As president Xi Jinping cements his grip on power with a move to enshrine his thought in the People’s Charter, commentators are weighing up the implications, not least for Chinese stocks that have had a good run this year. 
One thing is without doubt – China has a plan that has nothing to do with the furtherance of Marxism but in the re‐establishment of China’s wealth and power.
Xi Jinping will be keen to see that his tenure as president at the 100th anniversary of the Communist Party in 2021, is remembered for the return of wealth and political influence on the world stage.
Since the 1980s, China has been on a course to maximise its resources to become an economic and geopolitical power house. It has embarked on a long programme of industrialisation, export manufacturing and now private consumption.
Having started out as a manufacturer of cheap clothing and toys China is now the largest manufacturer of computers, smartphones and engineered goods; it has the world’s largest car market and plans to be the leader in new industries such as the and electric vehicle industry.
China has already demonstrated its commitment to change. In 1994 China nearly did go bust. Inflation hit 27 per cent, fiscal revenue fell to 10 per cent of GDP and the banking sector nearly collapsed. China began to dispense with the state‐owned enterprise model with cradle‐to‐grave benefits: 150,000 enterprises were closed; 25‐30 million people were put out of work and the banking system was recapitalised to the tune of 20 per cent of GDP.
The approach China has taken to succeed in its plan is borne out of the necessity of its demographics.
Economic growth (Y) is achieved by a combination of 4 factors, namely:
1. Addition to the labour force (w)
2. Reallocation from low‐ to high‐value add (r)
3. Addition of capital (fixed assets, education etc) (k)
4. Combining labour & capital more productively (i.e. Total factor productivity) (p)
In other words: Y = w + r + k + p
The first two components (w+r) are collectively known as the demographic dividend. This is mostly exhausted in China as indicated by the age distribution of China’s population shown below.
Additions to the labour force (w) are subsiding. In the 1970s and 1980s ‘w’ added 2.5 per cent of annual GDP growth on average. Between 1995‐2005 this had fallen to around 1 per cent and beyond 2020, it is expected to detract from growth. Similarly, the reallocation of workers (r) between 1995‐2005 contributed 1‐1.5 per cent of growth on average. From 2020 it is likely to fall to less than 0.5 per cent.
The ageing profile of China’s population is more like that of a significantly more advanced economy (in terms of GDP/Capita, more like $20,000 rather than the current $8/9,000). This means that China must focus on k + p to drive growth. And this is what we have seen.
No longer does China compete purely on the basis of cost and cheap labour. Most of that old industry has shifted elsewhere in Asia (Bangladesh, Cambodia, Laos, Vietnam).
Source: UN
Longer term the requirement to address this problem is what drives the Chinese to seek industries of the future in which they can dominate.
The Guinness Asian Equity Income fund uses a bottom-up process to invest in companies that have converted their competitive advantage into a persistent return on capital, and where the market undervalues that persistence.
Several companies in the portfolio operate in industries that currently benefit from (and are expected to continue to benefit from) a shift towards higher value‐added production. Some of these areas include:
High quality components in smartphones (AAC Technologies (acoustics and haptics)
Electric Vehicles and battery technology (eg. Hanon Systems)
Rising middle class benefiting from the higher wages from a more complex economy (e.g. Luk Fook, China Lilang)
AAC Technologies is a company already manufacturing advanced, high quality components used in major smartphone brands, and the company has been a strong performer for a while. As an important supplier of acoustic and haptics components for smartphones, such as the iPhone, it is a good example of a company turning its competitive advantage into persistent returns on capital. Its track record means the company has strong relationships with its key customers, further entrenching its position within the industry.
Hanon Systems is a Korean company specialising in automotive climate control systems for both combustion engine and electric vehicles. The company is well managed, is diversifying its customer base and has moved to paying a quarterly dividend which is unusual for a Korean company. Hanon should benefit from the clear emphasis that Chinese policymakers are placing on electric vehicles.
China already has the world’s largest automobile market and now policymakers are aiming to develop domestic manufacturers which will be leaders in producing electric vehicles.
Hanon should benefit from this drive as it is one of the few suppliers in the world who can offer a full range of products used in climate control systems. This is especially important with electric vehicles where lithium batteries are very sensitive to changes to temperature – hence the importance of climate control systems.
Source: China Automotive Information Net & WARD’s Automotive Group
As the manufacturing industry in China produces more higher‐value added goods, we expect to see wage growth to accelerate and so we expect the middle class, and as a result consumption, to continue to grow.
China Lilang (which trades under the LILANZ brand) is a designer and retailer of men’s clothing. Over the past few years the company has made improvements to designs, to the product range, to the quality of fabrics and to the structure of the distribution network. The chief designer has been hired from Armani; new product lines have been added in shoes, underwear and casual clothing; proprietary fabrics make up a bigger proportion of usage and their quality has improved; the distribution channel has shifted away from department stores to shopping malls. The management has proven itself to be both dynamic and adaptable, reflecting rapidly evolving Chinese consumer patterns. Strong results at the interim stage lifted the stock into our top five performers this quarter.
Luk Fook, a jewellery retailer, is another company which should benefit from rising incomes in China. The company generates most of its profit in Hong Kong but has had to adapt its business model as tourist inflows from the mainland have dropped. The company has responded by closing unprofitable stores in Hong Kong and opening new stores in the mainland to better respond to the changes in the market. As a result, same‐store sales are now growing in both regions and we expect the company to continue growing its presence in the mainland.
We believe that Asia still offers value after its performance this year based on its earnings prospects and economic growth momentum. We still think that a bottom‐up approach – identifying what we believe are good businesses in the first instance, rather than building a shape of the world and looking for investments that fit it – is the right way to go.
Edmund Harriss, is portfolio manager at Guinness Asset Management. All views are his own and should not be taken as investment advice.