewarm market demand. Historically, many factory workers don’t return to work after Chinese New Year(CNY) in that the CNY holiday is a good timing for them to switch jobs. A well-known kitchen solution provider told us that most of their immigrant workers came back to work in time this year, indicating that staff are concerned about the weak labor market and keen to keep their jobs.

Though some companies’ stocks rebounded significantly in recent two months,  in the short-to-medium-term, we don’t see structural growth in consumer durables, such as Furniture & Furnishing and Home Appliance industry, mainly due to the property market slowdown. Overall industry participants remain cautious on 2019 demand outlook and earnings forecasts have been broadly trending downward.

Foreign Investors Favor Premium Baijiu

Baijiu, the fiery Chinese spirit, is rarely found on the drink menus in western world. On the contrary, it’s topping foreign investors’ shopping list, with nearly 19 billion yuan flowing to the Top 2 Baijiu stocks in the first two months of 20191. We came across a few international long only fund and hedge fund managers on our way to a Baijiu distillery. We saw them show great interest in China Consumer stocks, and it’s not because they only want to do an arbitrage trade before MSCI announce its further inclusion of A-shares. Instead, they are convinced by the appealing valuations and structural growth story of the China Consumer stocks, which are more attractive compared to other markets, e.g. Japan and India.

(Local staff and visitors/research teams at the Baijiu distillery)

Key trends such as consumption upgrading and industry consolidation are still ongoing. Despite concerns over weakening domestic consumption, the demand for premium Baijiu remains strong. The wholesale price and retail price of Baijiu brands used to fluctuate largely due to supply shortage or poor inventory management. We’ve seen high-end Baijiu manufacturers adopt innovative methods to improve their sales channel and inventory management. When we visited a distillery in Sichuan, the company staff showed us their new anti-counterfeit package to be launched in mid-year. Every new package has an unique QR code – not only for counterfeit deterrence, but also for sales channel management. The Baijiu brand offers rebates to encourage distributors to scan QR code when they ship products to retailers so that they can collect data of product shipment, which will help manage channel inventory more effectively and get more consumer insights.

Improved Transportation Infrastructure to Boost Casino Businesses

The Hong Kong-Zhuhai-Macau bridge, the world’s longest cross-sea bridge, opened to public traffic on Oct. 24, 2018. China mainland visitors to Macau reached almost 900,000 during the CNY holiday from February 4 to 10, 2019, up +25.6% YoY2. Meanwhile, nearly 11% of the mainland visitors entered into the gaming hub through the checkpoint of the Hong Kong-Zhuhai-Macau Bridge2. We tried out the bridge and met some of the key casino operators that we’ve been closely tracking for many years during our research trip to Macau after CNY.

Casinos in Macau saw a substantial increase in Gross Gaming Revenue (GGR) last year, an increase of 14% YoY, with the mass market driving the growth3. As there’s a close correlation between Macau Gaming performance and macro economy, the Sino-US trade conflicts weighted heavily on Macau Gaming last year. Some worried that the VIP sector growth slowing down too much would hurt revenue as a large part of Macau GGR was still from VIP, thus the valuations of some quality names had gotten significantly compressed. A luxury casino resort we like is trading at an EV/EBITDA multiple of  1 SD below the 5-year-average 4. From our estimates, VIP represents nearly 50% of total GGR in 20185. On earnings outlook, we think the operator’s GGR growth will stay solid in 2019, with slower VIP growth, but mass and premium-mass market growth potential will offer sufficient downside protection. Macau Light Rail Transit (LRT) System is on track to open in 2H19, which is likely to bring more mass-market customers to major Cotai casino properties. We expect the improved transportation infrastructure to boost casino businesses and the undervalued quality names to play out this year.

[1] Source: Wind, as of Feb 2019

[2] Source: Macao Tourism Data Plus, as of Feb 2019; Public Security Police Force

[3] Source: The Gaming Inspection and Coordination Bureau, as of March 2019

[4] Source: Bloomberg, as of Feb 2019

[5] Source: Zeal Asset Management Limited, as of Feb 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.