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NOVEMBER 2016

ASIA 2017:
THE NEW ECONOMY WON.
WHAT NOW?

The questions "here" are the same as the questions


"there": New Energy, FinTech, Quality, and Infrastructure
The natural division of investment controversies globally between emerging market and
developed market is breaking down. Commodity consumption, government appetite for
reform, and financial system risk all still matter in emerging markets, just not as much.

Investment controversies in Asia now come down to disintermediation, competitive


moats, incremental return on investment, and the "twilight" for the losers. It is these same
questions that define investment controversies everywhere.

We explore the role of FinTech in India and China, New Energy in Asia and globally, the
search for Quality companies in Asia, and the lessons for India from Chinese
infrastructure investment over the last 15 years.

The highest-conviction ideas for 2017 from the contributing analysts are: CCB, KMB,
Wuliangye, Inpex, VA Tech Wabag, Keyence, Samsung Electronics, China Unicom, and
Jiangsu Hengrui.

SEE DISCLOSURE APPENDIX OF THIS REPORT FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS
BERNSTEIN

PORTFOLIO MANAGER'S SUMMARY


For each of the last four years, we have presented our combined view on the most
important questions facing investors focused on China in the year ahead. This year, we
broaden our gaze to Asia as a whole, reflecting our broadening coverage. Overall, we now
cover ~150 stocks across 16 sectors in 12 Asian markets.

What is striking when putting together the most important questions for investors in Asia
in 2017 is how similar those questions are to the issues confronting investors in
developed markets at present: FinTech; New Energy; the search for competitive moats
and high-Quality companies; and the role of hard (bridges and tunnels) and soft (4G)
infrastructure in accelerating growth. In this Blackbook, we consider questions in relation
to the lessons China offers to India in terms of developing infrastructure and capital stock,
the future of energy, how to identify Quality companies in Asia, and the risk of
disintermediation to the banking sector from FinTech in China and India.

The questions that have dominated our discussion of Asia ex-Japan in prior years
commodity demand growth and geological scarcity; government appetite for reform and
foreign investment; the risk that high-growth markets and sectors are "frauds" and
"bubbles"; and the ability of emerging markets to aggregate capital and manage public
and private debt are, in many cases, receding. Said differently, the New Economy won.
Economic growth in emerging Asia is now, irreversibly, about services and the consumer.

As we saw in 2016, there will still be cycles in terms of commodity prices and rotation in
and out of the Old Economy. But the broad direction of equity market in Asia is clear: the
Asian consumer's desire for entertainment, apparel, transport, credit, financial security,
information, and pizza will drive public equity market investment opportunities in Asia
just the way it does in the developed world to a far greater extent than the contents of
the Five-Year Plan (any Five-Year Plan).

The highest conviction ideas of contributing analysts are: CCB, KMB, Wuliangye, Inpex, VA
Tech Wabag, Keyence, Samsung Electronics, China Unicom, and Jiangsu Hengrui.

Michael W. Parker michael.parker@bernstein.com +852-2918-5747


Neil Beveridge, Ph.D. neil.beveridge@bernstein.com +852-2918-5741
Gautam Chhugani gautam.chhugani@bernstein.com +65-6230-4654
Venugopal Garre venugopal.garre@bernstein.com +65-6230-4651
Jay Huang, Ph.D. jay.huang@bernstein.com +852-2918-5746
Wei Hou wei.hou@bernstein.com +852-2918-5756
Chris Lane chris.lane@bernstein.com +852-2918-5710
Euan McLeish euan.mcleish@bernstein.com +852-29185780
Laura Nelson Carney, PhD laura.nelson.carney@bernstein.com +852-2918-5727
Mark C. Newman mark.newman@bernstein.com +852-2918-5753
November 29, 2016

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TABLE OF CONTENTS

SIGNIFICANT RESEARCH CONCLUSIONS 5


THE OLD ECONOMY AND THE NEW 17
The New Economy won the war and lost the battle in Asia in 2016
THE SEARCH FOR QUALITY CONTINUES 57
What can booze and drugs teach us about Quality companies in Asia?
IS IT INDIA'S TURN? PART I 127
What can we learn from China's rise?
IS IT INDIA'S TURN? PART II 179
Is it on the right track? Where are the opportunities for investors?
CONSUMER CREDIT IN CHINA AND INDIA 233
Which market faces more risk of disintermediation from FinTech players?
THE FUTURE OF ENERGY 261
Evolution or revolution?
FINANCIAL OVERVIEW EXHIBITS 321

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SIGNIFICANT RESEARCH CONCLUSIONS


THE QUESTIONS HERE ARE JUST 2017 will be exceptional for investing in Asia ex-Japan in one respect: for perhaps the first
LIKE THE QUESTIONS THERE time, it will be just like investing anywhere else.

