Shenzhen: The World's Most Dynamic City

As this is being written in mid-November 2014 most stories on China and Hong Kong in the financial press are about the "through-train"  scheme that allows cross equity investments between Hong Kong and Shanghai.  There are a lot of articles that can be found on this by better writers so I won’t add my two cents about this except to say it’s about time. 

While this is a very important step toward a more open China I think investors should not forget about Shenzhen, which in my opinion is much like Shanghai during the latter’s 1860s to 1940s heyday.

I believe that Shenzhen is the most dynamic city in the world’s most dynamic country. Foreign investors would be well-served to spend more time skipping across the border rather than just following the herd to Shanghai and Beijing.

Despite its freewheeling history and reputation, Shanghai is very much a government-led growth story.  Huang Yasheng and Qian Yi came to this conclusion in their co-written chapter titled “Is Entrepreneurship Missing in Shanghai” [1].   In it they noted that: “The story of Shanghai is one of two extremes.  At one extreme, Shanghai is viewed as a model of economic development and as a symbol of a rising and prosperous China. At the other extreme, as we have shown, Shanghai appears to lack private-sector entrepreneurship – a microeconomic mechanism widely regarded as important for economic growth, competition, job creation and innovation” (full document available here).  

After China was liberated in 1949, one of the first things the new government did was to clean up what was then perceived to be the “whore of imperialism”[2]. They did a very thorough job and most of Shanghai’s famous entrepreneurial zeal either left or was extinguished. Many of the more successful entrepreneurs fled to HK, Taiwan or further (one of these is Sir YK Pao whose biography I reviewed and can be found here).

The World’s Most Dynamic City  

Shenzhen’s growth in the last 25 years has been amazing.  It has evolved from a sleepy agricultural town of some 300,000 people when I first crossed the border in 1985 and is now a thriving metropolis of some 14m. 

The catalyst for Shenzhen’s rapid development was its designation as a Special Economic Zone (SEZ) under Deng Xiaoping.  One of its key backers at the time was Xi Zhongxun, Xi Jinping’s father (my profile of XJP is here).  

Leading the charge was Hong Kong’s internationally famous entrepreneurs who quickly relocated factories and manufacturing facilities.  Like Shanghai at the turn of the nineteenth century, Shenzhen initially grew from textile and other labor intensive manufacturing before expanding into trade and financial services.   Also like Shanghai, its openness to ideas and information brought new ways of thinking and information previously unavailable. 

Shenzhen's population came from all over China for a variety of reasons. The most important being that there are more opportunities. Others come for the better weather, freer lifestyle, or youthful ramblings and ambition. 

But opportunity and the possibility of a better life make up the key reason. This is analogous to the ‘old’ Shanghai where people from all parts of China – particularly from the lower Yangtze River area - moved into what was arguably China’s first cosmopolitan city.  There – as in Shenzhen today – they could mostly leave behind the prejudices that engulfed their traditional hometowns and make a new start in a young, vibrant and diverse city.

Like many new cities Shenzhen is reaching for the stars.  When it was built in 1985 Shenzhen’s International Trade Center was China's tallest building.  Later the Shun Hing Square become Asia's tallest when it was completed in 1996. The KK Finance Centre Plaza is now the tallest building in the city with 100 floors and a St. Regis hotel.  Its title will be short-lived as the 115-story Ping An International Finance Center is due to be completed in 2016 (from Wikipedia link here).

The border between Shenzhen and Hong Kong is coming down.  I’ve met several people who commute into Hong Kong’s financial district from their cheaper, bigger and probably more comfortable apartments in Shenzhen.  I’ve also met people who commute to Shenzhen on a regular basis as that’s where the growth and opportunities are.  This is especially true for young Hong Kong professionals that don’t want to uproot their families.

I think many foreigners also tend to overlook Shenzhen’s growing investment and financial sector.  In addition to being the home of Ping An and China Merchants Bank, there are numerous fund management, banks and other financial firms based in Shenzhen. 

