On China's Way to World's Biggest Economy, the Consumer Is Emperor

 | May 15, 2017 | 10:00 AM EDT
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China has surrendered the double-digit growth that it saw for many years. But who could keep up that pace, particularly when you're by some measures already the world's biggest economy?

Instead of outright growth, achieved mainly through exports and manufacturing, the Chinese government has switched its attention to consumption. Services and consumer spending are the way forward, it reasons, as China stands on its own two feet rather than depending on the West (frankly too unreliable!) to prop it up. 

That has led to clear investment themes that Francis Cheung, the head of China strategy at the Asia-focused brokerage CLSA, outlined in a briefing I attended on Friday. He has turned bullish on China and on consumer plays in particular, and highlights some contrarian plays as well as a few more standard picks.

The boys in Beijing have committed to ensuring that China maintains a growth rate of around 6.5% through 2020. That meshes nicely with the 100th anniversary of the founding of the Chinese Communist Party in 2021.

But it's important for another reason. The growth would see China approach the World Bank's level of a "high-income" nation with economic output of $12,500 per person. It's at $7,900 now.

The United States sits at $55,980 now, so China would still have a long way to go to approach Western rates of wealth. But the improvement would be marked in the way people go about their lives in China.

By one World Bank count, China is already the biggest economy in the world. Its $19.6 billion gross domestic product -- when adjusted into "international dollars" to account for the purchasing power of money locally -- has outstripped the $18.5 trillion figure arrived at for the GDP of the United States when calculated in the same way.

Not adjusted for purchasing power parity, China's $11.1 trillion economy is still well away from the $18.0 trillion economy of the United States, again using World Bank figures. But 52% of the Chinese economy comes from consumption. This is a "tipping point" for CLSA.

Particularly on the east coast, the "wealth effect" is significant. It is currently amplified by a property market that has rallied 24% since the last downturn and 42% this decade. 

Home ownership is at astoundingly high levels, 87% in urban areas and virtually 100% in rural ones, in large part because of China's one-child policy. In the largest cities, where restrictions designed to cool the market are common, parents get around barriers to buying a second home by putting it in their children's name.

A married couple now, if born under the one-child provision, have the exclusive attention of eight grandparents. That's a lot of support. So they're assured in their spending.

Brands have reduced their prices in Asia to attract customers. Latest in a long list is the British soccer club Liverpool, which has slashed the price it charges by half to $30 for a Chinese shirt with the same logo but a different manufacturer, and cheaper fabric, than the original made by New Balance, which is privately held.

The $65 price in Britain is ridiculous; the one in Asia a little less so. The company's parent, Boston-based Fenway Sports Group, wants penetration to be particularly deep as the club celebrates its 125th anniversary.

The gap between the price charged in China and the West should, however, narrow for all goods. That shift would allow for higher margins.

There are several sectors to watch to play the trend of rising Chinese wealth. Internet, consumer discretionary and materials stocks are performing particularly well right now, and have done so since Cheung made the "big change" of turning positive on China at the start of the year.

Cheung's top picks are JD.com (JD) , China's second-largest online retailer after Alibaba (BABA) , and Ctrip.com.

JD.com's forte is electronics and home appliances. The appliance sector is one of Cheung's favorites -- more on that later -- but perhaps more importantly JD.com just became profitable for the very first time in the first quarter. It is now also looking to expand abroad, moving into logistics in Indonesia, too.

The first quarter was a record quarter for a company that not only has its own extensive logistics unit, but is also diversifying into cloud computing, data storage and artificial intelligence.

He would also add Ctrip.com (CTRP) to his list, the leading online travel agency in China, which has also just shifted into the black after dodgy earnings for most of 2016. Both online travel and online homeware sales are "great long-term plays" in markets likely to see consolidation, Cheung believes. 

The first quarter of the year is typically weak for e-commerce, with the disruption of the Lunar New Year, when China effectively shuts down for two weeks. But this year the first quarter already saw 26% growth, year on year, in e-commerce sales.

"It's very robust," Cheung says. "There are just a lot of pickings." He's done the sorting for you.