The two most important industries in the world for most of the last 100 years and in
th
emerging markets today (still, just) are banks and energy. Throughout the 20 century,
the ability to aggregate and deploy large amounts of capital into energy-intensive,
commodity-intensive, labor-intensive projects was the "killer app" that shaped the
modern age. Electrification, highway systems, telecommunications networks, pipelines,
aviation, shipping, and construction together with oil, gas, and coal production itself, all
relied on the twin pillars of banks to provide capital at low cost and an infrastructure to
provide the energy to build an early version of machines building machines.

Over the first decade-and-a-half of this century, that capability aggregating and
deploying capital is how China separated itself from the rest of emerging markets and,
in particular, Brazil, Russia, and India.

Today, the banking sector and the energy sector, globally and in Asia, are under attack.
And the banking sector and the energy sector, globally and in Asia, are losing. In this
Blackbook, we explore FinTech and the Future of Energy and how these battles are
playing out in Asia. However, an aspect of our analysis that is easy to overlook is the fact
that Asia merely provides the backdrop. Fintech and the Future of Energy are global and
largely location-agnostic trends that are playing out at the same time in Asia, in the United
States, and in Europe. For the first time, the questions "here" are the same as the
questions "there."

In almost every industry, globally, new technologies with disruptive potential are attracting
capital. The difference between successful innovation and false dawn comes down
broadly to two factors, in our view: first, the depth and breadth of the "moat" (and the new
entrant's ability to cross it); and second, the return on incremental investment for new
entrants and incumbents. For successful innovations, the new entrants (or at least their
technologies) eventually win. Switching costs determine the length of the loser's
"twilight."

In this Blackbook, we look at the depth and breadth of the "moat" and the new entrant's
ability to cross it in Asia in two ways.

First, Laura Nelson Carney, our Asia-Pacific healthcare analyst, and Euan McLeish, our
Asia-Pacific beverages analyst, look at incumbent "moats" and the ability of new entrants
to cross them in terms of management quality and product quality in Asia. Most
quantitative-based metrics for Quality in Asia miss a number of good companies because
of either selection bias (MSCI inclusion is, in some ways, a lagging indicator) or data
sufficiency problems. Yet management and product Quality of new (and, almost by
definition, small) entrants are a key determining factors to disruption. Many Quant screens

ASIA 2017: THE NEW ECONOMY WON. WHAT NOW? 5


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systematically miss the relevant universe. We consider Quality in Asia from the ground up.
We look at false positives and false negatives in two diverse sectors healthcare and
beverages to determine if there are common, systematic trends in terms of what we
miss.

Second, our Asia-Pacific telecommunications analyst Chris Lane, our India capital goods
and infrastructure analyst Venugopal Garre, and our Asian capital goods analyst Jay
Huang consider the lessons that India can learn from Chinese infrastructure investment
over the last 15 years. Lumping developing economies with developed markets when it
comes to the risk of disruption only makes sense where the emerging market
infrastructure is up to the task. For example, given problems with power supply in India, is
electric vehicle adoption over the next 15 years a threat to incumbent vehicle
manufacturers in India to the same extent it is in China, the United States, and Europe? Is
FinTech a significant risk for a population largely communicating on second-hand 2G
phones (see Exhibit 1)? The quality of national infrastructure may itself represent a "moat"
at least in India for the kind of the developed-market disruption model we are
discussing.

EXHIBIT 1: Mobile wallet usage is fast expanding relative to plastic cards

Transaction Volume (INR in Bn) 3,132

2,407

2,056
1,900

1,540 1,591

1,213
955

429
206
29 82

FY14 FY15 FY16 FY17*

Mobile Wallets Debit Cards Credit Cards


Transaction Volume Growth (Y0Y)
190%
182%

152%

108%

28% 25% 27% 31% 27% 29% 30%


23%

FY14 FY15 FY16 FY17*

* FY2017 estimates are based on actual values during the April-August 2016 period.

Source: RBI and Bernstein analysis.

We then look at the return on incremental investment for new entrants and incumbents in
terms of both energy and financial disintermediation.

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Returns on incremental investment determine the success or failure of new technology.


The next ton of coal is deeper and less accessible than the last. Almost by definition, costs
rise and returns fall over time. Renewable energy is a technology and a manufacturing
process: costs fall with experience, rising expertise, and size; returns scale with increasing
efficiency and throughput. The end state is preordained based on incremental returns on
investment. The question is timing: the length of the twilight.