From personal experience several China focused fund managers have opened offices in Shenzhen to complement what they do in Hong Kong.  They are there not only because it is cheaper but also because it is actually China.  Which brings us to another topic.

Despite the growing links between the two, Shenzhen feels like it is China while HK maintains its separate system. Chinese nationals still need a passport and a permit to cross the narrow border into HK.  In Shenzhen one gets the pulse of modern China that eludes Hong Kong’s more international and ‘sophisticated’ population (or stuck-up depending on the circumstance).

Domestic brands that are big in China barely advertise or have made inroads into Hong Kong.  People in Hong Kong buy Daikin and Panasonic air conditioners.  People in Shenzhen buy Gree and Midea.  People in HK buy Japanese and German imported cars.  People in Shenzhen are just as likely to drive a Geely or Cherry.

Many of China’s largest and most successful privately-owned companies are located in or near Shenzhen.  These include Tencent (China’s largest internet portal), ZTE (mobile devices), Ping An (largest private insurance company), Huawei (telecom hardware), BYD (electronic vehicles), Konka (electronics and telecom hardware), and Skyworth (televisions).

But it is not the big companies that really contribute to growth and progress as it is the small and medium ones that are developing the next big thing.  

Stock Markets

The Shenzhen stock market seems to reflect the city’s youthful spirit and aspirations.  It has three ‘boards’ with different listing requirements: the Main Board, SME (small medium sized enterprises), and ChiNext (even smaller and younger companies). 

Altogether there are just over 1,600 companies listed in Shenzhen compared to 960 in Shanghai.  The average size of companies in Shanghai is much larger and includes some of the largest companies in the world such as China’s large SOE banks, telcos, and petroleum companies.  These super large SOEs account for close to 30% of Shanghai's total market capitalization. 

The Shanghai market is also more concentrated.  The five largest stocks in Shanghai account for 25% of the market value whereas the five largest stocks in Shenzhen account for just over 4%.

Shenzhen Stock Exchange

	Main Board	SME	Chinext
Number of Companies	480	726	400
Total Market Cap (In RMB b)	4,612	5,026	2,234
Average PE Ratio	20.9	41.4	67.8

Source: Shenzhen Stock Exchange Website (17 Nov 2014)

Shanghai Stock Exchange

Number of Companies	960
Total Market Cap (In RMB b)	18,097
PE Ratio (weighted average)	SSE180 Index: 9.1 SSE 50 Index: 8.0 SSE 380 Index: 26.9

Source: Shanghai Stock Exchange Website (figures above from end Oct 2014)

A quick glance at the five biggest companies in each market reinforces Shanghai's government led development.  The five biggest companies listed in Shanghai are all majority stated-owned and controlled by either SASAC or Huijin.

However none of the five largest companies listed in Shenzhen are majority owned by the government.  Three have a distributed shareholder structure with no single entity controlling more than 20%.  The two privately-held companies – BYD and Midea – are owned and controlled by individuals.

Shenzhen’s listcos are not cheap however.  Its main board now trades at an average PE of 21x.  The SME and Chinext are even more expensive at 41x and 68x respectively.  It seems that investors are expecting tremendous growth from the smaller companies listed in Shenzhen.

Shenzhen Stock Exchange – Five Largest Listcos

	Controlling Shareholder	Market Cap US$B	% of SZSE’s Total Market Cap
Ping An Bank	Distributed	20	1.0
China Vanke	Distributed; Central SASAC is largest shareholder	17	0.9
BYD Co. Ltd.	Private; Wang Chuan Fu and Lu Xiang-Yang family	17	0.8
Midea Group	Private; He Xiangjian	15	0.7
BOE Technology	Distributed; Beijing SASAC is largest shareholder	15	0.7

 Source: FactSet

Shanghai Stock Exchange – Five Largest Listcos

	Controlling Shareholder	Market Cap US$B	% of SSE’s Total Market Cap
PetroChina	Central SASAC	230	6.3
Industrial and Commercial Bank	Huijin	218	6.0
China Construction Bank	Huijin	182	5.0
Agricultural Bank	Huijin	139	3.8
Bank of China	Huijin	137	3.8

 Source: FactSet

Huge Caveat

Equity investors should tread carefully.  While there’s a lot going on just north of my Hong Kong base, valuations in Shenzhen are scary.  At 20x to 60x earnings much if not all of a firm’s growth is likely to already be reflected in its valuation.  Shenzhen is very dynamic, but no matter how dynamic things are, paying too much for any stream of future cash flows runs the risk of a permanent loss of capital.

