Increasingly Stronger

FALLS CHURCH, Va.–Preliminary economic numbers in China indicate that private consumption was the biggest contributor to China’s GDP for 2007. This confirms the idea that domestic demand is gradually becoming more important to the Chinese economy, as outlined here a few months ago. (See Silk, 12 December 2008, Dichotomies.)

When I discuss domestic demand in China, I usually concentrate on the retail numbers, which have been growing consistently. However, the interesting thing is that retail numbers don’t take into account rural sales, which have also been growing steadily; in fact, they’re now the main focus of the government as China tries to boost its rural areas. Higher agricultural prices–although negative for inflation–have been instrumental in increasing the rural population’s wealth and purchasing power.

It’s interesting to see this resilience in Chinese consumption, especially because the global economy has been slowing down for some time now. And because of strong wage growth, higher inflation and governmental efforts to stimulate domestic demand, expect this trend to continue.

Chinese authorities seem more willing to allow for faster appreciation of the renminbi. The Chinese currency has appreciated by 1.7 percent against the US dollar since the beginning of the year, which is around 20 percent in annualized terms. A long-term 20 percent appreciation isn’t a realistic expectation, the renminbi could easily rise 10 percent versus the greenback by the end of the year.

But the renminbi’s strength is important for the rest of Asia. Although many Asian countries recognize the need for stronger currencies, competition has stopped them from allowing their currencies to materially appreciate. But with China’s currency on the move, other Asian countries will feel more comfortable with a move in the same direction.

If this attitude holds, there could be changes in the notorious Asian mercantilist policies, namely the long-held view that weak currencies and low margins can sustain economic growth. Long-term global economic observers know that this approach to economic growth has been Asia’s approach to global trade, benefiting consumers around the world. At the same time, though, these policies have worked against Asia’s consumers and will eventually change; stronger currencies are a good start.

The chart below depicts the Asian Dollar Index, a trade- and liquidity-weighted index of 10 major Asian currencies (excluding Japan). As you can see, it’s seen strong gains during the past four years. This is a fundamental change that will continue into the future (i.e., Asian currencies will strengthen and become more flexible versus the dollar).

Non-Chinese currencies represent 70 percent of the index, and their strength demonstrates that, contrary to popular belief, the rest of Asia has benefited tremendously from China’s ascent, with the majority of the countries working toward reinventing their economies.

This is an ongoing and often slow process that will continue as long as governments remain focused and are willing to coordinate their efforts in achieving sustainable economic growth.


Source: Bloomberg

Asia continues to be a long-term story. It’s a huge region that’s urbanizing itself, leading to positive domestic demand trends, growth in construction and infrastructure and steady income increases. Notice that ex-Japan, Asia’s 37 percent urbanization level is well below the world’s average of 50 percent. Asia, despite the big movement of people into cities and the economic growth from that migration, remains less urbanized than Africa.

Thirty-three million people move to emerging Asian cities every year. For this huge population movement to be successful and produce the expected results on a sustainable, long-term basis, there needs to be structural domestic economic changes as well as open trade policies and high investment rates.

Domestic demand remains the focal point for the long-term investing case in Asia. But as the global economy slows and Asian exports weaken, domestic demand will soften. But the infrastructure spending that’s underway in Asia will help domestic economies hold up better.

The importance of infrastructure is that it’s structural in nature. Asian countries have realized that an improved infrastructure allows their economies to grow closer to potential, offering people better job opportunities and a more secure feeling for the future. And, as a result, they’ll be more willing to spend.

This also holds true for other developing economies such Russia and the Middle East. I’ll revisit the infrastructure theme in an upcoming issue.

Domestic demand (e.g., telecommunications, consumer staples) and domestic reflation stocks (e.g., banks) continue to dominate the long-only Silk Portfolio in an effort to capture the structural changes taking place in Asia’s economies.

The China-specific demand stocks in the Portfolio are Hengan International (Hong Kong: 1044, OTC: HEGIF), China Mobile (Hong Kong: 941, NYSE: CHL), and Alibaba.com (Hong Kong: 1688).

Hengan has been a Silk Portfolio holding for more than a year now and will remain so because of its solid market leadership, ability to weather cost headwinds, earnings visibility and cash-rich balance sheet.

