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Q1 2019: China

China is a market where, historically, we as a team have struggled to find many high quality companies in which to invest. This is partly due to process: we spend a lot of time studying the historical performance of businesses and past behaviour of owners and managers, and in China these track records are relatively scarce.

Nonetheless, we are well aware of the potential opportunity and are optimistic about generating a small handful of high quality ideas in the country.

From late December through to January, the team met with around 60 mainland Chinese companies through a combination of conferences, phone calls with management teams from our offices in Singapore and Sydney, and by five team members travelling to various parts of the country.

Two team members spent some time in Beijing, meeting a number of software companies, and Xiamen, focusing on some consumer franchises. While it remains relatively easy to get excited about quite a number of Chinese companies on paper – very many have net cash balance sheets, attractive profit margins and so on – once we dig a little deeper, we usually find serious reasons to steer clear. Examples from this trip range from a food company which demonstrates evidence of channel stuffing1; poor employee working conditions and substandard hygiene; to an internet security software business which has been in court for tricking its customers into thinking its browser software is an official patch from Microsoft or into believing a Yahoo toolbar is malware; and therefore makes uninstalling its anti-virus software extremely difficult.

We continue to believe strongly that a management team which fails to look after its workers is one which is less likely to do the right thing by minority shareholders, and a company which takes shortcuts in its operations is one which is likely to display risk-loving behaviour throughout its conduct, including accounting methods. Franchises built on cutting corners are unlikely to endure over the long-term.

Nonetheless, of the thousands of stocks listed in mainland China, we are looking for only two or three attractive ideas for our portfolios. We are perfectly happy discarding those companies which give us cause for concern. Our focus on capital protection and the lack of any pressure on us to conform to a benchmark mean we have the luxury of being extremely choosy.

At the other end of the country, three team members spent time in the Pearl River Delta, including in Shenzhen, which has emerged as China’s answer to Silicon Valley. A dense network of innovative technology firms are based here, ranging from fabless semi-conductor designers to online delivery start-ups.

The pace of change and short product cycles in technology hardware makes it difficult for us to properly assess the sustainability of any given firm’s profitability, especially given it appears we may be approaching ‘peak smartphone’. We continue to find quality of franchise somewhat lacking in these areas.

The most cutting-edge aspects of Shenzhen’s economy no doubt are focused on Artificial Intelligence and Machine Learning, technologies which are likely to be extremely important in coming decades. We visited some companies producing advanced, and hauntingly effective, software for facial recognition and gathering data on the population. The close involvement of the state with these companies means we find it very difficult to get comfortable enough to consider investing given their use in political repression.

We as a team continue to debate and constantly reassess our view of the quality of some of the more formidable franchises to have emerged in China in the technology space, not least Tencent. Of particular interest to us is that the proportion of revenues derived from computer games has fallen from 60% just four years ago to half this figure today. In our view, these are low quality earnings and the quality of franchise is improving as this figure falls. We still retain concerns around Tencent’s corporate structure, opaque accounting and the proportion of profits being earned from listing subsidiaries in a bubbly market for technology stocks, and so for now will continue to sit on the sidelines and watch.

Our visit to China was also an opportunity to meet with Foshan Haitian, our one current mainland China holding. Following a factory tour, we were lucky enough to meet with the Chief Financial Officer, which helped build our conviction in the company’s history and quality of management. During the trip, we also met several direct competitors and purchasers of Foshan’s, which were further chances to find out more about the company’s positioning and build our conviction. We certainly left China with an enhanced regard for the dominance of Foshan’s franchise in the soy sauce market, and the opportunities they have in the long-run to compete in adjacent condiment markets. China remains a difficult market for us and we will continue to be extremely picky in making investments there, as everywhere else. We will not compromise our approach to only investing in high-quality companies in order to gain exposure to a particular market, no matter how large a percentage of the index it becomes. We intend to continue visiting China, writing reports on Chinese companies and interacting with as many management teams from the country as we can in the pursuit of a small handful of potential high-quality, long-term holdings.