This Chinese New Year, we celebrate the 15th anniversary of China’s accession to the World Trade Organization. GDP per capita now exceeds US$8,500, up from US$1,200 in 2001, and the World Bank classifies China as a middle-high income society. Morgan Stanley believes China will achieve high-income status by 2027, yet China only ranks as the 75th richest nation per capita on earth. There is still a long way to go.
Highlights from our businesses
The strength of the Chinese consumer delivered for our companies this year, dwarfing any drag from the more sluggish aspects of the broader economy. Our businesses continued to grow revenue, with profits rising and the following notable accomplishments:
– Yeehoo ranked as China’s top babywear brand, tripled its November 11 Single’s Day e-commerce revenue, and attracted numerous suitors
– Castle Snacks completed two further acquisitions and reached domestic-IPO scale
– Lao Heng He quadrupled e-commerce sales growth, and doubled its traditional channel sales, two of our most important KPIs
Exits and distributions
We had success translating momentum into exits and generated distributions from several of our businesses during the year, which in total should return limited partners a substantial amount of capital. In most cases, comparable valuations for our businesses rose considerably, which will drive further uplifts in valuation. While we generally do not underwrite based on multiple arbitrage, we believe it presents us with tremendous optionality for additional upside.
Capital committed to new investments
We committed more than $100 million to new investments during the year. We were most aggressive in buying snack food companies, with the acquisition of Yao TaiTai, Orchard Farmer, and LifeFun. We also closed our investment in Honworld.
While this represents a growing amount of investment for us, it is still small compared to the size of the opportunity we are addressing. Far too small in fact. In critiquing our own performance, we believe that we have left too many opportunities sitting on the table, where we could have leveraged our platforms and driven growth at reasonable valuations. In babywear, for example, there were several large acquisitions we should have made, where investment and execution risk could have been mitigated by leveraging our market leadership. We missed similar opportunities in snack foods. We will work to better present these investments to our investing partners in the future, and ensure that we do not miss chances like these again.
Pipeline and investment focus
You will hear more from us about baby- and kids-related businesses, snack foods and condiments. Our team has strong conviction that our foothold in these sectors is an enormous opportunity to put more capital to work and deliver investment gains. We have about a half-dozen new platform concepts under serious consideration in areas like early education. We believe that we can leverage the large base of VIP customers we have built up through our Little Star Brands platform and provide Chinese families with more professionally run, higher quality educational services to compliment the clothing and supplies that our brands provide. We look forward to discussing similar ideas in travel, cosmetics, and other sectors with you soon.
We begin the year with more of the same concerns over a potential credit bubble, the weakening RMB, and the increasing the risk of some form of trade war. Domestic politics will also be a factor as the quinquennial process of making leadership appointments, including Xi Jinping’s likely successor, will occur.
Goldman recently postulated that a hard landing is likely over the coming three years. Morgan Stanley takes a different and very bullish view on China, believing that a shock will be avoided and a focus on domestic consumption and services will lead to high-income status by 2027. So, Goldman fears a crisis, Morgan Stanley urges focus on the long term positives, and, at Davos last year, George Soros said he was no longer expecting a hard landing, but already “observing it”! From what we see in our businesses, we believe that a series of soft landings occurred in 2008-09, 2012-13, and 2016. Together, these may be the speedbumps that slow growth, lower valuations, accelerate restructuring, and prevent the economy going off the rails. For now, we concur with Morgan Stanley (“[they are] able to navigate [it]”).
As for our investment strategy, we believe that for so long as China remains underdeveloped, with a high savings rate, reasonable asset prices, and a growing middle class of aspirational consumers, the opportunity to buy good consumer-focused businesses with the potential for growth at reasonable prices is compelling. We remain convinced that putting capital to work and mitigating risk through our operational efforts, disciplined focus, and ability to leverage control is a wiser course of action versus remaining underinvested.
Readers of our year-end letter (and of Nostradamus’ works) want predictions. Below is a recap of how our forecasts from last year fared, and the trends we believe remain in place based on the feedback we receive from our businesses, management teams and dealmakers:
Last year we forecasted that the impact of one-child reform would kick in. And it has. CLSA recently reported that China’s birth rate recovered to 12.95% in 2016, the highest since 2001. Expect the birth rate recovery to continue near term with 18-20 million new-borns in 2017-2020 – a “mini baby boom” that will drive consumption. We also predicted liberalization of the Hukou System would fuel further urbanization and internal migration, which was premature but remains low-hanging fruit to drive future consumption, and we believe it will occur soon.
We believed that the upper middle class would surprise and deliver non-linear growth rates of premium consumption in areas such as healthy food, overseas travel, education, healthcare and higher quality apparel. This trend continues. Each of China’s online shoppers will spend US $473 on foreign goods this year, up from $446 in 2015. Luxury brands like LVMH, are reporting “better momentum after a tough 2015” as are Re?my Cointreau and Kweichow Moutai. “Re-shoring” of luxury is accelerating as China cuts duties on luxury goods imported through official channels, and cracks down on “daigou” (overseas personal shoppers unofficially bringing back grey-market goods). This dovetails with our channel checks that show better sales domestically, but weakness in places that cater to daigou, like Hong Kong.
We were correct in foreseeing that the weaker RMB and lower equity valuations would fuel M&A. The demand to acquire good companies we control is positively impacting our portfolio, although the weaker currency has led to outflows for China-focused fund managers, and macroeconomic concerns for investors globally. We expect the currency will continue to experience a managed decline, and that it is the volatility, not the absolute level, of the RMB that most concerns policy makers. The market will grudgingly conclude that China has the growth, reserves, policy tools and force of will to bring the RMB in line with fundamentals while avoiding overshooting to the downside.
We also called the narrowing of the valuation gap between domestically listed A-Shares and Hong Kong-listed H-Shares, especially in the consumer sector, although our belief that this would be fueled by a rebound in the valuations of H-Share consumer stocks, which traded sideways, was a bit off. For the coming year, we anticipate that the stock-connect, which provides domestic Chinese investors access to reasonably-valued Hong Kong listed companies and, indirectly, foreign currency exposure, will become too tempting to resist and offer reasonably priced yield, versus the very expensive growth on offer elsewhere.
We overstated the risk that businesses and startups in China “losing more to sell more” would rattle investor confidence. Enough unicorns were minted to prove us wrong. Going into the New Year, we still see an overabundance of capital searching for a home, especially in early-stage venture-land. Growth is overvalued, but expect nonsensical start-up valuations and the general dodginess in industries like peer-to-peer lending to persist for a while longer. Domestic equity valuations will also remain high. While the local markets are imperfect, the trend toward higher quality listings, better regulations, greater institutional participation and more overseas involvement combined with China’s extremely high domestic savings rate will keep valuations robust.
Finally, we would like to recap our priorities for 2017:
First, we will continue making distributions and complete further closings for the exits we commenced in 2016. We believe we can do this while ensuring that these companies continue to grow.
Second, we aim to sell down our last two remaining investments in LCP-II, our vintage 2008 fund. To this end, we are off to a good start in 2017.
Third, we will optimize our remaining investments in LCP-III to achieve higher valuations, generate distributions and achieve industry-leading returns.
Fourth, we are taking advantage of the platforms we currently own to invest more capital, with a target of exceeding the $100 million we committed last year into further snack foods, sauces and baby/kids-related businesses and one new platform.
Fifth, we continue to build Lunar’s franchise and reputation.