Investors eye China services as the next big thing

By Clement Tan

HONG KONG, March 21 (Reuters) – As Chinese leaders encourage the country’s 1.3 billion people to open their wallets to boost domestic demand, hotel chains, supermarkets and other service providers offer investors a fresh tilt at the country’s growth story.

Beijing is targeting a 4 percentage point rise in the service industry’s contribution to GDP by 2015, up from 43 percent in 2010. Still well below the U.S. service sector, which makes up about two-thirds of the world’s largest economy.

For investors with longer-term horizons, services that cater to a growing middle class offer an opportunity to cash in on a shift in consumption patterns as Chinese consumers move increasingly up the value chain, say analysts.

“There’s a lot of pent-up demand for services due to supply constraints,” said David Cui, Bank of America-Merrill Lynch’s Shanghai-based chief China equity strategist.

Policy-makers want increased domestic spending to offset a reliance on exports, and have outlined plans to narrow the rural-urban divide and boost wages for 158 million migrant workers. The services sector is vital for future job growth.

Supermarkets, logistics firms and tourism companies focused on domestic travellers offer good opportunities, says Cui, who recently authored a report on China’s services sector, though analysts warn that stock picking is still vital.

Sun-Art Retail Group Ltd has among the best long-term earnings growth potential of Chinese consumption peers, ranging from sportswear brands to luxury goods stores, according to Thomson Reuters StarMine projections.

One of China’s largest hypermart operators, Sun-Art’s Hong Kong listing last July attracted robust interest, and it has strongly outperformed the index of Hong Kong-listed Chinese companies.

Other retailers, such as Golden Eagle Retailing Group and Wumart Inc, would benefit from policy-driven consumption initiatives, while supermarkets are seen as likely to be able to fend off foreign competitors because of their understanding of local preferences.

CHINA’S 1.3 BILLION NOT ENOUGH

Playing China’s consumption story has so far largely centred around retailers, including sportswear brand Li Ning, where investors have banked on China’s massive population to generate sales.

But rapid growth and foreign competition has led to shrinking margins and slowing sales growth. Li Ning’s long-term growth projection scores on StarMine now rank among the worst in the Chinese consumer sector.

Fund managers are looking for sectors that offer discretionary services that would be boosted by higher wages and increasing purchasing power of mainland Chinese consumers.

Beijing’s spending pledge is likely to spur the development of sectors that add more value to China’s economy, said Agnes Deng, who manages the $3.6 billion Barings Hong Kong China fund.

At end-February, 15 percent of Deng’s portfolio was invested in technology – another play on higher value consumer-focused services – and 9 percent in telecommunication services.

Baidu Inc and Tencent Holdings, two of China’s biggest internet companies, rank among Deng’s top 10 holdings, along with the mainland’s two largest telcos, China Mobile and China Unicom.

OPPORTUNITIES ABOUND

The services sector also presents opportunities that may repay a little diligence, say analysts.

The sector is under-represented in offshore markets, where most foreign investors get exposure to the world’s second-largest economy’s growth story, as many stocks are listed only in the mainland.

And even when stocks are listed, they don’t always command attention. No analysts cover Jin Jiang Hotels, among mainland China’s larger hotel chains and which counts China’s National Social Security Fund as its top shareholder, according to StarMine.

Market-leading logistic providers such as Shenzhen-based SF Express and Shanghai YTO Express are not even listed. But there are publicly listed alternatives, such as Sinotrans Ltd , a Beijing-based freight and transportation company.

Sporting a near-$1 billion market-cap, Sinotrans is relatively liquid and has an earnings yield higher than roughly 94 percent of its peers, according to StarMine’s relative valuation score, which takes into account current price-earnings multiples as well as yields.

Electronics firm Haier, which counts private equity firm Carlyle Group among its top shareholders, is also building a distribution and service provider business to complement the sales of its own brands. All five analysts who cover it rate it a “buy” or “strong buy”.

One caveat to development is the need for a liberalised financial sector, making it easier for non-state firms and more small- and medium-enterprises to raise funds via bank loans or the financial markets.

However, BofA-ML’s Cui sees a strong case for China to support the services sector as it fends off slowing global growth and pares back the over-investment in fixed assets following the massive stimulus via bank lending in 2008.

“If you look at how imbalanced the Chinese economy is today, just a reversion to mean would present staggering growth potential,” he says.

(Editing by Vikram Subhedar, Anne Marie Roantree and Richard Pullin)

This story was first published at Reuters.com.