Deregulation and private sector Growth
Comment of the Day

September 19 2013

Commentary by Eoin Treacy

Deregulation and private sector Growth

Thanks to a subscriber for this informative report from Deutsche Bank which is sure to be of interest to investors interested in China's equity markets. The full report is posted in the Subscriber's Area but here is a section
Another common feature of most successful large POEs [Ed. privately owned enterprise] is their ability to innovate. Investment into research, development and acquisition of new technologies serves as the key. Of the 10 leading POEs we studied, their average R&D expenditure to total revenue ratio rose from 3.8% in 2009 to 4.5% in 2012. R&D spending amounted to 10% of revenue for Tencent and Mindray. By contrast, the average R&D/sales ratio of MSCI China SOEs remained below 2% for years and even declined recently. Note that the divergence in R&D performance does not depend on the sector picks of our sample: in all sectors, large private firms' R&D spending/sales ratios are higher than their SOE counterparts (Figure 25).

An interesting way of private companies gaining market shares from SOEs [Ed. state owned enterprise] is to innovate to engage in “cross-sector” competition, bypassing regulatory entry barriers. For example, Tencent's Mobile application of Weixin is challenging the traditional SMS service of three SOE telco operators; Alibaba's ecommerce's is crowding out physical retail businesses; “Yu'e Bao” of Alibaba is shaking the nerves of traditional banking services; 3D printing is reshaping the concept of manufacturing. The pace of market reshuffling has accelerated, and many traditional SOE leaders are facing unprecedented challenges from dynamic private firms, some of which have the potential to be tomorrow's Apple or Google.

Eoin Treacy's view My view – In the last week I have heard the view evinced in the financial media that China does not have any world class companies capable of dominating their respective global niches. I was surprised that this view still received credence since so much has changed in the way the Chinese private sector operates over the last five years.

China has so far concentrated on buying the technological knowhow it seeks with Lenovo being a prime example. However, the way such companies have been managed subsequently suggests that the private sector is more than capable of competing on the international stages. AIA Group is another example. The company was split off from AIG following the credit crisis and as an independent entity continues to benefit from growth throughout the Asian region.

In the event that the plenary session of the People's Congress supports deregulation and support for entering discussions on the Trans-Pacific Partnership, it should be a bullish catalyst for the shares of private sector companies.

Companies with some of the more interesting chart patterns from the above report include:

The distinctive ping of Tencent Holdings's QQ instant message system resonates around the offices of many of China's factories and offices. On visits with Mrs.Treacy, I've often wondered how people stand the din but it is ubiquitous nonetheless. The share has accelerated higher since the April lows and is becoming increasingly susceptible to mean reversion. A break in the progression of higher reaction lows would represent an inconsistency.

While not mentioned in the above report Youku is worthy of mention. The company represents the Chinese equivalent of YouTube and Netflix combined. The US listed share had been confined to a base between late 2011 and this week. It is currently in the process of breaking upwards and a clear downward dynamic would be required to check momentum.

Mindray Medical International is listed on the NYSE and has held a progression of higher reaction low since mid-2011. A break in this sequence would be required to begin to question upside potential.

In the textiles sector, Belle International Holdings dropped from HK$18 to HK$10 between February and June and appears to be building support above the HK$10 area.

While not mentioned in the above report, Shenzhou International already generates most of its business outside China. Following a sharp pullback, the share found support in the region of the 200-day MA from July and a sustained move below it would be required to question the consistency of the overall uptrend.

In the energy infrastructure sector, ENN Energy has found support in the region of the 200-day MA on successive occasions since 2008 and a sustained move below HK$37 would be required to question medium-term scope for additional upside.

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