What trade war? A cultural obsession with getting into the best schools and a taste for expensive liquor underpin Paradice’s emerging markets strategy.
Being entangled in an anti-corruption crackdown at the hands of the Chinese Communist Party is not a common marker of performance for a stock.
But when sales for the high-end liquor maker Kweichow Moutai to China’s elite collapsed amid a corruption upheaval, the company turned to the broader and growing luxury consumer market.
That adaptation, says portfolio manager Edward Su, demonstrates the type of resilience behind Kweichow’s success.
Su and colleague Michael Roberge head up Paradice Investment Management’s emerging markets, or EM, fund, of which Kweichow makes up one of the 46 portfolio companies.
Kweichow Moutai makes the eponymous Moutai, a highly-prized brand of China’s “national liquor”, baijiu.
Moutai was commonly consumed by the elite and offered during dealings with officials.
But sales to the top end of town collapsed from 2012 following the start of the anti-corruption campaign initiated by the newly-installed head of the CCP.
“This is basically when the President Xi Jinping started going after some of these corrupt policies – one of the policies was that a lot of the Moutai liquor was being gifted to politicians to curry favour – and so he started to aggressively crack down on that,” Su explains.
As the demand from that segment fell, Moutai’s significant mark-up allowed a cut in price to capture the broader and rapidly growing luxury consumer market.
But the price drop did not hit Kweichow’s margins – it was downstream businesses that adjusted prices.
“The whole industry was kind of caught up in this and [Kweichow] was the only baijiu company at the premium end that did not have to cut their ex-factory prices. So their margins actually were quite resilient throughout this period.
“In that period, the price came down but the demand was still rather resilient, and there were ample people who are waiting on the sidelines willing to buy the liquor.”
Moutai baijiu fits into the EM fund’s focus on the structural change in the consumer markets of the developing world.
Using a bottom-up approach, the fund targets quality companies that provide exposure to the increasing wealth per capita of these highly-populated geographies.
Moutai exemplifies one of the trends that factor into other companies in the funds portfolio: “premium-isation”, which is the increased preparedness of consumers to spend more on premium, discretionary products as their wealth increases.
“[Moutai is] selling for upwards of ¥2400 [$500] right now to the end consumer and that’s an example of kind of aspirational brand that people are [buying],” Su says.
And for Su and Roberge, exposure to this theme is not limited to buying companies in emerging markets, but can include multinationals in the developed world with an EM sales presence, such as the €203 billion ($326 billion) luxury goods giant LVMH Moët Hennessy Louis Vuitton.
“[It] has about a 30 per cent-plus exposure to the Chinese consumer by nationality and we own that as a play on emerging markets despite it obviously being listed in France.”
But buying a company like LVMH for exposure to developing markets can mean paying more. The average price-to-earnings ratio for the MSCI Emerging Markets Index was 13.5 at the end of October. LVMH trades on 31 times earnings.
But that need not be a dealbreaker, provided the opportunity otherwise stacks up, according to Su.
“Our valuations would probably tend to be a bit higher than the [EM] index, but we don’t focus so heavily on valuation as a starting point,” Su says.
“For us we care much more about the business model, then thinking through what multi-year earnings growth is going to look like.
“Because, really, that’s going to be what drives compounding [returns] and not trying to buy something at 15 times [earnings] and hoping it goes up to 20 times.”
The fund has held LVMH since inception in May, during which time the stock added about 15 per cent. Over the last twelve months the stock has climbed about 51 per cent.
Kweichow’s share price has more than doubled. The Shanghai-listed company is up close to 120 per cent since November 2018.
Prior to joining the boutique Paradice, Su and Roberge were at Artisan Partners, the large, US-based investment manager with $US112.5 billion ($164 billion) under management.
“We were the number two people behind the Artisan developing world strategy,” Su says.
“I think we reached a point in our career where we wanted to make a bet on ourselves, and then take a little risk and head up our own strategy.
“The Paradice model fit because they allow their investment teams to run themselves rather autonomously.”
While there are 46 companies in the Paradice EM portfolio currently, the fund can hold up to about 60 companies, and does not look to the benchmark MSCI Emerging Markets Index when it comes to portfolio construction.
And the freedom to diverge from the benchmark has seen the portfolio go overweight in the world’s second largest economy.
“We’re benchmark agnostic but China is such a big market, a deep market, with a lot of good companies [and] dominant companies, and so for us China would be our biggest market as well.”
The fund’s combined exposure to China and Hong Kong is close to 36 per cent, Su adds.
But the strategy driving the increased market weighting is not about the country’s significant export industries.
“In terms of our exposure to China, what we see there is a very vibrant consumer,” Roberge explains.
“We’re very focused on these domestic consumption stories and what we see is a very large population of consumers that are aspirational, willing to increase spending quickly, in areas that matter to them.”
And while Roberge acknowledges that there are concerns of a moderation in the Chinese economy, including as a consequence of the trade war with the US, the opportunities remain compelling, he says.
One company that is defensive due to non-cyclical demand is New Oriental Education and Technology Group, Roberge explains.
The Chinese company, which is listed on the New York Stock Exchange, has successfully targeted preparedness of consumers to give their children the best opportunities through education.
“What you have in China is a strong cultural obsession with kind of getting into the best schools. New Oriental is premium after school tutoring, and one of the largest providers of private education in China,” Roberge says.
“The [kindergarten] through year 12 after school tutoring market is large, about ¥500 billion ($104 billion), and growing at a double-digit rate.”
Over the last 12 months the company’s share price has increased by about 100 per cent, although the investor demand has now driven the P/E to 59 times.
“The exciting thing for us is that we see in the emerging markets a very large population with per capita income that is rising,” Ed says.
“There’s a lot of growth potential in quite a few of these markets, whether it’s China, India, Brazil, or Russia.”
by Luke Housego