Established in 1985, Hengan is the largest sanitary napkin manufacturer and the second-largest disposable baby diaper manufacturer in China; it’s also a leading producer of high-end tissues. Overall, it’s the largest local disposable paper hygiene product (DPHP) player in China.

The main growth engine of the company is its diaper division. Diaper demand, driven by demographic changes and rising living standards, is on the rise. But penetration is still low, indicating strong growth potential.

Disposable diapers have been available for 20 years in China, but industry growth has picked up to 40 percent–60 percent in Hengan’s case–during the last few years as young parents in urban areas see rising incomes.

Young couples are willing to spend more on child care products, food, entertainment and education. Child-related consumption accounts for a relatively large share of overall household spending. The population of Chinese up to age six in urban areas is expected to continue to increase for at least another five years; the opportunity will remain intact for quite some time. Diapers have a low penetration rate in China at around 8 percent, but that will change as the financial situation of the Chinese consumer improves.

Hengan is a strong brand name in China, and branding is important to the Chinese consumer. For instance, Hengan sells its tissues at a 5 percent premium over its larger competitors (premiums are much larger over smaller competitors), indicating both brand and quality leadership. This point was emphasized recently as the company decided to raise tissue prices by 5 to 10 percent this year (partly also to offset rising pulp costs), while at the same time it’s been revising sales up. Buy Hengan International.


Source: Hengan International

China Mobile, one of the largest mobile service providers in the world, is a recent addition to the Portfolio. Its main qualities are high earnings visibility and skilled management. The nationwide mobile penetration rate is around 40 percent and is growing rapidly. In rural areas in particular, which are becoming the government’s economic priority, the penetration rate is around 19 percent. Buy China Mobile.

Alibaba.com has been a disappointment since its IPO in November, but the longer-term prospects are still notable. The company posts products for sale or purchase on its Web site for free. China and Hong Kong suppliers are billed an annual fee, as well as suppliers from other regions. The potential market is China’s rapidly growing Internet base, which is estimated at around 162 million users. That’s second only to the US and is on track to be the world’s biggest by early 2009.

After its IPO, Alibaba stock jumped the most in Hong Kong after Microsoft made an offer to buy Yahoo!, which owns about 39 percent of the Hong Kong Internet giant. If the deal goes through, there’s plenty of room for collaboration between Alibaba and Microsoft. But even if Microsoft fails to acquire Yahoo!, Alibaba remains the prize to be had. Expect more attempts from established technology companies to add Alibaba to their portfolios.

The stock isn’t cheap, and it’s one of the most speculative Silk picks. But assuming that China’s growth will continue, it could be a real moon shot. In this context, Alibaba.com remains a buy.

Fresh Money Buys Mechanics

I provide a list of Fresh Money Buys, a guide to fund allocation for both new and long-term readers at the end of each issue. My aim is to comprehensively communicate my preferred countries, sectors and stocks so you can allocate money accordingly. This is a useful tool, especially if you’re interested in investing in more than a few stocks.

I try to find a balance between momentum and value-oriented markets and sectors. At this time, Russia, Hong Kong and South Korea are the top three markets, in order. If you pick one stock from each of these three markets using my recommendations in Fresh Money Buys, buy the following:

  • Russia–Energy–Gazprom (OTC: OGZPY)
  • Hong Kong–Banking–Bank of China Hong Kong (Hong Kong: 2388, OTC: BHKLY, BOCHK)
  • South Korea–Banking–Shinhan Financial (NYSE: SHG)

Continue like this all the way down the list, or buy more than one stock in each country, in which case you should follow the order of the sectors in parentheses after each country.

This list is only a suggestion; you can pick stocks according to personal preference in risk tolerance, investment horizon and the like.

Fresh Money Buys

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the portfolios on the left-hand side of your screen for details.

  • Russia (energy, telecommunications)
  • Hong Kong (banking, real estate, infrastructure)
  • South Korea (banking, electric power)
  • Philippines (telecommunications, real estate)
  • India (pharmaceuticals)
  • China (consumer, telecommunications, coal, e-commerce, oil, water)
  • Singapore (banking, telecommunications, industrial)
  • Taiwan (telecommunications, ETF)
  • Malaysia (ETF)
  • Europe (industrials, communications equipment)
  • Japan (banking, industrials)