What You Need to Know about Small-Caps and China

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Have you ever surfed the net and ended up on a page you had no intention of finding? You might have been jumping from link to link. First you started reading about Donald Trump’s election victory. Then you ended up reading about health tips and morning routines.

I’ll admit it. I find myself reading articles and wonder how I ended up there more often than I’d like. Sometimes that’s nothing but a waste of my time. But sometimes I happen across something useful. Like yesterday, when I came across a story which screamed ‘invest in Aussie small-caps!’

The Australia Financial Review article highlighted former Trade Minister Andrew Robb’s thoughts on Aussie investment into China. He believes Australian businesses aren’t investing enough into China.

Yet there’s a reason behind their lax Chinese ventures.

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China punishes big business

According to the AFR:

He [Andrew Robb] said Australia’s biggest companies had become “fat and lazy”, were often uncompetitive “oligopolies” and that our investment levels in the region were “embarrassing.”

It’s not that Aussie businesses aren’t involved with China. Around 32% of Australian exports were shipped to China in 2015. Yet Robb’s point is that we don’t engage within the region.

There is evidence backing up his claims. Australian businesses invested $2.1 trillion overseas last year. How much did China see? Around $70.2 billion, or only 3.4% of this total. That puts China in 5th place, behind the US, the UK, New Zealand and Japan.

But isn’t it supposed to be ‘Asian Century’, with China at the forefront? I’m sure you’ve heard all about Australia riding on the back of Asia’s growth. Shouldn’t China be the number one country Aussie businesses invest in?

Well, it’s not that our big businesses don’t want to invest in China. Most would love to. But China imposes restrictions on foreign direct investment (FDI). These restrictions make it less attractive for bigger companies to invest in China.

1421 Consulting Group explains there are three types of categories for foreign businesses in China: encouraged, restricted and prohibited industries.

Encouraged industries generally receive favourable tax treatment. As you’d imagine, China limits FDI with restricted industries, including that foreign businesses/investors are only able to have limited/minority ownership or shareholdings. Prohibited industries cannot have any form of FDI into China at all. An example is the antique or cultural relics industry.

A lot of foreign investors run into the impediment of restricted industries. They are only able to hold a 50% (or less) stake in the business. To do business at all, foreign companies end up forming joint ventures (JVs) with a Chinese company. The JV, at best, is split 50/50 in 15 Chinese industries. More often than not, you’d expect to see the Chinese partner holding a controlling interest.

As the AFR explains:

The big corporations generally don’t have the patience, skill or necessary risk appetite for operating across the region… Both ANZ and the Commonwealth Bank were quick to jump on the opportunities presented by China’s partial privatisation of its banking sector a decade back. But then both found themselves blocked from buying more than 20 per cent of any one bank.

This is why Australia’s biggest companies were never going to lead the way in China.

So Robb is right. Big Australian businesses aren’t investing into China as much as they could.  But there are good reasons for it. There are still 14 restricted industries in China. And big Aussie companies don’t want to have little to no control over their business or be diluted when investing in China.

However, the story is a little different for smaller Australian companies. They are still exposed to restrictive Chinese policy. But they have unique advantages when venturing into China.

Small-caps playing big

Forbes contributor Helen Wang believes the first thing businesses should know about the Chinese market is that it’s fragmented. And ‘it will probably remain so in the foreseeable future,’ Wang wrote, adding:

‘This causes a big headache for large companies rolling out their distribution channels nationwide. But it also creates opportunities for smaller brands to establish themselves as market leaders in their region.

The fragmented Chinese market allows smaller companies ‘to play big’. They can become a market leader in a niche market. Being a market leader in one geographical area gives smaller companies ‘significant advantages in terms of charging premium prices and winning customer loyalty,’ Wang said.

It’s no secret that smaller companies are nimbler than their larger cousins. They can trash and reinvent products more easily. They can also generally bring products to market quicker because of fewer people involved in the creation process. And their structure is usually lean.

The take-away? If you’re looking for potentially lucrative exposure to China’s massive consumer market, think small.

And if you want to know how our small-cap guru, Sam Volkering, has managed an average return of 66.5% with his 2016 stock recommendations for Australian Small-Cap Investigator, you can find out more here.

Regards,

Härje Ronngard,

Junior Analyst, Money Morning

Harje Ronngard

Harje Ronngard

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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