And let’s not forget the skyscraper curse.  While not scientific its uncanny how economic decline often follows when tall, record-breaking building are announced or built. The Empire State Building was completed on the eve of the Great Depression, the Petronas Towers were finished just as the Asian Financial Crisis unfolded, and the Burj Khalifa was unveiled about the same time as Dubai/UAE economy faltered in 2010 (more info here).

Shenzhen Represents China's Future

Shenzhen has a lot going for. It is the headquarters of some of China's largest private companies. It has a lots of start ups and available funding.  Its population is relatively young and mostly composed of migrants from other parts of China.  Even its stock market has outperformed Shanghai year-to-date. 

While its equities are expensive investors could do worse than hopping across the border. With some 1,600 companies to choose from, I suspect there are many diamonds yet to be found.

Shanghai is not dead by any means, but in my mind it is more of a representation of China’s past.  Shenzhen is China's dynamic, private and entrepreneurial future. 

Shenzhen and Shanghai Composite Indices - 17 Nov 2014 YTD

Source: FactSet

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[1] International Differences in Entrepreneurship; Edited by Josh Lerner and Antoinette Shoar, University of Chicago Press, 2010.

[2] Taken from “The Party”, Richard McGregor, Allen Lane, 2010

Peripheral Europe On Sale. Follow The Smart Asian Money

European equity markets are in a funk.  The Euro is down some 8% vis-à-vis the USD and RMB over the last several months.  Most markets have given up their gains earlier this year and several are trading far below than where they were at the beginning of the year. The fall is particularly acute in several of Europe’s ‘peripheral’ markets of Greece, Portugal and Austria.  The Athens Composite Index is down 31% in the last six months alone.  

As at 20 Oct 2014	3 months (% chng)	YTD  (% chng)
Portugal	-19.4	-23.8
Greece	-18.1	-20.5
Austria	-12.1	-18.2
Italy	-9.2	-2.2
Spain	-5.3	0.0
Hungary	-3.1	-7.6

Many in the financial community are projecting deflation, a third recession and a breakup of the Eurozone if not a breakup of the entire European Union.  

Even a European friend has turned bearish saying the cultural differences between the countries are just too difficult to overcome.  He believes that the people and culture of Germany, France and Italy - the three biggest countries in the EU - are just too different for the countries to stay together.  If this is the case, what about the Greeks, Poles and Portuguese?

However other native European friends – and many Asian ones – are looking at Europe and salivating at its cleaner air, cheaper prices and overall better standard of living compared to Hong Kong if not much of Asia. 

I don’t know for sure, but I suspect many of these worries are already reflected in equity prices, especially those that suffered the most during and since the 1998 global equity market meltdown. 

Except for similar demographics, the comparison to Japan doesn’t make sense.  Japanese equities traded at some of the world’s highest ever valuations in the late 1980s and early 1990s with PEs and CAPEs reaching into the 100s and 90s (see this website). 

In contrast ‘peripheral’ European countries such as Greece, Portugal and Austria have amongst the least expensive equity markets in the world based on several longer term valuation metrics.  

Other asset prices have also decreased.  Newspaper articles note that property prices are down some 30% in many European countries.  Several friends have recently bought or are thinking of buying property in various European countries.  

My opinion is of course colored by being located far away from the storm in Hong Kong. I’m not subject to the nightly news reports on unemployment, stagnation, and government ineptitude that must drag on sentiment.

