SJB Surplus: New Capital China Equity Fund (WKN A1J3EX) Monatsbericht Juni 2022

As we highlighted in the past letter, since late May, we observe clear signs of policy shifts in China in multiple key areas like Covid policy, monetary policy, property policy, internet policy and consumption stimulus in auto. The policy pendulum has swung to the accommodating side, for the first time since 2Q21. China market rallied with MSCI China All Shares Index up by 7.3%. Growth stocks and ADRs led market performance.

• Entering July, after two months of outperformance, China market saw profit taking, especially on growth stocks, on expectation of liquidity withdraw by PBOC from the ample level for crisis management seen in May-June. However, in the week of July 11th, there are news reports of increasing number of home buyers boycotting mortgage repayment for halted property projects, which we will discuss in details in the next section. Increasing risks in the property chain, diminishing likelihood of a quick recovery of new home sales, upbeat fundamentals in growth sectors like EV, wind and energy storage, and a clear need to maintain accommodating policies drive growth names to outperform again.

• With reopening, fundamental recovery since April continues into June. China also reported 2Q22 GDP growth of 0.4%, meeting the government target set in May. Industrial production and export continue to surprise on the upside. Infrastructure investment also beats with government financing and strong recovery in total social financing. Though auto sales is a bright spot with solid EV demand and tax stimulus for ICE, other consumption areas remain lackluster. Property remains a key drag and the most problematic area for the Chinese economy. We expect the recent boycott of mortgage repayment to further delay the recovery of property sales, which we will discuss in the next section.

Home buyers boycotting mortgage payments for halted projects

On June 30th, home buyers of an Evergrande project in Jiangxi collectively announced that they are going to boycott paying their mortgage as construction of the project has been halted for long. As the news spread on social media, home buyers of at least 300 projects have announced boycotting their mortgage payments nationwide as of July 15th.

o New home sales in China are on pre-sale basis. The proceeds are required to be put into a regulated account to ensure construction and delivery of the property. However, there are cases of misconducts of developers and banks, where the proceeds are taken to be used elsewhere like buying a new piece of land. In this case, when a developer is facing liquidity problem, construction of a presold project is halted, home buyers cannot get their property on time and the supply chain cannot collect receivables.

o The recent round of “unfinished buildings 烂尾楼” started to emerge when Evergrande got into trouble 2-3 years ago. Government crackdown on the property market since 2Q21 has led various private property developers to default or extend the payment of their debt and interests, who account for ~30% of projects under development.

o The boycott did not emerge until recently because the cost for home buyers are too high. Failing to pay for mortgages will ruin the individual credit record, got blacklisted by banks and face various inconveniences in daily life like not able to buy air tickets or take high-speed-rail. Therefore, most of the home buyers are still paying their mortgages, even when the project has halted construction with no sign of resumption in sight. However, when individual home buyers are acting collectively and when it is spread on social media, we see surging number of such boycott cases.

o There are also cases of moral hazard. Buyers of some projects with falling prices though still under construction are looking to take this opportunity to see if they can take this chance to get away from the mortgage payment and purchase agreement.

o Frankly speaking, the problem of “unfinished buildings” is well known for long, but little has been done by the government to help home buyers until the past few days.

• This boycott of mortgage payment is a too big to fail issue.

o Referencing analysis from various research, we estimate as much as Rmb3trillion of existing mortgage balance is linked to projects developed by financially troubled developers with high risks of seeing halt in construction and home buyer boycott, which is equivalent to ~3% of China GDP.

o Besides, property is the most common collateral in bank loans. If property prices fall, there will be ripple effect to other bank assets.

o In other words, if the situation develops without any forms of action and control, this can result in systematic risks for sure.

o However, the good news is that, history tells us that if we all know something will take us into a deep crisis, is it not likely to happen anyway. The things that will take us into real trouble are usually the ones we are not fully aware of its impact.

• We have been waiting for immediate actions taken by the government over the weekend, and thus delayed sending out this letter a bit.

o As of the weekend of July 16th, the government has taken action to control the spread of boycott news in all forms of media to calm down home buyers. Regulators, PBOC and official media have been vocal in their support for project resumption. We do see slowdown in the growth rate of projects getting into boycott.

o According to our channel check, meetings have been held at various level of government over the past few days, and funding consumption status of projects are now required to be reported on a daily basis, so that the construction status is well supervised on project basis now. Local governments have been working with banks to provide funding to projects and communicating with home buyers.

o We believe such actions will help, as the demand of home buyers are getting theprojects back to construction, so that they can get their home. If the projects are back to construction and home buyers regain confidence, the risk of boycott should be controllable.

o We believe more needs to be done to solve the problem, and we are seeing media reports of government weighting on different options with banks and developers. We will keep a close eye on the development, adjust our portfolio and update our investors when appropriate.