Alibaba, China's Amazon.com (AMZN) , is also among CLSA's top selections -- probably the first stock most international investors think of when they think of China.

Founder Jack Ma believes it's not enough to be a pure e-commerce play. That will become a "traditional" industry very shortly. He prefers to focus on what he calls "New Retail" -- the integration of online and offline sales with logistics and data, all across a "single value chain."

You'd be hard pressed to bet against Ma. But Cheung prefers to scout for lesser lights.

Tencent (TCEHY) is a large part of CLSA's core portfolio, but isn't a stock that he would be adding to right now. The story of what's now Asia's largest company is too well-known. "We try to find things a little bit out of the ordinary," Cheung says.

The Macau casino operator Melco Resorts & Entertainment (MLCO) makes his list. That has come in and out of favor, depending on Macau's fortunes, which in turn depend heavily on how many Chinese gamblers Beijing wants to allow in across the mainland border. We now appear to be in a stable period, after a corruption crackdown and strict visa restrictions created a lot of empty tables.

Hong Kong-based and -listed luggage brand Samsonite (SMSEY) is a pure play on the boom in travel and tourism. China is learning to play and many Chinese are taking their first vacation; they need a wheelie case to take along.

Likewise, Uni-President China Holdings (UPCHY) , which produces juice drinks and instant noodles, is a clear consumer-spending play. But if the company is to stay relevant and keep up with changing tastes, investors should watch whether it manages to offer healthier products to increasingly savvy consumers.

Sino Biopharm HK:1177 makes and sells both Chinese traditional medicine and Western drugs. China is shifting from a state of mind where either the state provided health care or you got nothing. Health services, having been discretionary, are now becoming essential.

State-owned oil giant Sinopec, officially China Petroleum & Chemical  (SNP) , is an oil-and-gas behemoth. It is spreading its international wings, but ultimately brings all of that fuel back home where it literally stokes the Chinese economy.

CONTRARIAN PLAYS

Cheung also has a few contrarian picks that may be of particular interest to investors. 

Chalco is China's largest producer of aluminum. Officially called the Aluminum Corporation of China (ACH) , and also "historically one of the most hated stocks in China," Cheung notes. Tech grabs the headlines. Heavy industry does the heavy lifting.

Aluminum is the next target of China's efforts to curb production, after steel and coal. Beijing is keen to cut excess capacity but equally wants to avoid being slapped with the label of "dumping" aluminum on world markets at prices supported by government subsidies.

Producers will also likely fall under the watchful eye of the authorities when it comes to reducing pollution. Cheung thinks Chalco should benefit when the pressures mount on production and pollution. "It still looks very valuable," he explains, despite its traditional lack of appeal to investors.

Golden Eagle Retail Group (GDNEY) is a Hong Kong-based shopping mall developer and owner. Its portfolio is concentrated in Jiangsu Province just north of Shanghai, although it also operates in the old capital of Xian in central China, and Kunming in the very southwest, near the Vietnam border.

The ongoing crackdown on corruption launched by President Xi Jinping also spilled over into conspicuous consumption. But the fervor appears to have cooled, with the focus back on apparatchiks taking kickbacks, rewarding Chinese retailers.

Xi says the objective of ensuring that officials don't dare be corrupt "has been basically achieved." The number of Communist Party members expelled and prosecuted started to fall in 2016, and new anticorruption cases fell 26% in January and February, compared with the period in 2016.

Although corrupt officials shouldn't start counting their ill-gotten gains, consumption isn't an evil word anymore. "Shopping malls are seeing positive foot traffic again," Cheung says. "People are returning to the malls."

The Chinese appliance maker Gome Electrical Appliances HK:0493 is ubiquitous in China's homeware sales. Cheung likes the appliance sector because it has high margins, and also because people like to shop for those white goods in person, in a store, where a salesperson can explain the features.

Kitchen appliances in particularly are an area that Chinese homeowners are likely to upgrade as they get wealthier. That raises the prospect of much stronger sales and also potentially higher profit margins on big-ticket items.

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