Mid-year outlook July 2023

Good day everyone, I am Jianping Hu, the CIO of Tenbagger Capital. I am pleased to welcome you all to our mid-year review and outlook for 2023. I would like to express my gratitude to our investors and corporate partners for their support. Firstly, I will introduce the changes in our company and the investment process and fund’s performances of the first half of the year. Then, I will report on our current views of the market, and finally, I will answer any questions you may have.

We have a topic for our discussion today that reflects our current view of the market – “Calmness, But Not Lying Flat”. Investing in Chinese assets has entered a new stage that is in line with the development of the Chinese economy and capital markets. At the same time, we do not agree with the very pessimistic views that have been prevalent in the market recently. We still believe that Chinese assets are rooted in the most creative Chinese economy and have bright potential. While the Chinese economy faces challenges, most of these challenges already existed before, and our ability to solve them is stronger ever than before.

From company’s perspectives, we added an analyst to our team, and we are also planning to recruit another two analysts who specializes in consumer and healthcare sectors. If you know any suitable candidates to introduce and welcome to reach out to us. In addition, our quantitative strategy product has made excellent progress since its commercial operation in September 2022. Its performance has exceeded our internal expectations and has shown a decent risk-reward profile.

At the beginning of the year, we believed that investment had entered the era of lean production. On the one hand, the market has undergone significant changes. On the other hand, there is still much room for improvement in the management of our industry compared to other industries, for example manufacturing- the management level is still relatively needed to improve. In the first half of the year, there were minimal changes in our portfolio, and the top holdings remained almost the same. There were some minor adjustments in the holdings of a few stocks, and the holding style also changed slightly.

To recap our portfolio performed very well in January, which made us feel confident and optimistic. However, the performance started to decline in March, and it was negative from April to May. It began to improve slightly after June. The tactical asset allocations behind our portfolio constructions are to hold companies that manage human resources and forklift companies, which express our confidence in the recovery of the Chinese economy and the progress of overseas markets. As you all know that we also hold internet e-commerce, express delivery, and sportswear companies, betting on the improvement of consumer sentiment. We also hold several companies that we have been tracking closely from the bottom up, as well as telecoms operators, which will benefit from improvements in the governance structure of state-owned enterprises (SOEs).

As we have avoided real estate-related companies all along, but one of the property management services stocks we invested in performed below our expectations. We also hold some overseas companies that are mainly focused on the southern countries, expressing our attention to opportunities in that region. We hold few semiconductor companies that underestimated the impact of the semiconductor cycle on profitability, while we continue to keep track of opportunities related to the cycle.

We hold some small companies, which may be more impacted during economic downturns. Apart from few companies, the performance of our top holdings in the first half of the year was in line with our expectations. While some companies experienced a slight decline in profitability due to slow economic recovery and intense competition, most of them have been increasing their actual capabilities and relative positions.

However, the market has placed expectations for many companies under the scenario of long-term concerns about the Chinese economy, which has magnified the impact of these companies' stock prices. Overall, our portfolio is currently showing characteristics of undervaluation. So far, the performance of our fund has been relatively balanced, with no significant differences between those that invest overseas and those that do not.

 One lesson we learned in the first half of the year is that when the market is weak, betting too much on winners in intense competition can result in significant losses in investment experience. This is because even winners are affected by economic downturns, and although their relative positions may improve faster, people still tend to focus on the former.

Overall, there were two market opportunities in the first half of the year. The first was SOEs, and we have been holding assets such as telecoms operators for two to three years. This is mainly based on the decline in opportunity costs, the high barriers to entry in these businesses, the peak of capital expenditures having passed, and the increase of payout ratios in dividends. Later, we realized that these were companies that had the following characteristics: high industry status, reduced industry volatility, peak capital expenditures passed or even decreasing, and most importantly, and directional improvement in their governance structures.

While we focused on one indicator - the ability and willingness to sustain dividends. For small and medium shareholders, if a company with a P/E ratio of 10 never pays dividends, it doesn’t matter how much profit it makes. However, if a company continues to improve its dividend payments, its operations become more closely linked to the interests of small and medium shareholders. We believe that the historical mission of Chinese state-owned enterprises is undergoing some meaningful changes, which are brought about by the changing times, not individual wills.

In the past, state-owned enterprises could be simplified as a mixture of social responsibility and profit objectives, but in the future, the weight of profit will increase. Historically, a significant portion of social responsibility was reflected through new investments, but many industries no longer have much room for new investments. For example, China Shenhua's 100% (1088.HK) dividend payout in the coal industry is a leading example of this trend.