In fact my more positive view is formed by seeing and hearing reports of Asian investors – mostly from China – taking advantage of low asset prices and investment friendly policies.  (See article here.)

One of the largest and highest profile foreign investors in Europe is Shanghai’s Fosun group which I wrote about in my 2011 book on Hong Kong and China conglomerates.

For those that don’t know, Fosun is one of the largest privately held conglomerates in Mainland China and likely the most active in raising equity capital.  It has stakes in over 15 listed companies and, through various PE funds, another 16. 

They are amongst the better investors having grown from its biotech roots, into a diversified conglomerate mostly through savvy investing.  The group’s co-founder and largest shareholder, Guo Guangchang has been compared to both Warren Buffet and Li Ka-shing, Asia’s richest person.  (Full Disclosure: I hold shares in a couple of the companies they’ve taken stakes in). 

In the last few years Fosun has bought several companies in ‘peripheral’ Europe.  This includes Folli Follie, the Athens-listed accessories designer and retailer, Club Med, the Paris-listed vacation and resort provider, and Raffaele Caruso, the Milan-listed men’s suit tailor.

Most recently it has been buying assets in Portugal, one of the worst hit countries since 2008’s financial crisis.  So far this year they’ve bought subsidiaries of state-owned insurance company Caixa Seguros E Saude and one of its largest health care providers, Espirito Santo Saude.  They are also reported to be looking at Novo Banco, which was formed from the remains of this year’s big corporate blow-up of Portugal’s than largest lender, Banco Espirito Santo. 

There are a lot of risks in Europe.  The Euro could continue to slide, the needed policy changes may never materialize, the Euro and European Union could break up.  These are much of the same fears that gripped financial markets some two years ago and sent equity markets there plunging.

And they could continue to plunge.  My base case for crisis investing is Indonesia which suffered the most during the Asian financial crisis.  Between 1998 and 2003 the Indonesian index rose and fell by over 30% no less than five times.  After an initial 108% rally from its March 1998 bottom, it fell 42% between July 1999 and March 2001.  If Europe is similar, the fall in equities prices may have further to go and Greece’s 30% dip over the last eight months could extend further despite its attractive valuations. 

However buying an asset at a low price tends to minimize risk of further downside. Prices are low now, but this does not mean they can’t get lower going forward.  But than prices could just as easily rise. Investors who missed 2012's low now have a second chance to get in at decent prices. 

Many, if not most or all, of the risk  are already reflected in the prices, and investors could do worse than taking advantage of the negative sentiment and news flow to pick up some quality assets at decent prices.  Longer term investors like Fosun are making significant investments and this may be a chance for the rest of us to get some others while they’re on sale.

Book Review: Critical Generations – Out of the Succession Dilemma of Chinese Family Businesses (关键世代：走出华人家族企业传承之困) by Prof. Joseph P. H. Fan

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below intrinsic levels if not outright cheap.

Academia is one of my favorite sources for information on corporate leaders and business structures.  There are a handful of academics in various business sub-disciplines that look at corporate structure, and objectively research leaders' backgrounds and relationships.  While most write for entrepreneurs and a public policy audience, many times their studies contain helpful information for investors.

Professor Joseph Fan who works at the Chinese University of Hong Kong is one such expert.  Individually and with others he has authored and published many studies and articles on what works and does not for family owned businesses in Hong Kong, Taiwan, Mainland China and other Asian countries. (Prof. Fan's research and personal homepage is here).

This book – like many of his other studies – is geared more toward helping entrepreneurs and wealthy families structure with their succession plans.  Intergenerational gaps many times lead to failing businesses, broken extended families and sometimes both.

While investors are not the target audience Critical Generations does contain some interesting observations:

• Many companies listed in greater China are still led by the founder. In many instances the founder is quite old and close to retirement age. The next ten years will see a lot of changes in corporate leadership as their founders and key builders step down (at least the ten years after the book’s 2012 publish date).