First, our Chinese banks analyst Wei Hou and our India financials analyst Gautam
Chhugani look at the emergence of financial technologies (FinTech) in China and India and
the risk that these financial innovations pose to both the financial system and to
incumbent banks (both SOEs and the private sector). As in any sector, where the cost of
the incumbent to retain customers is higher than the cost to the innovator to acquire
customers (retail branch versus online banking), the switch in the sector over time is clear.

Second, our global energy storage and electric vehicles analyst Mark Newman and our
Asia-Pacific oil & gas analyst Neil Beveridge review the Future of Energy. Given the
increasing likelihood that either through compliance with fleet fuel-efficiency standards
or in response to customer demand electric vehicles will become a larger and larger
part of annual auto sales (perhaps as high as 25% by 2025), we consider the effects on
oil, coal, and gas and the switching cost from fossil fuels looking out decades.

At the end of 2016, the questions "here" (in emerging markets in Asia) are largely the
same as the questions "there" (developed markets globally): Quality, Infrastructure,
FinTech, and New Energy.

THE NEW ECONOMY WON THE In Asia, the New Economy finally "won" in 2016. Measured by long-term stock market
WAR AND LOST THE BATTLE IN performance, sources of economic growth across the region, falling energy intensity, and
ASIA IN 2016
the sources of profit growth in the public equity marketsthe Old Economy is over.

Emerging Asia will never have a traditional "industrialization" phase where the majority of
economic output comes from manufacturing, construction, and industry. Since the largest
economies in Asia are now through that phase or (like India) are unlikely to ever enter it, it
is now all about services (see Exhibit 2). That does not mean that the equity value of the
Old Economy will fall monotonically each year. Energy and materials were the two
best-performing sectors in Asia in 2016. The rallies in materials and energy this year
reflect both the recovery in the underlying commodity prices since the first quarter and
the mean reversion within the sectors regionally. Quality and Growth continue to look
extraordinarily expensive in Asia.

Value and Income continue to look extraordinarily cheap. But the gap has closed since the
mid-year. The materials and energy stocks were the primary beneficiaries of this shift in
the second half. We believe that the historically high gap between Quality and Growth,
and Value and Income will continue to close.

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EXHIBIT 2: Pan-Asia agriculture/industry/services GDP share (1967-2015E)

60% 0.30

0.29
50%
0.28

0.27
40%
0.26

30% 0.25

0.24
20%
0.23

0.22
10%
0.21

0% 0.20

Energy Intensity (RHS) Agriculture Industry Services

Source: World Bank, and Bernstein estimates and analysis.

We also believe that owning financials and utilities are a better way to participate in the
mean reversion in 2017, rather than chasing energy and miners.

EXHIBIT 3: Profit pool (1H2016) share by sector for MXAPJ EXHIBIT 4: Profit growth(1H2016-1H2015) share by sector for
MXAPJ
Includes only those sectors which had postive Net Income
growth (1H16 v 1H15), ex one-off gains/losses for BABA,
Consumer
Energy Staples Internet Health BHP, Vedanta, South 32, Rio Tinto, and Fortescue
3% 2% Care
2% 1%
Utilities Healthcare Utilities
4% 17% 1%

Materials
4%
Financials
Telecom 45%
6%

Industrials Internet
7% 52%

Real Materials
Estate 30%
8%

Consumer IT (ex
Discr Internet)
8% 10%

Note: Excludes one-off gains/losses for BABA, BHP, Vedanta, South 32, Rio
Tinto, and Fortescue.
Source: Bloomberg L.P. and Bernstein analysis.
Source: Bloomberg L.P. and Bernstein analysis.

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Compared to historical valuation multiples, financials and utilities remain at or more than
one standard deviation below the long-term trend. Energy and miners are at or above
long-term average valuation multiples.

The Asian consumer continues to look strong. Profit growth has been dominated by
consumer-driven sectors like the Internet and healthcare (see Exhibit 3 and Exhibit 4). The
Asian consumer's desire for entertainment, apparel, transport, credit, financial security,
information, and pizza will drive public equity market investment opportunities in Asia. The
Asia Blue Chips now reflect this reality. Tencent, Alibaba, AIA, China Life, HDFC, Samsung,
and TSMC among others largely play on the Asian consumer more than on Asian
manufacturing capabilities.

We maintain a "focus list" that reflects, in part, confidence in Asia Blue Chips in an
environment of a healthy Asian consumer and a structural, long-term rotation to the New
Economy. We also include high-conviction thematic ideas that largely sit within the
consumer sector. In addition, we incorporate stocks in the "focus list" that follow the
direction implied by our factor analysis. Currently, that means dividend and FCF-yielding
stocks are inexpensive on a P/B and P/E basis versus their history. At present, that means
a clear overweight toward financials (China Life, AIA, Bank Mandiri, ANZ, CCB, and ICBC)
and utilities (Huaneng Power, KEPCO, and China Resources Power). We are net neutral on
energy between Shenhua (a "Short") and PTT E&P.