The second opportunity is that state-owned enterprise profits will become a sustained and reliable source of income for governments at all levels. As China's nominal GDP declines, tax revenue growth based on turnover taxes will be affected, but the expectations for government spending have not decreased. While property taxes may be a bit far off, governments at all levels can use state-owned assets well. With state-owned enterprises' annual profits exceeding 4 trillion yuan, compared to our fiscal revenue in the range of 20 trillion yuan, if stable dividends of half are paid, it can be a solid source of revenue for government financial budgetary.

For example, in Guizhou Province, people only see the high debt levels, but they overlook the economic potential brought about by the formation of one of the top five total mileage highways in the country, which has surpassed 8,000 kilometres in a short period of time. In addition, Guizhou Province is also a major shareholder of quality assets such as Kweichow Maotai. When we worry about the sustainability of Guizhou's debt or even China's local debt, we often neglect the fact that comparing debt ratios with those of other countries is meaningless in isolation from the asset and liability structure. Considering the existence of a large amount of state-owned assets, our theoretical upper limit for debt is much higher than that of many other countries with similar debt levels but almost no state-owned assets. Assumed Guizhou Province were to sell its stake in Kweichow Maotai, it could solve most of its debt problems.

In summary, we believe that from the perspective of small and medium shareholders, the improvement in governance structures of state-owned enterprises is historically supported and sustainable, and this is the biggest ESG factor for such companies in China. More than a decade ago, when I saw that Russian oil companies had a P/E ratio of only four, we were operating in an environment where A-share companies had P/E ratios in the tens. We thought we had discovered a major opportunity, but in fact, their low P/E ratio and lack of dividends had nothing to do with us. Now we believe that China's state-owned enterprises will coexist harmoniously with small and medium shareholders.

Mr. Xu Gao chief economist from Bank of China International (BOCI) mentioned in an article the perspective of China's high savings rate. Based on his view: one important reason for the lack of harmonization between savings of enterprises and households is that they are separated from each other. As a socialist market economy, China has many state-owned enterprises that can use dividends to bridge the gap between enterprise and household savings and increase consumer spending power. I think we have seen this trend.

Moreover, this type of investment opportunity is not driven by high growth, and it is suitable for a long-term and steady approach. At the same time, it also places high demands on the sustainability and stability of a company's operations. Many companies may not be able to increase dividends to ensure their continued operation. Historically, our market has been characterized as being more focused on financing than on investment. If state-owned enterprises can take the lead in promoting dividend payments, our market can become more balanced.

Another opportunity is in AI, or more specifically, general artificial intelligence. This is a major change, to quote Tencent says is worth investing in for 100 years, and Alibaba says every industry is worth redoing. Even Nvidia's CEO, Jensen Huang, has said that computing is worth redoing. The market prices of companies in this field have already reflected the world's expectations for them. We have not bought any domestic popular companies in this sector, but we can see that the demand for computing power is reflected in Nvidia, and some large companies are continuously improving their models, which can roughly keep up with the level of GPT-3.5. Leading companies are developing some applications, and some Chinese-made components have joined the relevant supply chains.

We tend to believe that China's large-scale models will be a relatively closed market, and computing power is the most obvious demand in the short term. There will be different solutions presented later, and there may be variables in how demand and supply match up. Currently, there is a good match between demand and supply, with good prices, and this needs to continue. Under these circumstances, the corresponding P/E ratio expectations are not low.

Our view is that some domestic companies will develop some applications, but most of them are likely to be trapped in a cycle of trial and error. What is more sustainable are the scenarios? Which can either improve efficiency in existing scenarios or create new ones. We have not seen many companies that can create new demand, although there have been some cost-saving achievements. Currently, we are more focused on applications that have scenarios as they are more sustainable.

Overall, we have some concerns that the expectations for some companies in the A-share market are a bit too high, such as the pharmaceutical and new energy industries, which have been the fastest-growing industries in China in the past five years. However, this does not mean that the stocks of companies in these industries will not decline. One of the major difficulties that the market is currently facing is the aftermath of the overpricing of hotspots. There will be peaks and valleys in the market.

