China has many faces, as befits its 1.4 billion heads. Business potential is strongest inland as the country's manufacturing base shifts away from the developed east coast. That's thanks to higher labor costs and rising incomes.
But those fatter wallets are exactly the same features that should attract investors. China's megacities are where the action is already, not where it's going to be soon. Stock buyers should still concentrate their attention on companies with the greatest exposure to developed China.
That's particularly true when it comes to real estate, the industry that flows through China's veins as its economic lifeblood. There's a tier of property developers where investors can build a portfolio. And there's a tier that should be avoided, particularly as the housing market teeters on the brink of a downturn.
Investors should avoid developers with the highest exposure to smaller cities. Principal among them are China Evergrande Group (EGRNY) , Country Garden Holdings (CTRYY) and China Overseas Grand Oceans Group HK:0081.
For urban China, prospects are poorest for the middle reaches of the Yangtze River and the "Cheng-Yu" conurbation around Chengdu and Chongqing, according to Standard & Poor's, which says in a new report that "regionality" could surface in a downturn. Cheng-yu and inland Yangtze cities are "more vulnerable" after witnessing high investment that isn't matched by their weaker population trends, S&P wrote.
Any rebound in lower-tier cities happened over the last two years, "but has already peaked in our view," S&P states. The saving graces would be if homebuilders have healthier cash balances, bigger scales, higher margins and contracted sales on the books that they have yet to recognize.
Stronger developers have withstood the fierce competition in China's biggest cities over the last couple years. Their lower cost of financing has let them pick up cheap land and projects from distressed sellers. That is feeding through to higher margins and stronger sales, leaving them better placed than in the last downturn.
Investors should focus any buying attention on developers devoted to the bigger cities: Gemdale SH:600383, Yanlord Land Group (YLDGY) , China Overseas Land & Investments (CAOVY) and China Resources Land (CRBJY) . Three of those four, with ADRs, are obviously easily accessible to U.S. investors.
China Resources has particularly high gross profit margins on recognized sales, approaching 50%, with Yanlord not far off. Gemdale and COLI are approaching 40% gross margins.
Margins are mid-20% range for Country Garden and China Overseas, half that of their high-end competitors. While China Evergrande is more profitable, it is also the most indebted Chinese developer.
Cash-strapped companies are forced to pay higher and higher returns to borrow money. On Jan. 25, Evergrande retapped the market for US$3 billion in bonds repayable in 2020, 2021 and 2022, at coupon rates from 6.3% to 8.3%. That's one-third of the US$10.4 billion in debt issued by Chinese developers to date this year.
Some companies have been paying eye-popping rates of return to lenders. Zhenro Properties Group HK:6158 (10.5%), Ronshine China Holdings HK:3301 (11.5%), Yango Group SZ:000671 (12.0%) and Redco Properties Group HK:1622 (13.5%) have all issued bonds paying double-digit coupon rates.
That's fine while sales are strong and cash flows are fast. Any decline in the pace of the market threatens that model, leaving overleveraged companies in trouble. Investors may want to note that the Hong Kong market allows shorting, which is impossible with mainland listings.
Chinese developers as a whole have US$72.6 billion in debt maturing this year, mostly in onshore bonds, according to S&P figures. They repaid US$29 billion last year, but any disruption in financing flows in 2019 could spell the death knell for the weakest developers.
Even the hint of such conditions would prompt a flight away from the most indebted companies, making it impossible for them to secure the refinancing they require. It could also deter homebuyers from putting money down on their developments, which normally raise money for construction through off-plan sales.
Sentiment has turned very sour indeed. For 2019, 61% of property professionals are negative about the mainland market when polled by China data specialist Real Estate Foresight. That's up from 43% in 2018 and just 18% in 2016, the last spike in optimism, when 50% of those surveyed were positive about the market.
Hardly anyone is now bullish about China property -- just 11% in the latest Real Estate Foresight survey, the lowest level in recent years. The 28% that are neutral on China real estate is also a recent low, as the ranks of those expecting red ink in the industry have swelled.
The forecasting company anticipates that slowing price growth eventually will turn to widespread declines by year-end, with Chinese residential prices posting a 0.5% decline in December, year on year, from price increase of 5.1% the same time last year. Volumes will be down, too, off 2.6% in September, although they may then reverse that trend.
Mass-market and even distressed developers may see rapid share-price rebounds if the Chinese economy finds itself on firmer ground. For now, investors should concentrate their attention on safer, well-capitalized names.