Growth in China

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Growth is the essential part of the investment strategy known as “growth at a reasonable price.” Without growth there is no strategy. A cheap stock of a stuck-in-the-mud company may still be too expensive. Growth is first among the four equally weighted fundamental aspects of financial strength that MarketGrader assesses in grading companies and assembling high-scoring stocks into indexes.

MarketGrader’s evaluation process can ferret out growth almost every place it looks—even in China’s badly battered market, which has toppled more than 40% since mid-June despite the central government trying unsuccessfully to minimize the damage. MarketGrader’s China A-Shares 200 Index—equally weighted stocks of the financially strongest of 2,618 Chinese companies that MarketGrader follows—has plunged, too. One indication of how much havoc this massive sell-off has caused is that 15 companies selected for the index last March, when China’s markets were skyrocketing, have ceased trading on China’s two main exchanges in Shanghai and Shenzhen.

MarketGrader China A-Share 200 Index – 1 Yr. Total Cumulative Return CNY
[visualizer id=”2720″]

China’s economy also has made global headlines, with reports of growth slowing from its previous torrid pace to a level many countries may fantasize about but can’t achieve. Nonetheless, the slowdown marks a sea change for China, with repercussions stretching around the globe as export/import trade ratchets lower. Part of this slowdown is intentional, as the Beijing leadership attempts to transition the Chinese economy to consumer-driven goods and services from industrial, export-dependent manufacturing. But this maneuver turns tricky in a world where most economies—with the exception of the United States—are barely trading water and some are slowly sinking.

Against this gloomy backdrop, survival rather than growth might seem to be the priority. But growth is there if you know where to look. Don’t bother with the bloated, state-run behemoths, even though China recently announced an initiative to get them into shape. Because the central planners, not all of whom are on the same page, won’t let them fail, these companies never learned discipline. There is no growth to look for among this lot. Instead, expect privatizations and closures in the years ahead.

Much of China’s recent strength has come from entrepreneurial companies born in the early days of the country’s swing to a market economy. Those companies enjoyed China’s economic boom but more importantly know how to weather tougher times. Many of these companies are run by Chinese who were educated in Western universities to employ modern management techniques and strategies. These executives learned how to identify customer needs, develop products and services to meet those needs, and to institute modern production, marketing and distribution functions. They also learned how to keep an eye on the financial side of things. They built companies that place financial strength among their top priorities, knowing that such strength is an especially useful asset when cold winds blow.

MarketGrader uses financial strength as a proxy for managerial excellence, identifying financially solid companies as most likely to succeed—not only in whatever businesses they are in but also in the stock market. The main reason for this approach is that the metrics for financial strength are comparable from one company to another, while measurements for production, marketing, etc. are not. MarketGrader tracks 24 financial indicators, grouping them into four categories: growth, value, profitability and cash flow.

Before getting into the growth that MarketGrader has found, it is useful to understand the makeup of the China A-Share 200 Index. The 200 stocks started out in March 2015, the semiannual rebalance, with a median market capitalization of US$2.4 billion. As is usual for MarketGrader indexes, this one is solidly in the mid-cap range. Nearly six months later, the median market cap had fallen to US$2.28 billion—a drop of only 3.7% compared to the stock-market bloodbath.

There were some ranking changes as a result of the market collapse. For example, Industrial Bank Co. started out as the largest in the index, with a market cap of US$50.2 billion. But it lost 13% of its size in the downturn and fell to second largest behind Shanghai Pudong Development Bank Co., which shrunk just 3.7% to a market cap of US$43.8 billion. Seventy-five of the companies actually grew larger during this period. One of them was Xinjiang Tianrun Dairy Co., which started out as the smallest company in the index at US$294 million and grew 30.3% to US$383.5 million, making it second smallest.

The index components’ MarketGrader scores also fell during the sell-off, but by much less than the market decline. The median score when the companies were selected for the index in March was 66.3; by early September it had dropped 7% to 61.6. At selection, the highest score (89.6) belonged to Heilan Home Co. But that score fell 6.5% over the next five months, moving Heilan Home to second place. (Despite its name, Heilan Home makes worsted wool fabrics and men’s suits. In China, companies’ names in many cases have nothing to do with the lines of business they are in.)

Assuming the top rank was Hubei Jumpcan Pharmaceutical Co., whose MarketGrader score rose nearly 1% during this period to 85.4. (This company does make pharmaceuticals, but it used to be in machinery and valves and was known as Hubei Hongcheng General Machinery Co. Many Chinese companies quit one business and go into another as new opportunities arise; they may or may not change their names in the process. Usually the stock symbol stays the same, which becomes the chief way of tracing lineage.)

In terms of sector representation, the A-Share 200 is a fairly diverse index, roughly reflecting the sector makeup of the overall Chinese market. The scale is smaller, of course. There is only one telecommunications company, for instance, and just three in the energy sector. This pie chart shows the sector composition of the index near the end of the six-month period in which these companies were components. (Note: Only those companies still trading were used in these computations, and the total of these companies was the divisor.)

[visualizer id=”2713″]

With this background in mind, the growth story becomes even more compelling. There is no way to summarize it in words. Let the numbers, compiled as of September 1, 2015, speak for themselves.

Median Change in Trailing 12 Months vs. Year Earlier
Sales
Operating Income
Net Income
Free Cash Flow
MG China A-Share 200
19.46%
19.86%
18.41%
-14.98%
Consumer Discretionary
18.27%
21.10%
18.29%
-10.70%
Consumer Staples
2.19%
8.15%
7.55%
-28.44%
Energy
31.85%
24.55%
29.49%
-17.73%
Financials
27.91%
15.37%
27.21%
32.68%
Health Care
23.50%
22.60%
20.11%
34.20%
Industrials
14.76%
13.20%
20.88%
-53.79%
Materials
14.50%
8.56%
4.82%
-46.88%
Technology
21.40%
27.11%
20.82%
-36.89%
Telecommunications
15.54%
6.00%
37.06%
-38.64%
Utilities
-1.80%
-3.41%
0.57%
-11.92%

These growth figures are nothing short of spectacular. Other than slippage in utilities and weakness in consumer staples, double-digit growth predominates. The negative change in free cash flow doesn’t represent a problem in this one-year snapshot, although it could if it becomes prolonged. Free cash flow is calculated by subtracting capital expenditures (future asset growth) from cash flow generated by current operations. Most of these companies are in strong expansion mode. Even so, 83 of the index components grew their free cash flow in this period, and 38 of them did so by more than 100%. Many of them are in the financials and health care sectors, which are the only two to show substantial increases in free cash flow.

Growth is alive and well in China, MarketGrader finds, though it may not be as widespread as it once was. Selectivity thus becomes the key to investment success.

Editor’s note: This is the first in a series of posts on MarketGrader’s China A-Share Indexes and the quality of the companies in them. In the next installment, we’ll discuss the latest rebalance of the MarketGrader China A-Share 200 Index, which was just completed this past Friday.

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