Last month, China wrapped up the inaugural session of the 12th National People's Congress (NYSE:NPC). This marked the completion of China's leadership handover to the 5th generation of leaders of the People's Republic of China. As the Chinese economy holds the key to global economic growth prospects, investors should pay close attention to developments. Politics always play a critical role in economic direction, but in China, the leadership directly drives the economy with a strong political mandate. During the leadership transition, the economy has suffered from less emphatic policy-making, as the new leadership has been selected. Now this process is complete, more defined policies will follow.
In this article I will explore the implications of this "Great Rotation," outline some of the main players and their agenda, and suggest some stocks which stand to benefit from these policies as they play out over the next decade. The sectors and stocks I see as standing to gain are: Resources (NYSE:BHP), Energy and Tech (NYSE:GE), Plant (NYSE:CAT), and Consumer Discretionary (NYSE:COH). These stocks are in sectors that will directly benefit from the implementation of economic policy in this directed economy over the next decade. All these sectors have seen price falls during the China growth trend reversal of recent months. I believe that these stocks will outperform in their sectors, either through size, market position, management quality, or a combination of these factors.
To understand China, it is important to understand the Chinese leadership and their policy priorities, and the annual NPC provides the best insight.
This year's NPC session was especially important, as it was the scene for the official election of the State Council, which is the primary decision making body in China. This session followed the 18th Party Congress in November 2012 where Xi Jinping was elected as the General Secretary of the Communist Party, de facto Head of State. He was formally elected as the President of China at the NPC, confirming his leadership which can be anticipated to last for the next ten years. Li Keqiang was confirmed as Premier of the State Council, the key executive body in China.
The State Council is charged with stewardship of the economy, mainly by implementation of the Five Year Plan, which is a rolling 5 year blueprint for the economic management of "China incorporated." The current plan covers the period 2011-2015.
Xi Jinping outlined the key leadership priorities late in 2012.
"Our people have a great enthusiasm for life. They hope for better education, more stable jobs, more satisfactory income, more reliable social security, medical services with higher standards, more comfortable living conditions and a more beautiful environment. The people's desire for a better life is simply the target of our endeavor."
Underlying this statement is an understanding that for the Communist Party to retain power in a changing environment, there needs to be a stronger accountability to the working population, more efficient government, and demonstrable efforts to reduce corruption. The Party has suffered a lack of public confidence from scandals such as the ousting of key leader Bo Xilai. In a recent speech Xi laid down a hard line.
"We must have the resolution to fight every corrupt phenomenon, punish every corrupt official and constantly eradicate the soil which breeds corruption, so as to earn people's trust with actual results."
A major priority is the reduction of the complex governmental apparatus, which has been a work in progress for decades. Since 1978 the number of ministries and commissions has halved, from 48 to 25 remaining in the latest restructure. Changes were made in the administration of transport, energy, and health and food safety.
The formation of a single energy administration underlines the importance of an increasing environmental mandate to generate increasing capacity from renewable sources. Targets for renewables for 2013 were released, with significant increases in solar and wind power.
Renewable Energy Capacity (GW)
Changes to improve the transportation infrastructure include the abolition of the Ministry of Railways, and the incorporation of a new State owned enterprise, the China Railway Corporation, and reorganization of the maritime administration.
Important ministerial positions
Wang Yi, the new foreign minister, comes with a strong pedigree of international diplomacy, having been the ambassador to Japan, and the former foreign minister, Yang Jeichi, was appointed to the state council. Yang had a stint as ambassador to the US from 2000 - 2004. This team is well placed to manage the key relationships with Japan and US. This bodes well for the management of the tensions between Japan and China, a key risk for the region. The elevation of these career diplomats heralds a continued strengthening of bilateral ties, and a broader policy of international engagement.
This outlook is further enhanced by the appointment of Gao Hucheng at the Commerce Ministry. Gao has most recently been responsible for international trade negotiations. His agenda is likely to include further bilateral agreements to support trade flows and currency convertibility agreements. China has been expressing discontent with the US dollar's reserve currency status, and has convertibility agreements in place with Japan and Australia to build on a series of long term swap agreements with key partners like Russia and Brazil
The current 5 year plan focuses on the development of sustainable economic growth by the modernization of industry to help China move up the production value chain, the promotion of domestic demand over exports, and addressing the widening income disparity between rich and poor. The target for growth is reduced to 7% GDP growth annually for the period. The plan prioritizes investment in energy efficiency, biotechnology, telecoms and aeronautical manufacturing. Urbanization of the population is expected to continue, with a targeted increase of the city dwelling population from 47.5% to 51.5%, which generates demand for some 50m new homes over the period. Inflation is planned to be kept in the current range of 3.5 - 4%.
The shift in focus away from maximizing headline growth to ensuring sustainability and quality of economic development should benefit the market. The 7.7% first quarter GDP growth falls short of the 8% market estimate, but not catastrophically so. The market reaction to this seems to be overstated, and could present opportunities in some stocks with exposure in key areas for long-term investors.
My favorite stocks in this environment are:
General Electric. GE is active in several of the sectors which should see consistent demand from China.
Its Power and Water segment offers turbines, generators, combined cycle systems, wind turbines and solar technology, and water treatment services and equipment. This segment is well aligned to the growing power needs of China, and with combined cycle and wind turbines, is well aligned to China's clean energy policy. Solar offers less opportunity, not because of a lack of demand, but an excess of supply. However if the government allows the unviable panel makers to fold, a more sustainable competitive landscape in solar should emerge. Water treatment demand will be vast, as the urbanization of the population continues.