• If the boycott does not result in crisis, we think it is positive for liquidity and growth stocks, and negative to banks.

o We believe banks will need to provide working capital financing to help halted projects resume construction. The pre-sale deposits have been misused, and the banks are the only party with money. Meanwhile, local governments will also need to work with banks and use their administrative power to help projects resume, as the halt of construction may also be due to various other complicated reasons that need administrative coordination. Banks will need to take some losses anyway, but the loss of providing working capital should be lower than that of having mass boycott in mortgage payment.

o When handling the crisis, we will need to keep liquidity in the market and maintain decent economic growth and employment with accommodative policies. Luckily, China has the lowest inflation of ~2.5% among all the major economies in the world, offering the largest room for accommodating policies globally. This will be positive to growth stocks.

o Despite the control of systematic risk, we believe “unfinished buildings” will deeply hammer confidence of home buyers and property investors. It will take much longer than previously expected for new home sales to recover. This is negative to the property supply chain and value style in China market.

Fund Performance & Positioning

The Fund returned +5.6% in June, underperforming the benchmark by 170ppts, due to fund holiday on the last trading day. Net of the fund holiday impact, unaudited numbers show we outperformed by ~10bps for the month.

• Top alpha contributors of June 2022 are:

o Shenzhen Dynanonic (+38%): Shenzhen Dynanonic is the leading LFP cathode producer for EV and energy storage. Its proprietary leading “liquid phase” technology can help make products with higher consistency and energy density, as well as providing a larger room for cost cutting than peers. It is also leading in LMnFP cathode and recognized by key customers like Tesla, CATL, BYD, etc. LMnFP is the key area for technology development for batteries, which is set to help Dynanonics to grow and differentiate beyond 2023.

o PDD (+23%): PDD is our top alpha contributor for two consecutive months. It is offering strong earnings growth and highly attractive valuation. While the market is concernedabout its topline growth given its number of users is reaching the ceiling, we think it has big room to cut expenses to deliver margin and earnings opportunities. We also see clear signs that even though the company is cutting marketing expenses, its user frequency is still increasing thanks to its value-for-money proposition – it is on track to become a cash cow, still with at least double-digit topline growth and big room for further expense cutting.

o BYD (+13%): BYD is our top alpha contributor again. It has an overwhelming product pipeline with strong orders for hybrids and pure EVs. Particularly, its DMi hybrid technology leads the industry by far and has a sweeping success in sales volume by addressing both mileage concerns and high oil price for consumers. Besides, its integrated business model with self-supply of semis and batteries make their execution and delivery outstanding. It has also officially announced supplying battery to Tesla in June, making it a clear share gainer in the global supply chain.

• Key changes made to the fund:

o As we heighted in the past letter, when we see the clear policy shifts, we made risk-on and pro-growth adjustments to the portfolio. We identified auto and China reopening as the key investment theme in China for the rest of the year, and we are OW for related industries and stocks. We took the volatility and profit taking to add on those themes.

o For stock picking, after the strong rally in May – Jun, we diversified our holdings for single stock risk exposure management and smaller cap exposure. For example, in new energy, we took some profits in BYD and Shenzhen Dynanonics to add smart vehicle related names like Huizhou Desay SV and wind names like Ningbo Oriental Wire & Cable.

o As we mentioned in the past letter, we have been cutting commodity related exposure since May due to weak demand and change in global macro from stagflation to recession. We are UW commodities now.

At the beginning of this year, we like China as it is at a different point of economic cycle and policy cycle versus the rest of the world – China is in recession and easing. With home buyers boycotting mortgage payment now, we expect a clear and strong need for accommodative policies to stay to keep economic growth and employment.

• China has the lowest inflation across all major economies now, even lower than Japan, for the first time in decades. China CPI will rise in the next few months with pork prices, but it is not likely to exceed 3% by too much based on our item by item analysis – still a level comfortable for accommodating polices, the only major economy with such room globally.

• As mentioned in our past letters, history tells us that Chinese policies work like a pendulum – it swings from side to side, and just-right is rare. There are various policy mistakes in the past decades (to be fair, there are also a lot of great policies), big or small, but there is always an error correction mechanism to get the country back to right track and grow to its current
significance. We regret that last year and the first few months of this year is tough on policy side, but we are seeing a clear shift in policy since May.

• The reason why we are positive on China for the long-term lies in the vast amount of Chinese people who really wants to become somebody in the society and willing to strive hard for it. When they are given the opportunity and when the policy environment is favorable, history tells us they can create miracles.

• History also tells us as long as the error correction mechanism is working, which we see clear signs now, investment return in a 6-to-12-month horizon is good coming from such extreme situations.

• As always, please do not hesitate to let us know if you have any questions.