Turning to our views on the economy. There are obviously some challenges facing the Chinese economy, which have been reflected in the PPI and CPI on a macro level. The economic growth rate in the first half of the year was also lower than market expectations, and low prices and a relatively high youth unemployment rate are both signs that the economy has not fully realized its potential. Our views differ from the market's implicit views, mainly in the following aspects:

When looking at the current challenges in the Chinese economy, we cannot just focus on the present, but also need to consider the long-term factors that have led to this situation. Over the past three years, the Chinese economy has faced three major changes: the China-US relationship, the COVID-19 pandemic, and the real estate market. With the support of some policies, our economy has still achieved an average annual growth rate of 4.5%, which is lower than the 6% level in 2019. At the same time, in just three years, the structure of China's economy has undergone significant changes, with the contribution of net exports rising and the contribution of consumption declining. This is due to the expansion of manufacturing investment and the downturn of some service-oriented consumer industries. Our GDP has increased by more than 15% compared to 2019, but many industries, especially some service-oriented industries that can absorb more employment, may not have fully recovered yet. The changes in energy consumption intensity also reflect this transformation. Some links in the real estate chain are still lagging 2019, which may lead to less-than-ideal employment after the pandemic, as well as low-profit margins after the expansion of manufacturing investment, which will affect the confidence of both individuals and entrepreneurs.

The current insufficient total demand is the result of various factors, including some structural factors as well as some short-term impacts. For example, after the peak of the real estate market, there was a drop in demand. However, there are still some limitations on our demand, which will be lifted in the future, providing some help.

The impact of inventory has experienced a passive destocking from pessimism to the release of demand after the Spring Festival last year. Later, as demand weakened, companies took the initiative to destock, which also affected total demand. Currently, inventory is at a low level, and the destocking process in the US has also been added. From the perspective of inventory and the inventory-to-sales ratio, their destocking is also coming to an end.

The decline in consumption rate is evident. Before the outbreak of the pandemic, the consumption rate for urban residents, estimated through household surveys, was 66.3%. In 2020-2022, it was 61.6%, 63.9%, and 61.7%, respectively. With the end of the pandemic and the recovery of production and life, we do not expect to quickly return to the level before the pandemic, but some degree of recovery is a normal expectation. The consumption rate has shown some significant improvement in June, and we have seen signs of continuous recovery in domestic air travel data, which will drive the recovery of many service industries and the continuous recovery of the consumption rate.

We have noticed that the temporary fiscal policies have not been smoothly implemented, which may be related to the strong economic recovery in the first quarter. However, there are increasing signs that some positive fiscal policies are being implemented to support the recovery. Our view differs from the market in that we do not need a major policy breakthrough, but rather the continuity of some temporary fiscal policies, which will have a significant short-term impact on the economy. Monetary policy has been loose, but its full effect requires active fiscal policy coordination. If both policies become positive in the second half of the year, it will be very helpful for the economy.

Looking at the longer term, as China's nominal GDP growth rate continues to decline and the goal of high-quality development is pursued, there is further room for optimization of fiscal and administrative powers between the central and local governments.

We continuously maintain a positive view for the long-term economic situation. There are currently two prevailing views, one of which is the population issue. This is indeed a problem that we have been concerned about since 2012 when Liang Jianzhang's doctoral thesis "Is China Overpopulated?" was published. We realized that he had studied one of the most important issues, which few people were paying attention to at the time. I rarely buy books to give to others, but I gave away many copies of this book. Indeed, we could have acted earlier, but so far, we have not taken too much action. However, consensus has gradually formed. The birth data we see now are without significant policy support. According to our understanding, once there is a consensus, our greatest power will come from "significantly distorting market prices in a short period of time" to tilt resources towards a certain group, such as significantly intervening in the cost of childbirth. At that time, we can draw conclusions about the long-term prospects of the population issue.

Indeed, the population issue is a big problem that needs to be addressed sooner rather than later, and forming a consensus is a crucial first step. In addition, we should also pay attention to another data point that has a short-term impact on the economy. The current population of college students in the workforce is around 100 million, and it will reach around 200 million by around 2030. It will peak around 400 million by around 2040. The dividend from the improvement in the quality of human capital will offset some of the pressure from the increasing population.

There is also a concern about Japanization, which has become a popular view lately. However, we believe that this possibility is very unlikely. The popular explanation for Japan's economy losing several decades is balance sheet recession. However, we cannot equate a normal economic cycle with a balance sheet recession. The passive debt contraction caused by the sustained and significant decline in asset prices has a great deal of specificity. In 1989, when the Japanese stock market peaked, the Japanese stock price-to-earnings ratio was nearly 70 times, while other countries were between 12-15 times. Japan's total market value accounted for less than half of the global market value, and it subsequently fell for 12 years, with 80% decline. Currently, our price-to-earnings ratio is just over 10 times, which is much lower than Japan's at the peak. Therefore, we do not believe that Japanization is a major concern for China's economy.

