China’s Transition

June 2013

Following a surge of investment-driven growth in the wake of the global financial crisis, we are now witnessing a transitional phase in China’s economic growth model.  Specifically, Chinese leadership is seeking to slow the growth rate of fixed asset investment, as infrastructure spending is proving to be increasingly less productive, while aiming to simultaneously increase consumption as a percentage of GDP.  This strategy implies not only a downshift in the trajectory of the country’s GDP growth, but also a change in its growth composition. 

Large state-owned enterprises (SOEs) that have historically dominated China’s cyclical industries should play an increasingly smaller role in the economy. SOEs are generally inefficient users of capital—something the government is explicitly targeting—that are currently plagued by excess capacity and shrinking profit margins. The government prefers to support more dynamic and innovative private companies, which seek to maximize profits and efficiently allocate capital. This is consistent with the leadership’s goal of rebalancing the Chinese growth model away from state-funded or affiliated companies.

Private companies realize higher productivity on their investments. Having more of China's capital allocated by private companies should help the government achieve its goal of a healthier and more efficient economy.  The difference in business approach and operating structure between private companies and SOEs is apparent in the former’s superior profitability and earnings growth, and theoretically superior stock performance. 

The discrepancy can be seen clearly in the chart below, which shows the trailing two-year relative cumulative performance of an equally-weighted basket of the largest one or two private sector companies in each sector of the Chinese economy, versus an equally-weighted basket of the largest one or two SOEs.    

Relative Performance of Chinese Private Sector Chinese Companies Versus Their SOE Peers

Relative Performance of Chinese Private Sector Companies vs SOE Peers
The chart shows the cumulative returns of a basket of private companies minus the returns of a basket of state-owned enterprises (SOEs). The upward move charted above shows the outperformance of private sector companies during the past two years.

The Driehaus Emerging Markets Team continues to focus on businesses with superior and sustainable growth models, such as select private Chinese corporations.