bingfengwu
What Happened
The MSCI China All Shares Index rose 3.5% in the quarter, its first positive quarterly return since the first quarter of 2023, as the government announced more policy measures to try to boost the economy and stabilize the country’s ailing real estate sector.
In April, China released details for a trade-in program for electric vehicles, equipment and home appliances. Although expectations were high, early results seemed underwhelming. Only 113,000 cars qualified for trade-in subsidies through the end of June—a blip in a country where monthly sales exceed two million cars. Local governments, which are responsible for supplying between a third to half of the funds for the subsidies, are also hampered by high indebtedness and poor fiscal conditions.
Meanwhile the real estate sector’s woes continued as home sales by value tumbled 30.5% in the first five months of this year compared to the same period last year. Among the many measures announced in May to boost this sector was a combination of lower down payment requirements along with lower mortgage rates for both first- and second-home purchases. Local governments have also been urged to instruct state-owned-enterprises to purchase some unsold home inventories for redeployment into affordable housing. The announcement of these policy measures by the government led to an improvement in sentiment and returns for companies in the Real Estate sector. Stocks of China’s power utilities companies, indirect beneficiaries of a stabilization in real estate, rallied during the quarter on expectations of better demand over the next few years from growth in AI data centers, solar and electric vehicles, all energy intensive businesses. Utilities was the best performing sector in the quarter.
MSCI China All Shares Index Performance (USD %)
|
Sector |
2Q 2024 |
Trailing 12 Months |
|
Communication Services |
13.5 |
4.7 |
|
Consumer Discretionary |
1.7 |
-4.6 |
|
Consumer Staples |
-11.0 |
-18.8 |
|
Energy |
10.3 |
38.3 |
|
Financials |
8.3 |
6.8 |
|
Health Care |
-9.0 |
-25.6 |
|
Industrials |
3.9 |
-7.4 |
|
Information Technology |
0.9 |
-16.1 |
|
Materials |
-1.1 |
-2.1 |
|
Real Estate |
1.5 |
-28.2 |
|
Utilities |
15.5 |
18.2 |
|
Source: FactSet, MSCI Inc. Data as of June 30, 2024. |
|
Companies held in the portfolio at the end of the quarter appear in bold type; only the first reference to a particular holding appears in bold. The portfolio is actively managed therefore holdings shown may not be current. Portfolio holdings should not be considered recommendations to buy or sell any security. It should not be assumed that investment in the security identified has been or will be profitable. To request a complete list of holdings for the past year, please contact Harding Loevner. A complete list of holdings at June 30, 2024 is available on page 6 of this report. |
Communication Services was another strong performer, led primarily by Tencent (OTCPK:TCEHY), whose shares rebounded after fears related to spending curbs for online gamers proved to be unfounded. The government’s stance towards gaming companies currently appears supportive, with positive remarks from officials this year. Tencent’s business outlook remains very good, led by strong demand for video account advertisements while its new game launch pipeline looks impressive.
On the other end of the spectrum, Consumer Staples was the weakest sector, reflecting tough demand conditions in the country. Moutai, a market leader in premium alcoholic beverages ( baijiu), saw wholesale prices for its products decline sharply, signaling weak retail demand. That triggered a sell-off not only in Moutai’s stock, but also those of baijiu manufacturer Wuliangye Yibin and other liquor companies, which dragged the entire sector.
By style, the top quintile of quality was the worst performer and the only quintile that had negative returns. The value rally currently underway in China also remained firmly in place, with double digit returns for the cheapest quintile of stocks, led by outperformance in the shares of low-quality utilities, banks and energy companies. For the last three years, the cheapest quintile of stocks has outperformed the most expensive by nearly 3,000 basis points on an annualized basis. The strength of low-quality companies may have been triggered by supportive comments from Chinese officials in 2022 as well as documentation in 2023 mandating that state-owned enterprises improve corporate governance standards by appointing external and independent directors to their boards and evaluating their efficacy.
