China’s economic slowdown is making veteran global investors like David Herro more cautious, but the manager of the $19.7 billion Oakmark International fund says some of the fears may be overstated.
The lackluster recovery from three years of Covid lockdowns and crackdowns on the internet and property markets has added to growing wariness about China’s debt levels. Geopolitical tensions and a more interventionist approach by Chinese leader Xi Jinping only adds to those concerns. These issues have contributed to a $2 trillion decline in the market value of the MSCI China index since its peak in early 2021. There’s also the possible fallout in Europe and emerging markets that are closely tied with China’s economy.
Barron’s caught up with Herro, who has managed Oakmark International (OAKIX) for more than three decades, to talk about ripple effects that China’s slump could have for the European luxury and auto stocks he owns. He also discusses his thinking about the bargain basement prices on Chinese internet stocks like
Alibaba Group Holding
(ticker: BABA). An edited version of our conversation follows.
What impact will China’s slowdown have on European auto makers?
We mostly own premium [auto makers] like
Mercedes-Benz Group
(
MBG.
Germany) and
Bayerische Motoren Werke
(BMW.Germany). They are still seeing strong order books. About a third of their business is from Asia, mostly China, a third from Europe and a third from the U.S. So far so good. One thing they really learned during the pandemic was to not chase volume over value.
In meetings with German auto makers, we are getting the same story: Business is holding up and profits, if anything, will increase over time. The electric vehicles they have been developing over the last decade are in full swing; BMW has a new class coming out in 2024-2025 so there is cautious optimism. Plus, they trade at three times cash flow, have big chunks of cash and are buying back stock.
What about the competitive pressures from BYD and other Chinese auto makers?
At this stage, the
BYD
s (BYD) of the world are more mass market. BMW continues to increase share in terms of sales of electric vehicles in both Europe and China, despite what’s happening with BYD and
Tesla.
I had a call with the CEO of [another European auto maker] that I don’t own, who said people are underestimating that they are coming out with competitive products and costs are dropping substantially such that they think they will be able to compete. The message we have gotten from German auto makers is: They know [the Chinese] are coming and they claim they will be ready. We will see but I don’t know if it’s necessary to automatically think they are cooked. And the premium auto makers are more well-protected.
The China market is important for premium auto makers’ sales, but so far it has been more fears than reality. But Xi Jinping isn’t like the reformers [before him]. He’s more nationalistic and militaristic and there’s a worry there. The balance is that right now there is excess fear over optimism; two to three years it was on the other side.
You own luxury makers like Kering. Could “common prosperity” efforts to tackle inequality lead to problems for these companies, as it did earlier in Xi’s tenure?
[That crackdown on luxury goods in 2014] started with efforts to deal with corruption through gifting and was directed at officials buying expensive jewelry or premium alcohol on the government’s dime. But meanwhile, among rank-and-file Chinese consumers, there’s still a migration to the upper middle class and they still have urbanization. These are big positive factors. [China’s slowdown] is an issue but luxury makers have a very broad audience globally: We saw that when China was locked down, European sales increased. Luxury is a unique business because of the low capital intensity and high barriers to competition and high margins.The caveat is that Xi is more unpredictable. There used to be all this foreign direct investment going in. One of the biggest problems today is that Xi has scared off foreign investors.
China has been wooing foreign companies and investors, including recent talk of loosening ownership restrictions. Is that a start?
You need a lot more. I’ve been going back to China since the 1980s. What you’ve seen over the last 30 to 40 years is an economic miracle. The view is that Xi is stealing defeat from the jaws of victory. Youth unemployment is 20%. That used to be Italy! In the past, people used to ask what your China exposure was and say you were underweight. Now, no one is saying that. People are very cautious.
How much do you have allocated to China?
Just 3% to 4% and it’s invested in really good and inexpensive companies like
Alibaba Group
and
Tencent Holdings
(700.Hong Kong) through
Prosus
(PRX.Netherlands). The bad news is that there’s still uncertainty, including [with the revised anti-espionage] rule this summer that’s so unclear. They need to have more transparent rules and regulations to make foreign investors feel welcome. China has turned from initiating policies that accelerate growth and economic development to paranoia and the Party first.
But China’s tech sector is world-class. I don’t own
Baidu
(BIDU) but the big three [which also includes Alibaba and Tencent]—and even others like
JD.com
(JD)—are good companies selling really cheaply. At these levels, upside could be explosive. One thing that’s clear is the regulatory onslaught that started three years ago appears to have backed off because that [sector] is the oil that keeps the economy going.
Take Alibaba. The regulation has made it it easier for competitors. We always thought Alibaba’s 40% market share wasn’t sustainable. Now, with the government’s help it makes the market share decline a bit quicker. On the other hand, [market share and profitability] hasn’t collapsed because you can’t compete versus this monster. It’s like competing against
Amazon.
Plus, [Alibaba’s plans to] spinoff businesses will help bring visibility into its inherent value. They have been a bit more proactive in putting the right people in the right place and will go with spinoffs. That will be a partial catalyst, but the biggest will be stability [in China’s economy]. They will need to be more aggressive at rolling out some sort of reform.
Thanks, David.
Write to Reshma Kapadia at [email protected]
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