• Share prices decrease in anticipation of the founder leaving the company.  In a study that looked at 250 family-owned companies listed betweeen 1980 to 2000 in Hong Kong, Taiwan and Singapore, Prof. Fan found that share prices decreased over 50% in the five years before the founder retired.

• The transition does not mark the end of share price fall.  In the five years before and three years after the succession, the market value of 200 family owned listcos in Hong Kong, Singapore and Taiwan went down by 60% on average. In other words, if an investor bought shares valued at $100 five years before the succession, the value of their shares would be reduced to an average of $40 three years after the succession.  Hong Kong companies dropped the most losing some 80% on average with Taiwan and Singapore family owned companies falling about 40% and 20% respectively.

• Founders bring intangible benefits. Owing to their personal attributes such as creativity, leadership style, craftsmanship, and personal connections with company stakeholders, the founder is a major ‘intangible’ asset and many times the essential asset.  Think of Li Ka-Shing and Steve Jobs Prof. Fan writes.  The book goes on to note that rarely does the company do better under the second generation than it did under the founder.

• Market notices the passing of founder.  Not all successions result in a decline in market value. In some cases, the passing or a rumor circulating around the poor health of the leader leads to positive market response.  A year after the Hong Kong industrialist Lim Por Yen passed away in 2005, share price of his Lai Sun group companies increased by some 50%. (For a more recent example, Sincere’s shares increased by 40% after its founder’s death – see article here).

• Political connections hurt in China.  In another study Prof. Fan tracked the post-IPO performance of 630 state-owned Chinese enterprises.  He found that firms with politically connected CEOs (i.e. CEOs who are current or former government officials) on average exhibited a 40% loss on market-adjusted stock returns over the three-years subsequent to their IPOs, while those without politically connected CEOs deteriorated by just 10%.

• In contrast government connections can help in Thailand.  Prof. Fan’s study on prestigious Thai-Chinese families reveals that a marriage between the offspring of government officials and business leaders led to a 4% increase in the family firm’s market value. Contrastingly marriage to ordinary families contributed nothing to the share price.

• Trust-held companies trade at lower valuations. Fan’s research finds that among 216 family owned listcos in Hong Kong, one-third are controlled by trusts, but the performance of these companies is no better than those that are directly controlled by family members.  Financial performance of businesses that are controlled by trusts tend to be worse off when family members have a dispute.
• During the financial crisis the price-to-book value of businesses held directly by family members fell to 0.97 while for businesses controlled by trusts the ratio fell to 0.87.
• Companies controlled by trusts are more reluctant to invest on improving business efficiency, and have slower growth rate in the number of employees and sales.
• Family owned companies controlled by the trust structure tend to distribute more dividends. 

• More firms to use capital markets to spread wealth.  If greater China entrepreneurs take Professor Fan’s advice, there should be a lot more public companies. He wrote that a stock market listing is a good way to distribute ownership to family members. 

The above bullet points account for a small part of the book.  The bulk of it provides research, insights and tools families can use to improve their structure and, with luck and foresight, the firm’s transition to the next generation.

Note that the book was originally written in Chinese, although several of Prof. Fan’s studies have been published in English.  My very capable assistant JC Ho read and summarized the Chinese version from which this blog post is based.

Critical Generations can be ordered from the Chinese University of Hong Kong (link is here)

Prof. Fan’s new book The Family Business Map: Assets and Roadblocks in Long Term Planning is in English and is due to be published toward the end of October 2014 (link here).

Alibaba, Hong Kong and the US's Hot IPO Market

As this is being written Alibaba is in the middle of its roadshow to promote what is shaping up to be one of the world's largest ever IPOs. 2014 is turning into an investment banker's wet dream with IPO activity in the US expected to be the best since 2000 according to a recent report by Renaissance Capital.  

As most readers will remember the year 2000 was when the Nasdaq topped out at just above 5,000 before falling by almost 80% in the following 2.5 years.  The index is now close to that 5,000 level after 13 long years.