Its Aviation segment offers jet engines, turboprop and turbo shaft engines, and maintenance. The Chinese aviation sector as measured by passenger throughput has grown an average of 15% since 2008, compared to 5% global average, and this is expected to continue. According to Yahoo Finance, China buys 100 passenger jets each year, 10% of global demand. As part of the focus on developing transportation Xi's leadership will continue to promote the development of the local aviation sector.
The Healthcare segment provides medical imaging and information technologies, medical diagnostics and patient monitoring systems - with Healthcare and urbanization high on the political agenda, demand for new hospital equipment will continue.
The Transportation segment offers freight and passenger locomotives, diesel engines for rail, marine, and stationary power applications, railway signaling and communications systems - these find demand in the China Railway Corporation and the new maritime administration, which is mandated to improve maritime infrastructure.
With this mix of businesses at its core, GE is remarkably well aligned with the economic priorities outlined in the China 5 year plan, which will now see a focused effort from the newly established leadership.
GE is already seeing the benefits of Chinese demand in its 1st quarter results. Despite headwinds in Europe and at home, GE reported an EPS increase of 15%, notable in that China recorded 67% growth. The share price fell by 4% on release of the results and currently stands at around $22 and at a p/e multiple below 11 GE offers yield of 3.5%.
BHP Billiton is a strong play on China's ongoing resources needs, and offers the most diversified exposure of the main players in the sector. BHP has a market cap of over $170bn, and holds a leading position in several of the major commodities including coal, copper, aluminum, iron ore, manganese, nickel, and oil and gas. As such, much of the BHP demand is in China. The continued urbanization and development of critical infrastructure envisaged in the 5 year plan will boost demand for BHP's products. As a hedge, BHP also has a significant shale oil interest via its US based Eagleford project.
BHP is also under new management, with CEO Andrew Mackenzie having slimmed down its management structure upon taking the helm. BHP will wind back CAPEX and focus on production cost efficiency. This will secure earnings even in a period of reduced demand while the Chinese economy proceeds at the slower targeted growth rate.
The China GDP figures drove down the mining and resources sector this quarter, continuing a slide in price for most of this year. The stock is trading at $64, down from a high of $80. BHP now trades at a p/e multiple of 13.6, and yields 3.5%.
Caterpillar is also closely associated with the resource sector, and heavily tied to the Chinese infrastructure and construction sector. CAT is the global leader in earthmoving equipment. CAT reported its 1st quarter earnings on 22nd April, which came in just below analysts' estimates. This is on the back of reduced 2012 demand flowing through as dealers reduced inventories. CAT is acting to manage through this period, with both CAPEX and its own inventories reducing to keep costs down. Shareholders are being rewarded for their patience with a targeted $1bn buyback. Despite management reducing 2013 earnings guidance, its 2014 outlook is for continued demand from construction in China and US.
CAT shares have been penalized by the market response to slowing China growth, and were prior to the earnings release trading at $80.43. The market response to the positive outlook and management actions was strong, lifting the shares to $84. At this price CAT trades at a p/e multiple of around 11, and offers a dividend yield of 2.5%.
Coach is another stock with a high China opportunity. Coach had a 2012 earnings miss which took the share price down nearly 20% China demand should enable COH to generate significant earnings growth, however its exposure to Japan does create some fx headwinds given the yen devaluation. Coach reported its latest quarter earnings on 23rd April which as I predicted in January exceeded expectations on the back of China sales growth.
Coach has been shifting its geographic focus over the last few years. Historically a US dominated company with an international business spearheaded by Japan, it is rapidly becoming a China play. US now accounts for only 2/3 of its sales, while over 100 new stores in China are increasing sales at a growth rate of 40%. Xi Jinping's austerity and anti corruption measures could be a threat to Coach, as the giving of luxury goods is common in government and business circles in China. However, the sales growth of 40% for the quarter came at the period when government cutbacks were at a peak. COH could even benefit from this as a more affordable alternative to Rolex and Gucci.
Coach shares did well on the earnings release date, and currently trade at $56, which is a p/e of 15 x earnings. An increased dividend offers around 2% yield. COH is no bargain at these prices, but offers fair value and good long-term growth potential. I think that the rapid China expansion will change the earnings pattern and generate volatility in quarterly earnings. If this in turn continues the volatility in share price, some good buying opportunities should arise for those who have confidence in the brand and management's ability to execute.
I show here the relative 12 month performance of each stock compared to the S&P 500. Only GE has not underperformed the index over the last year. These now represent value comparative to the broader market.
ETF's such as Market Vectors (NYSEARCA:PEK) or iShares (NYSEARCA:FXI) offer a broader exposure to China, but investing in Chinese stocks can be a volatile business, and generate less targeted exposure. I prefer to gain exposure to China by seeking value entry points to the best in class stocks with exposure to the most promising sectors.
China's leadership has been undergoing a once in a decade change, which has created policy inertia for the last several months. The leadership rotation is complete, and Xi and team are positioning for change at a slow and steady pace. Growth will remain strong, albeit at a slower pace than the double digit percentages reached in recent years. The advantage of a controlled economy is that there is an unusually high level of transparency and predictability of policy. The 5 year plan gives insights into sectors which will receive government attention, and that generates directional guidance on sectors which will see directed demand.
For the long term investor, stocks in these sectors offer good value, with prices having been suppressed by slowing global growth. The companies I have highlighted seem well positioned in this context.
Disclosure: I am long COH, BHP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am a private investor,not an investment advisor. This article should not be regarded as investment advice. Investors should consult a professional investment advisor before making any investments.