Buying the Sandwich for the Mustard

Walter Mewing, one of my early mentors and a devout follower of Ben Graham’s value investing philosophy, often warned me against buying “the sandwich for the mustard”.

By this, he meant buying shares of a large, slow-growing company out of disproportionate enthusiasm for a promising but tiny division. Very often, even if a small division ends up delivering on its promise, it may be years before it makes a meaningful difference in the total profit of the parent company.

Today, a number of investors believe that the “safe” way to profit from China’s potentially awesome consumer market is to buy the shares of large, multinational, consumer-oriented companies. They reason that these large multinationals, with world-famous brand names, will likely be the early leaders in penetrating the Chinese market.

Based on the early evidence, these investors may well be right. But they still may be buying the sandwich for the mustard.

CLSA recently looked at eighty large companies with combined revenues of $5 trillion -- half of them listed in Europe and half in the United States. For nearly three-quarters of those multinationals, Asia contributed less than 10% of revenues or profits (for most companies, China is not yet important enough to be reported separately). Only eight companies derived more than 20% of earnings or revenue from Asia, but not one was a consumer company (Unilever, at 16%, was the consumer company with the highest Asian revenue contribution).

Mc Kinsey & Co. points out that the Asia-Pacific region accounts for only 19% of total US direct investment abroad. With some additional pencil pushing, they guesstimate that sales of foreign subsidiaries in China account for only 1.4% of the total sales of US multinationals. (Admittedly, this figure understates the case since it excludes exports to China). After studying 100 firms in greater detail, they conclude that investors in US multinationals who hope to gain exposure to Asia are likely to gain much heavier exposure to Europe.

I have previously mentioned that I expected the political and regulatory environment in China to become more volatile in coming years. This is also relevant in this context.

Regulatory unpredictability will not be entirely new: the Chinese government has a history of fine-tuning the development of its economy’s fledgling sectors to prevent any one company (especially foreign) taking too commanding a lead. Reportedly, this happened with Carrefour when it met with spectacular early success in opening hypermarkets in China. Various semi-occult retarding measures were taken until the likes of Wal-Mart and a couple of local competitors had a chance to catch up.

Two recent articles in the South China Morning Post reinforce my argument. One describes the difficulty Beijing is having in enforcing its directives, however well-intended, at the local level (Beijing’s Power Ebbs Away); the other indicates that there remains a fair amount of longing among the populace for the days of Mao Tse Tung, when life was more predictable and “corruption was less widespread” (Denizens of the Net Pass Judgment on the Helmsman). These conditions, I believe, explain recent efforts to strengthen the Communist Party’s control over the country and foreshadow an increasingly dirigist style of economic management. This is why I expect increased volatility and reduced visibility in the regulatory environment.

Besides this uncertainty, the Chinese consumer market, potentially attractive as it is, remains incredibly complex to penetrate.

The logistics of supplying a huge country that has an inadequate transportation infrastructure are compounded by the scarcity of reliable distributors. A majority of firms, for fear of not being paid by their agents, still insist on being paid cash on delivery.

In addition, the Chinese consumer market is far from homogeneous. The CEO of a highly successful European personal care products firm told me, some time ago, that “in every city that we seek to penetrate, previous experiences (even from nearby cities) are irrelevant. We start from scratch in terms of tastes, merchandise offering, price segmentation, etc.” To sell shoes nationally, Yue Yuen is testing at least a half dozen different retail formats.

Finally, while brand conscious, the Chinese consumer is incredibly price sensitive. Of course, some nouveau riches will pay a few thousand dollars on a bottle of wine, to show off. But more generally, it is startling, when shopping with a Chinese, how they know the price of everything. The result is a steady pressure on prices and, by and large, low margins for consumer-oriented companies.

With respect to brands, I should remind the reader of the fierce competitive environment. As you stroll through a department store, the booths for most of the well-known global brands are interspersed with others that have Italian or English sounding names but are totally unknown outside of China. Yet, to a fresh-minded consumer, these local start-ups have the same chances of becoming favorites as the more established brands.

Thus, it is very difficult to identify the future winners in the Chinese consumer market, even when some contenders seem currently ahead of the pack. At least, if an investor is right about a Chinese company, he or she may hope to reap 100% of the gain. Unfortunately, in most cases, one is already paying for the hope. As for foreign multinationals, especially in a less-than predictable regulatory environment, large profits in China may be very slow to come to them.

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Whether it is in picking hedge funds or investing in exotic markets, today’s investors are displaying a misplaced caution. Whereas they used to accept an additional degree of risk in the hope of higher returns, they now try to eliminate the risk factor altogether, even when choosing inherently risky investment vehicles.

However, investing is all about taking considered risks. In the case of China, and particularly its consumer market, there will come a time when conditions are ripe to take that type of risk. But the time may not be now and, when it comes, the best vehicles may not be the shares of large, multinational “sandwiches”.

François Sicart

December 28, 2005

© Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.