This recent history has stuck with me for a while.  As I wrote in a previous blog post my gut feeling is that a large number of IPOs tend to signal an expensive and overbought market.  

What is good for corporate capital raising and bankers is unlikely to be good for investors.

In that post I found that my hypothesis is not watertight, at least on a global scale. In several years an increase in IPO proceeds foreshadowed a good market the following year.  It seems that all the positive feedback from the hype surrounding IPOs as well as good post-IPO performance encouraged people to get into the market. 

What I did find was the opposite.  A widely-followed global index increased every year after capital raised via IPOs decreased.  In other words, investors were rewarded in the year after proceeds raised through IPOs decreased.


United States

Using similar data - this time from Renaissance Capital - it appears that there is a stronger relationship in the US between IPO capital raised and subsequent market performance. (Renaissance Capital's reports can be found here and here.)

As seen in the chart below, the S&P 500 index mostly moved in an opposite direction to the change in IPO proceeds in the previous year.  This happened in 10 out of the last 12 years as shown by the large number of red arrows.

When IPO proceeds increased in one year, the index was largely flat or declined in the following year.  And vice versa.  

The average rise in the S&P 500 index in the seven years after IPO proceeds decreased was 10.8%.  The average fall in the index in the five years after IPO proceeds increased was 0.5%. 

Readers should bear in mind that these are all rough numbers and based on a small sample. 

Hong Kong

Closer to home things get more interesting.  

In the last twelve years Hong Kong's IPO proceeds have given a much different signal. It appears that there is more of a momentum effect of IPO proceeds in Hong Kong.  High IPO proceeds in one year leads to a rising index in the subsequent year.  

In 6 out of the last 13 years the direction of the Hang Seng Index's rise or fall was the same the previous year’s change in IPO proceeds.  In other words, positive IPO issuance in one year tends to foreshadow an increase in the index the following year.

This was almost all during the go-go China boom years of the early and mid-2000s.  IPO proceeds increased some 14x from the 2001 low of HKD22b to the 2006 pre-GFC high of HKD332b.  

Since 2008 there has mostly been a negative correlation between the two.  (Again I need to emphasize the extremely low number of data points).

The average rise in the Hang Seng index in the 8 years after IPO proceeds decreased was just 2.3%.  The average rise in the index in the 5 years after IPO proceeds increased was 10.8%.

Hong Kong More Influenced by the US? 

But where it gets even more interesting is comparing the directional change in the main US and Hong Kong indices.  In almost every year since 2001 the direction of the Hang Seng index was the same as the S&P 500.   This is highlighted by the blue arrows between the last two columns in the chart below.  

From this quick and dirty analysis it appears that the US IPO market has been a better predictor of subsequent performance of the Hang Seng index than the local IPO market. 

This corresponds to my experience. When I was a sell-side equity analyst many of my portfolio manager clients in Hong Kong complained that they spent more time trying to figure out what the US market would do rather than analyze the situation in Hong Kong or China.  

Back to 'Baba

I do not know what direction the Hong Kong, US, or any other market will go next year.  It has been shown time-and-again that most predictions are useless.  In my opinion they are typically no better than one's astrology sign or Chinese zodiac.  

However with Alibaba's huge IPO, US equity indices reaching new highs and some believing that the US equity market is in bubble territory I'm feeling even more cautious than when I wrote the previous blog post last December (see John Hussman's market comment here).

But investors should bear in mind that I had the same feeling when Facebook went public in May 2012. Like Alibaba it was one of the largest IPOs ever. Upon listing it was the largest company to float with a market capitalisation of some USD100b.  It is now worth over USD200b, and is up slightly more 100% since its IPO price.  

Since Facebook's IPO, markets have also done well. The S&P500 and Nasdaq indices are up 41% and 50% respectively. The Hang Seng Index is up 19%. 

I was wrong about Facebook signaling a market top and lost out on considerable upside.  There are many reasons that I could be wrong again, but after this analysis I’m even more cautious on not just the US but Hong Kong as well.