No China No Grow

China part deux
As I wrote last month, it is tough to ignore China’s growth potential. So having come back dissatisfied from my previous trip to China, I went back to Shanghai to dig deeper. Delving further into the China story, we realize that China, is not like any other country in Asia. 138 major cities with populations ranging anywhere from under 1m to 20m people per city, we are literally talking about a “Continent”, not just another country. Case in point, the number of credit cards in China grew from practically zero to nearly 20m cards within a period of less than 2 years and is now growing at 1-2m cards/month. Even if credit cards in circulation were to grow at 100% p.a. for the next 3 years, it would still account for less than 20% of total debit cards currently in circulation. Interestingly, 99% of owners of the 900m debit cards in circulation use it only to withdraw money and not to buy goods. When you throw these kind of numbers around, no wonder credit card companies are plunging headlong into China.

Still, the key question remains how to invest profitably in this kind of climate. Property is always a good key indicator of wealth creation, and in Shanghai, property prices have been increasing on average 30% per year since 2002, and was up almost 200% in the past two years. However, recent attempts by the government to cool the property sector are starting to take some effect. How serious could things get? Very serious, according to Credit Suisse First Boston's Dong Tao, chief economist for Asia ex-Japan in Hong Kong. He reckons mortgages account for 40% to 50% of all bank lending in Shanghai and that Shanghai property lending accounts for a fifth of all mortgages countrywide. A Shanghai crash could slam China's already shaky banks. Property generated about one-quarter of Shanghai's 14.3% growth in gross domestic product last year. Moreover, while Shanghai accounts for just 5.4% of China's GDP, a crash could have a ripple effect. "It affects demand for materials and electronics, insurance and mortgages. It's the source of fiscal revenues and consumer confidence," Dong says. "If we see a major dip in Shanghai it will be a substantial risk to the national economy and the global commodity market."

Still that doesn’t seem to be stopping some investors. The Carlyle Group, one of the largest private equity investors in the world, just dropped US$120m for 110 villas in Shanghai. With rents in Puxi going for close to US$23.6/sqm/mth, average rental yields for these villas could come to 10% based on prices Carlyle Group paid for them. Still, that’s not quite the going price for prime Shanghai property for the ‘average’ millionaire on the street.

If you want a pad in the heart of Shanghai in one of the most exclusive developments in Shanghai, it’s going to set you back a cool US$6m, which works out to US$10k/sqm (fully furnished), or almost 3.5 times what Carlyle Group paid for their villas. Still there doesn’t seem to be a shortage of demand as all 15 units were sold out in the development I looked at…

Suffice to say, we will not be hurried into investing purely due to the strength of the market there so far but will continue to search for a direct China play which meets our investment criteria.

Vietnam is sizzling, but is it burnt?
On another note, another hot investment destination on everyone’s minds (and lips) is Vietnam, the second fastest growing country in Asia, after China. To put everything into perspective, the current market capitalization of the Vietnamese stock market is US$5bn and this is expected to increase substantially by 2010 (target: US$40-50bn, according to one of the largest funds invested in Vietnam). Valuations accordingly are not cheap. Based on consensus forecasts, the Vietnamese stock exchange is trading on an average PER of 15x FY07 earnings, against expected EPS growth of 11-12%. With the amount of money chasing limited investment opportunities in Vietnam, the market is already up around 100% YTD.

I personally prefer Indonesia
On the other hand, I want to highlight a less sexy but potentially more interesting and better valued alternative. For slightly cheaper valuations, investors can buy into Indonesia at 13x FY07 PER, and whilst Indonesia is trading in line with Asian FY07 PER (based on average PER valuations from our brokers), EPS is expected to grow by an average of 20% p.a. for the next two years, which is almost twice the average Asian EPS growth rate and almost twice Vietnam expected EPS growth rate for the next two years.

Although Indonesia is not expected to grow as fast as China or Vietnam in terms of GDP growth, note that in absolute terms, Indonesia will grow its GDP by US$20bn, which will be almost six times more than Vietnam’s expected +US$3.5bn for FY06. In the meantime, GDP per capita for Vietnam is still less than half of Indonesia. Based on similar principles, China will generate additional GDP of US$160bn for FY06, which is 8 times more than Indonesia’s GDP growth this year.

Looking at it in another way, as a corporation looking to target domestic consumers, their primary focus will not be so much on GDP growth but more on how much disposable income each consumer has in his/her pocket. If the average GDP per capita for a Vietnamese citizen is only US$633, a growth of 8% will only generate additional capita of US$50. On the other hand, if the average capita per Indonesian is US$1,263, a 6% growth will generate additional capita of US$76, theoretically a more attractive proposition given a population size that is also almost 4 times larger than Vietnam. In addition, I can’t imagine the cost of living for a low end worker to be substantially different in Indonesia versus Vietnam. So it is no wonder international consumer companies are drooling over the thought of the developing Chinese consumer, because GDP per capita there is expected to grow by US$138/person, and with a population size 4 times larger than Indonesia and who have GDP/capita of $1,728, almost 37% more than the average Indonesian.

Interest rates in Indonesia are falling the fastest of any Asian country, down almost 200bp since the beginning of the year to 10.25% with expectations for another 200bp by the end of 2007. With improving outlook, I expect signs of FDI to start picking up and as a result, together with a buoyant stock market, we can potentially see falling rates and a strengthening currency scenario, a bullish outlook for not only domestic demand, but also the stock market.

Given that we are a bottom up focussed fund, we didn’t waste anymore time in China (or Vietnam for that matter) and our second trip to Indonesia in the past couple of months yielded the latest addition to our fund, Arwana Citramulia (ARNA IJ). At 5.7x our FY07 forecast against expected EPS growth of 43.5% for FY07 and 30% EPS growth for FY08, our disappointment at not finding any suitable investment opportunities in China were more than compensated by our latest investment. Arwana, a low to mid end floor tile manufacturer serving the domestic market, the only one with multiple factories around Indonesia is a perfect play on rising consumer spending power in Indonesia. Transportation costs account for a large proportion of costs and having factories near customers is a key success factor for the company. Part of the reason for Indonesia’s slower than average GDP growth has been the fact that a lot of investments have centred around Jakarta. However, with the capital city accounting for only around 6% of the total population of the country, this was not going to be a sustainable growth proposition. Increasing investments into infrastructure to other parts of Indonesia will mean it’s only a matter of time before FDI follows, and more people in other parts of Indonesia can afford to tile their floors…