In addition, China is a dual society, which is very different from the relatively homogeneous society of Japan. This dual society is both our weakness and our development space, and there is still much we can do. We are different from Japan at the time when it experienced income doubling and the island renovation plan, which helped boost its confidence. The fact that China is rising has also contributed to Japan's decades-long stagnation. While there are other countries that are catching up to us, it is almost impossible for them to achieve the same level of rise as China due to our unique advantages.

Therefore, we believe that the concerns about Japanization are not applicable to China's situation. China has its own unique strengths and challenges, and we should focus on developing our own economy in a sustainable and balanced way, rather than comparing ourselves too much with other countries.

In summary, we believe that the current market pessimism is largely a self-fulfilling result. The stock market has fallen, earning money is difficult, and the prevalence of pessimistic comments has played a significant role in reinforcing these negative sentiments. However, we believe that the Chinese economy has shifted from pessimism to optimism and back again in just a few months since the fourth quarter of 2022, and the changes in our emotions have been greater than the slow economic recovery without government stimulus.

Therefore, it is important to keep a balanced perspective, rather than being swayed too much by short-term market fluctuations and negative sentiment. We should focus on long-term trends and fundamentals and take a rational approach to investment and economic decision-making.

Indeed, we cannot go back to the past. For example, in terms of China-US relations, we may not be able to return to the level of cooperation and trust that we had in the past. Similarly, we may not yet have identified the next big industries to upgrade after the photovoltaic, electric vehicle, and pharmaceutical industries. However, in 3-5 years, we may have solved most of the bottlenecks in the semiconductor industry.

Looking at the current situation, AI is thriving in the United States, but the stock prices of Germany and Japan have also risen significantly. Does this mean that their industries are better than ours? The new construction of real estate has already decreased by nearly half compared to 2019, and the new construction of residential buildings in 2022 has dropped to 880 million square meters. However, it is unlikely to drop to zero in a straight line.

Therefore, we should take a forward-looking and adaptable approach, rather than relying too much on past successes or comparing ourselves too much with other countries. We should focus on our own unique advantages and opportunities and invest in research and development to stay ahead of the curve.

It is true that the market's implied expectations are often too pessimistic, as we have seen in the case of ADRs stocks. Due to the tensions between China and the United States, domestic regulations, and high valuations in the past, many investors have lost confidence in these stocks, causing them to drop significantly. However, many of these companies have a very high net cash ratio, stable business, low incremental capital expenditure, and a very low price-to-earnings ratio. Even if they do not trade, many of these companies will not be affected in the long term.

It is true that even if China-US relations enter a period of ice age in the second half of this year, there may still be seasonal variations in the relationship, which reduces the risk of miscalculation. In addition, time is on our side in terms of inventory, fiscal policy, various economic policies, and low interest rates. The exchange rate is also lower than it was at the beginning of the year, which may boost exports. The data on summer travel is also improving, and with a price-to-earnings ratio of just over 10 times, we do not believe that there is a need to be overly pessimistic.

China's economy and stock market have changed significantly in recent years, and it is no longer as easy to make money as it was before. This is also true for the United States, where it is difficult to make money outside of a few companies. However, we should remain calm and objective, and avoid the extreme approach of "lying flat". The future of China's economy and market is still promising and worth looking forward to.

Assuming a thought experiment. If we were to develop photolithography machines, with a plan to complete the project within three years, but instead we managed to complete it in just one and a half years, it would be a good thing. After completing this project, we could move on to other things, and we could celebrate our achievement with a toast.

Now, let's compare this with building houses. According to the general rule in other countries, it takes a developing country half a century to reach a point where each person has an average of 40 square meters of housing. However, China has achieved this in just 25 years. Despite this achievement, many people are worried rather than proud. It is true that construction workers cannot easily transition to other jobs, but overall, this is a happy problem to have. It is much better than taking half a century to solve this problem, and it provides us with more options.

Certainly, choices also involve interests, but having more choices should be better, not worse.

The challenges that China faced in the first half of this year were real, and different interpretations and assumptions about the causes of these difficulties have led to different emotions. China is a large country with a high savings rate, insufficient employment, a deep and broad industrial structure that is constantly upgrading, and a domestic market with many untapped opportunities. Therefore, the problems that China is currently facing are mainly cyclical and developmental in nature. We believe that the market is too pessimistic about China’s prospects.