Samir Mehta: The role reversal driving equities in China and India

Are global equities on the cusp of a structural change? Pendal’s SAMIR MEHTA explores the fundamentals driving bull and bear markets in the East

• China undergoing “serious” consolidation
• BYD and Tencent Music clear winners in China
• Find out more about Pendal Asian Share Fund

BUSINESSES are commercial opportunities spotted by risk-taking entrepreneurs with access to capital and other helpful resources.

Traditionally, one needs competitive “moats” to deliver sustained high Returns On Capital Employed (or ROCE). But, like much in the world, moats are no longer stable.

The internet, strident monetary actions by central banks, government policies and ideological competition have drastically modified the way that moats are built and, importantly, destroyed.

So far, we have seen momentous changes encapsulated in the mantras of:

• Deng Xiaoping and his astute strategy to “hide your strength and bide your time”
• Jeff Bezos and his simple focus on “your margin is my opportunity”
• Masayoshi Son and his grandiose declaration that “in our industry, winner takes all”

China directed its state apparatus to foster industries from scratch. Amazon became laser-focused on the long term, with nary a care for short-term losses. And Softbank handed over copious amounts of capital to one player in an industry with an explicit directive of killing competition and emerging as a winner through the carnage.

Role reversal

So, what kicked off a bull market in China around the same time as a bear market in India?

Was it just foreign investors switching from India to China, or Xi Jinping recognising the folly of his ideology and a change in heart?

Could it have been a “DeepSeek moment”? Or because (in President Trump’s world) perceived allies are worse than avowed enemies (hence India losing out from harsher tariffs)?

One can’t be sure of the exact root cause.

But let me offer a more fundamental justification: there is a significant role reversal occurring between China and India, led by the change in attitudes of management teams towards profits and ROCEs.

For decades until the pandemic, China Inc. epitomised the three mantras I referenced above.

A heady mix of abundant low-cost capital, regulatory help (including subsidies), insane hunger for scaling business, and a priority for market share over profitability defined most businesses.

Despite many ambitious talented entrepreneurs with varied opportunities, few companies achieved the haloed status that Mr Buffet might covet.

On the other hand, before the pandemic hit, India Inc. was the opposite.

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Burdened with a high cost of capital, hindered by governmental regulations, and entrepreneurs with limited ambitions prioritising high ROCEs above all else.

Since 2021, economic growth in China slowed as a result of regulatory crackdowns, geopolitical headwinds and a bust housing market.

Venture capital investments slowed to a trickle; several businesses, including start-ups, shut down. The stock market tanked and foreign capital withdrew from China. And a deflationary slowdown prompted local investors to buy more bonds and shun equities.

Post-pandemic India was the rising star – benefitting partly from the ‘China plus one’ strategy (that is, diversify away from China to minimise risks).

A production-linked incentive scheme (tax benefits) in India encouraged large-scale incremental manufacturing. There grew a belief of achieving GDP growth of 7-8% p.a. for the next decade. If China had achieved it in the past, why not India?

India’s downdraft

Stock markets boomed and corporate earnings grew when China struggled. Equity valuations skyrocketed, trending closer to twice the mean valuations compared to the past decades. Retail investors, global asset allocators, venture capitalists and even China-focused hedge funds wanted to invest in India.

What went unnoticed, however, was a loosening of discipline by management teams under this illusory guise of assured growth.

High ROCEs in many industries attracted new entrants as conglomerates, nimble start-ups and medium-sized firms backed by venture capital attacked incumbents. A heady cocktail brewed – fueled by high equity valuations, cheap and plentiful venture capital, and unfettered ambition.

For example, the paints industry in India was a cosy oligopoly led by Asian Paints. Decades of steady growth, high margins and high ROCEs meant that even its smaller competitors thrived.

While some international companies tried to build a business in a cautious manner, struggled to break the oligopoly and gave up, Grasim (part of the Aditya Birla group) thought otherwise. The manufacturer of viscose staple fiber and chemicals invested upwards of Rs100b (US$1.25bn) in just three years, while market leader Asian Paints invested approximately Rs.97.2b over the past decade.

Another example is Zomato, which started out as a restaurant aggregator and grew into a formidable food delivery platform. Through Blinkit (which was recently acquired), Zomato expanded into quick commerce to deliver groceries and goods to consumers within 15 minutes via ‘dark stores’ or warehouses.

Swiggy (listed, venture-backed), Zepto (unlisted, venture-backed), Reliance Industries, and Flipkart (owned by Walmart) have committed several millions in investments chasing this opportunity, while other potential competitors could also enter the fray.

Elsewhere, Ultratech Cement announced its entry with a US$200 investment in manufacturing cables and wires (another oligopolistic sector). Shares of Polycab and KEI Industries promptly fell 25-30% in less than a week.

And Reliance Industries has begun expanding into carbonated soft drinks through Campa at a much cheaper price, threatening ROCEs of Pepsi bottler Varun Beverages.

I could cite many more examples, but you get the drift.

China’s updraft

In China, after years of competition, we now have serious consolidation.

For instance, in the electric vehicles space, perhaps six to eight serious competitors (of the 80-100 start-ups and brands) have survived over the past two decades.

Build Your Dreams (BYD), the clear winner, has achieved a level of scale cost and technological leadership which, in my view, is unparalleled. BYD’s ROCE has risen from a range of 7-12% pre-pandemic to 25-30% in the past three years.

In online music, Tencent Music is almost a duopoly with Netease Music (though Bytedance is still in the mix as a marginal player). Despite slashing its marketing and sales spend in recent years by 75% (compared to 2019/20), Tencent Music has continued to gain subscribers and substantially increase gross margins.

Full Truck Alliance (Uber for logistics) has come through the downturn and emerged as one of the strongest competitors matching shippers and truckers of cargo.

Its ROCE has risen from negative pre-pandemic levels to 9-11%. And if my analysis is right, it could double over the next three to five years as it gains scale and operating leverage.

Bull or bear in the East?

Capital and competition go through phases.

While I do not suggest that these changes in China are permanent, the point I do wish to make is that Indian corporate ROCEs are waning, while those for China are ascending.

Because when structural changes in industry dynamics (higher ROCEs) combines with investor disinterest (low valuation multiples), the resulting profit growth and valuation multiple expansion for Chinese stocks can surprise on the upside.

This bull market in China – in many stocks – has legs. And if the Chinese authorities provide some stimulus, or if President Trump agrees to a deal, we could take that as superfluous arguments for capital to chase what is becoming a structural pivot.

About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal’s Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Perpetual Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

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