Geopolitical tensions also continued during the quarter. The most prominent was related to a European Union investigation to determine whether Chinese Battery-Electric Vehicles (BEVs) benefit from unfair subsidies. Following the investigation, the European Commission announced that it will levy provisional duties on Chinese-made BEVs ranging from 17.4% on those made by BYD (OTCPK:BYDDF), China’s biggest electric car maker, to 38.1% on those made by SAIC, the largest state-owned car manufacturer in China. The new duties will be in addition to the EU’s existing 10% most-favored nation tariffs on Chinese BEVs. This will likely lead to a slowdown in imports of Chinese-made BEVs and electric vehicle components into the EU over time, and also risks potential retaliation by Chinese regulators on imports of goods from the EU, including cars. Last year, China was the top importer of EU merchandise while the EU was China’s top export and import partner. Weeks earlier, the United States also announced that a tariff on Chinese electric vehicle imports would be raised from 25% to 100%, however the impact should be minimal since American imports of EV from China are negligible.
How We Did
The Chinese Equity composite declined 0.3% gross of fees in the second quarter, compared with the 3.5% rise of the MSCI China All Shares Index. Weak stock selection in Industrials and Information Technology were the primary causes of the portfolio’s relative performance shortfall, offsetting strength in Health Care.
In Industrials, our capital goods holdings fared the worst. Sanhua Intelligent Controls, which makes thermal management components, reported underwhelming 2023 and first quarter 2024 results, reflecting a slowdown in its auto parts business due to slower end market demand from customers as well as escalating rivalry as competitors won more business from new entrants in the electric vehicle market. Shares of Inovance, the domestic leader in industrial automation control components, declined due to weaker May order growth following a strong April, as well as downward earnings revisions (which still project 10%+ growth). Shares of pneumatic-equipment manufacturer AirTAC (ATCXF) also fell on lower-than-expected sales in May.
In Information Technology, increasing competition has hurt solar equipment company LONGi, which is enduring a downcycle fueled by industry overcapacity. Shares of semiconductor manufacturer StarPower fell due to a downcycle in power semiconductors and oversupply in some of its markets while laser control system manufacturer Bochu declined after the company announced that its five founders planned to sell 2% of total shares outstanding in May to various global institutional investors.
Second Quarter 2024 Performance Attribution
Sector: Chinese Equity Composite vs. MSCI China All Shares Index
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Source: Harding Loevner Chinese Equity composite, FactSet, MSCI Inc. Data as of June 30, 2024. The total effect shown here may differ from the variance of the composite performance and benchmark performance shown on the first page of this report due to the way in which FactSet calculates performance attribution. This information is supplemental to the composite GIPS Presentation. |
The portfolio benefited from strong performance from medical storage manufacturer Haier Biomedical. Shares rallied after the company reported that domestic revenues rose strongly. Per customer revenue grew 20%, and the company’s win rate for public equipment tenders, mostly for public health organizations and blood banks, was close to 50%, much higher than its usual 30% market share.
What’s On Our Minds
China is experiencing weak consumer consumption as a result of the contraction in real estate prices. Existing home prices have fallen 13% from their 2021 peak, resulting in depressed consumer spending and poor consumer confidence. Indeed, as measured by the domestic Consumer Price Index prices have fallen in five of the last twelve months. Despite this headline economic weakness, certain pockets of the domestic economy have performed well, particularly those that have adapted quickly to changing market dynamics and consumer behaviors.
One such area is the domestic cosmetics industry. Cosmetics manufacturer Proya has become the leading brand in major online shopping festivals in China, unseating global cosmetics manufacturers such as L’Oréal (OTCPK:LRLCF) and Estee Lauder (EL). For example, during the recent ”618” online shopping festival (which lasts about one month, from late May to around June 18), Proya was the top selling cosmetics brand on Tmall, posting nearly 31% year-over-year sales growth over last year’s festival, becoming the only brand to surpass RMB 1 billion in sales on Tmall during this event. Other domestic Chinese cosmetics manufacturers posted similar gains. Meanwhile, L’Oréal Paris, and Estee Lauder, the first and third bestselling brands last year, saw year-over- year sales declines of nearly 11% and 16% respectively. L’Oréal’s management cited weak consumption and channel shifts as the reason for its lackluster numbers.
