At the end of July talk of “the new China bubble” had begun to gain momentum to such an extent that all anyone cared to talk about was “upside risks”. At the same time, we felt that the market remained blind to rising risks of policy intervention. Another dynamic which investors had not been focussing on enough, in our view, was the accelerating flood of placements and new IPOs, which seemed to sprout like mushrooms all over any rally that lasted more than a few days. In this heady atmosphere, we found great comfort in running a tight ship and reining in risk.

Following a steep-ish correction in China markets – particularly the domestic A share market -  and increased investor focus on both the possibility of early tightening and a possibly less than 100% healthy IPO market, we feel that the risk-reward is more balanced and we have been moving to increase our gross with a first-rate selection of longs and shorts while keeping net exposures low.

The exposure we had to Chinese property is largely gone now. This is partly because with no solvency discount, the “margin for error” is smaller and partly because we suspect that some part of the very strong property sales seen in the first part of this year derived from pent up demand, which could fade. Most of all, though, it is because China property IPOs have been getting out of hand. Some of the companies coming to market have pressure from pre-IPO venture capital investors to “do it now while you can” while others are listing mainly because they cannot afford to be the only substantial property developer in the area without access to capital markets. Most of these will be priced to sell. If the IPOs go well it means more competition – and if they go poorly, it should mean a hit to sentiment and compressed valuations for the sector. We have a few shorts here.

While policy-driven sectors such as property and financials were key in the early stages of the recovery, now that China’s economic growth and recovery has broadened out, we have turned our attention to domestic consumption and are now running a substantial gross exposure here with a moderate net long position. Domestic consumption remains a “no-brainer” story in China. The reasons for this are well known and include an under-leveraged consumer, rising incomes, an increasing propensity to consume, increased availability of consumer credit and an improved shopping experience with better retailers. Government policy towards improved medical care  and  social security on to outright subsidies for computers and washing machines is also proving supportive and coaxing savers to spend.

That growth in domestic consumption in China looks like a pretty safe bet has been a consensus among Asian fund managers for some time and we feel pretty confident in saying that it will remain consensus for a while longer. Many of the biggest and best known names such as the premier department store Parkson Retail are already trading at around 30x this year’s earnings for perhaps 20-30% growth over the next few years. While this strikes us as fair, bordering on expensive, given our sense that global investors’ long-term expectations for China’s domestic consumption growth are only going up in the near term, there is a good chance this will get more expensive before it gets cheap. We don’t own Parkson and we aren’t short of it either. The risks here are pretty balanced.

On the other hand, China’s burgeoning sportswear and athletic footwear space is starting to look crowded. While there are perhaps 10 listed department store vehicles in Greater China, there are just as many branded sportswear retailers – and the barriers to entry are lower. Given the rapidly intensifying competition, the likelihood of margin compression, and disappointment is increasing. Dongxiang’s recent decline in same store sales growth may be the canary in a coal mine. We do find many stories to be excited about. Our modest net long exposure to China domestic consumption includes recent listing Lilang (fashion menswear) and Silver Base (liquor distributor that we bought into when other investors sold it off on the wrong inference that it would be suspended along with its main supplier). We also still like some of China’s advertising and media companies.

We also like China’s financial sector, though we do not hold much here just at the moment. We realize views here are somewhat polarized, between those who say that asset quality is sure to deteriorate and others who like the growing loan book and improving margins. We tend to side with the latter. For those who say asset quality will deteriorate we say: perhaps, but what are your assumptions? We estimate that it would take a recession of greater severity than the one we have just been through to really bring pain to Chinese banks’ balance sheets. Loan growth continues to be strong and the loan mix is improving. Margins are expanding. The market is not pricing in much growth. We have even heard some hedge funds are long of US financials and short of Chinese ones, on the spurious logic that US banks could go up by 60% (high beta) while Chinese ones couldn’t (stodgy). We are looking to add here so watch this space.

Many investors have questioned whether China’s growth is sustainable, given the very strong role that government policy played in Q4 last year and during the first half of 2009.  Won’t this all evaporate once the stimulus stops? For starters, infrastructure projects tend to last for several years and many have only just begun construction. There are many more in the pipeline, most of which are necessary (i.e. subway systems in cities with 3mn+ populations, etc). Second, the recovery has now broadened out to private investment (i.e. factory expansions, retail network rollout, residential property, etc) and this process is still in a relatively early stage. We are under no illusions that the loan growth seen so far this year is sustainable at the current pace. That said, the large numbers of projects in process have generated further demand for loans as they broaden out to include working capital demands on suppliers and contractors. Although there will be no repeat of the 2009 surge, we still expect new lending in 2010 to be up significantly from 2007 levels.  Even the export sector, which has so far been “the weakest link” in China’s economy has begun to see a sharp improvement, and will see positive growth by the end of the year. And of course we expect domestic consumption to be a strong and steady positive contributor. The economy is now in a self-sustaining positive feedback loop.

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