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The hole truth

20/06/2012

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Why do we believe investors should spend so much time analysing companies and their balance sheets? Well, here is a story involving a business we do not own – and indeed both a theme and a country we are avoiding – that vividly illustrates why. For good measure, it also raises an awkward question or two about the global economy.

China’s economy, according to its national bureau of statistics, grew 8.1% over the first three months of 2012 while quarterly fixed-asset investment – essentially construction and infrastructure and one of the country’s principal economic drivers – surged 20.9%. Yet, according to an associated trade group, the China Construction Machinery Association (CCMA), sales in china that quarter of bulldozers, diggers, loaders and so forth plummeted.

At least one of these pieces of information must be wrong or there would appear to be some strange things going on in the Chinese economy. We would not presume to suggest which piece it may be, although the bearish headlines concerning Chinese property construction have been there for all to see.

So let’s examine the case of one particular business operating in the Chinese construction sector – the Hong Kong-listed Zoomlion Heavy Industry Science and Technology Co. with sales of some $7bn (£4.5bn) of construction equipment every year, it is a big company and, in that tough first quarter for heavy construction machinery, it actually saw its sales grow by 8%.

Not bad going with markets so tough, however not everything is as it may first appear in the Chinese bulldozer market. For one thing, analysis by stockbroker Jefferies shows that a lot of machinery Zoomlion sold in the first quarter went to customers who do not need it – for example, Jiangsu province has been one of the company’s biggest areas of sales growth and yet it currently uses only one in three pieces of heavy machinery it owns.

That should serve as one warning flag. A second stems from the fact that when a Zoomlion client buys something, they are not actually required to pay anything upfront. Some people might commend Zoomlion for the very generous financing terms it is offering its customers but the practice does raise the delicate issue of when a sale is not a sale.

This also leads on to a third red flag, in that many such customers take delivery of their bulldozer or whatever and immediately use it as collateral against a loan from a bank. There is a real liquidity crunch going on at the smaller end of the market in china with small and even mid-sized companies finding it tough to borrow money from the country’s regional banks.

Using heavy machinery for which they have not even paid a deposit as collateral is a handy way for such companies to find financing. However, at the very least, such a practice highlights not only an issue with borrowing in certain areas of the Chinese economy but also that companies are booking sales and revenues on the basis of false demand – their customers are actually after financing rather than diggers.

In a price mechanism such as china’s, things can become confused. any question marks over its ability to finance businesses or the validity of sales booked by its companies, or even ones resulting from any differential between official statistics and what appears to be going on at the ground, can hardly be good news for the country or, very probably, for other parts of the world.

To return to our original point, the case of Zoomlion is a fairly broad-brush illustration of why you need to be very careful when assessing a potential investment. For one thing, following a company’s cashflow is usually more important than trends in a company’s revenues – an approach that would have highlighted very quickly a few of the issues surrounding zoom lion’s sales growth.

Furthermore, as a subsidiary observation, when companies we are looking at are very exposed to trends that appear elevated – which these days would particularly include china – we treat them with extreme caution. As such, we tend not to be exposed to commodities or countries and companies that have been driven by the bull run in the commodity sector.

 

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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