A key reason why Chinese cosmetics brands have fared much better than global peers in the weak consumer environment has been the shift from offline to online retail channels. When offline channels were dominant before the COVID-19 pandemic, Western, Korean, and Japanese brands thrived, greatly aided by extensive sales networks—brick-and-mortar beauty counters in every shopping mall across China.
But Chinese brands such as Proya have led the transition to e-commerce, helped by their smaller size, and willingness to adapt to new consumer preferences. An important feature of Proya’s success has been its recognition of the importance of social commerce. China is the global leader in social commerce, with penetration rates more than twice those of the US, three times more than Korea, and seven times more than Japan. The social commerce landscape involves partnering with influencers to market products through short videos or livestreaming sessions, with companies offering discounts or free gifts to encourage consumers to purchase directly through social media or content creation platforms.
Proya, for example, has optimized its operations on Douyin (the Chinese version of TikTok) by establishing different official accounts for various product lines, allowing precise targeting of different demographic segments. The company closely monitors emerging influencers and tailors products and marketing messages to align with their followers’ preferences, maximizing exposure and sales turnover. The younger user profile of social commerce is also a perfect match for the younger consumers of Proya. In 2023, the company generated 93% of its sales online.
Consumers Using Social Media For Online Purchases
Chinese beauty brands also are less reliant than global brands on travel retail, a key channel for global brands that suffered post-pandemic. Before the pandemic, many consumers used duty-free outlets to purchase Western beauty products at lower prices (without import duties), mostly in international airport shops or authorized retail stores located on Hainan Island, a domestic duty-free destination in China. Over the pandemic, the domestic travel retail channel further grew since tourists could not travel abroad. However, fewer travelers are going to Hainan than pre-pandemic, severely restricting a key source of sales for these global brands. Less travel combined with the shift to e-commerce has created a supply overhang in Western luxury beauty products on the mainland; the discounting required to ease the glut of products has resulted in brand erosion for some Western companies.
Meanwhile, Millennials and Gen Z consumers have observed the improvement in the quality of made-in-China brands during their lifetime. Made-in-China beauty products are now more likely to be thought of as high-quality, trendy, and desirable, a view that greatly differs from younger consumers’ parents, who grew up believing that premium brands were made by Western firms. As a result of younger consumers’ different perceptions, domestic beauty brands are in demand and can command higher prices for their products. Since early 2021, the average selling price of Proya products sold on Douyin has risen from around $20 to $50, a reflection of consumers’ increased willingness to pay more to purchase the higher-end products made by the company. Proya is moving into the “masstige” market, where price points are higher than mass market but less than premium or luxury levels by Western brands such as Lancôme and Yves Saint Laurent (owned by L’Oréal) and La Mer and Estée Lauder (owned by Estée Lauder). It could portend an eventual offering in the luxury beauty tier designed to compete with the designer beauty products being offered by Western brands.
Younger Chinese consumers’ increasing preference for Chinese cosmetics brands may also be reinforced by geopolitical events of the last several years. The 2021 deployment of Korea’s Terminal High Altitude Area Defense missile system is a contentious issue for China, which may have led Chinese consumers to distance themselves from Korean pop culture and brands. Korea’s The Face Shop, once popular among young Chinese women, has withdrawn from the market after declining consumer interest. Other Korean brands such as Etude House and Innisfree have also closed stores and scaled back their operations in China. Japanese brands such as Shiseido may also be experiencing the effects of consumer ire following Japan’s 2023 decision to discharge treated wastewater from the Fukushima nuclear plant into the Pacific Ocean. The declining interest in Korean and Japanese brands allowed Chinese brands to move into the “masstige” market and they have won consumer recognition in a short period of time.
This inclination toward domestic brands extends to other consumer categories as well—many companies have continued to grow domestically despite a weak consumer environment. Home appliances are already dominated by brands such as Midea Group and Haier Smart Home (OTCPK:HRSHF), which delivered 10% and 6% growth in the first quarter of 2024 despite the weak housing market, led by higher-end products like central air conditioning. Sportswear brands such as Li-Ning (OTCPK:LNNGF) and ANTA Sports (OTCPK:ANPDY) are also on track to meet their growth guidance of around 5% and 7% for 2024.