QUALITY IN ASIA Quality has proven more elusive to investors in Asia than in developed markets. The
longstanding gripe about investing in Asia where are the companies with rapid earnings
growth, high ROIC, good management teams, large competitive advantages, and strong
balance sheets? has, in 2016, narrowed down to: I cannot possibly own any more
Tencent.

Our Quality tools for Asia are arguably unreliable for one of four reasons:

We use too narrow a hunting ground (we only look at stocks already inside the MSCI
All Country World Index, and our regional Asian factor analysis only considers
companies with a market cap above US$1 billion);

We demand too long a historical dataset (we exclude stocks where historical data on
a number of factors is unavailable, yet some of the best-quality businesses in Asia are
newer than in developed markets);

Our selection criteria (strong balance sheet, low debt, high ROIC, and little associate
income) generates stock recommendations like Huabao (a Chinese PLA tobacco
additives company) or Dong E-E Jiao (a "traditional" medicine company making
products derived from donkey skin and urine that lack evidence for efficacy) that do
not really resemble anyone's idea of quality; or

We overlook or ignore the reality that Quality in emerging Asia looks different to
Quality in developed markets (e.g., some Quality companies in growth phases choose
to make temporary trade-offs between growth and ROIC, addressable markets in

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Asia can be much higher growth than in developed markets, and robust risk
mitigation strategies are even more important in Asia).

EXHIBIT 5: What does Quality look like in Asiaand how to evaluate it? Our seven-dimension Quality framework
Quality of Parameters to assess Quant proxy we used Fundamental
analysis needed
Strategy Expanding margins (targeted mix shift) Increasing net income margin (2014-18E)

Clarity and focus of growth strategy



Optimized mix of products or service offerings

Strength of distribution reach

Exposure to and mitigation against key risks

Products or services Investment in future products 3 yr average R&D spend to net sales (201215)

Clear differentiation versus competitors

Affordability of products

Strength of brand and reputation

% of revenue from outside home market

Addressable market Consistent sales growth Net sales growth CAGR (2014-18E)

Size and growth of addressable market (s)



Market structure

Earnings and Earnings derived primarily from core business 3 yr average % of income from asc income (2012-15)
financial returns
ROIC > WACC 3 yr historical average ROIC / WACC (2012-15)

Strong FCF yield 3 yr historical average free cash flow yield (2012-15)

Capital structure and Balance sheet strength 3 yr average net debt to assets (2012-15)
financial statements
Optimized capital allocation

Clean and consistent revenue booking approach

Fair value of goodwill and intangible assets

Management Depth of relevant experience

Diversity

Higher founder ownership (if applicable)

Free from historical corporate governance scandals

Reasonable level of exposure to related transactions

Investors Savvier shareholders % institutional ownership

Foreign ownership

Source: Bernstein analysis.

The nature of what Quality means in emerging Asia is a little different than in developed
markets (see Exhibit 5). The next question is: how and why? What are the core set of
differences that should color how we think about what Quality means in Asia? We see at
least five differences to point out:

Less mature industries and companies in Asia: Many companies (and industries) are in
growth phases of their development, which comes with trade-offs against what
would be defined as high Quality in mature companies elsewhere. This often means
trade-offs between ROIC and growth (either in scale or margins). For fast-growing
companies in Asia, sometimes management teams, choose growth over margins.
Thus, we may see a period of contracted margins, when compared to peers in
developed markets. A simple generalization that overlooks this temporal trade-off
may lead to overlooking high-Quality companies.

10 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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Shorter histories of historical data in many companies: In some sectors and countries
in Asia (healthcare included), many of the largest companies are all less than five
years old. Global quant approaches often look for five years of historical data, which
knocks out many Asian companies (particularly in new economy sectors).

Quality management looks different than those in developed markets: Founders are
often still running the company, family members are often still involved, and
professional management teams are less common than in developed markets. This
can mean that narrower diversity and depth of experience are the norm. Moreover,
the prioritization of management capabilities varies depending on the stage of
industry development.

Competitive differentiation: Competitive differentiation can be more fleeting than in


developed markets, given the pace at which business models, products, and ideas
are copied and improved upon (particularly in China). Strong balance sheets look
different in Asia; in some sectors, many companies sit on mountains of cash and carry
little to no debt.

We identify Quality companies in the Asia healthcare and beverages sectors that meet our
criteria, but which the normal pass using developed market filters might miss. We think
there are lessons here across Asia beyond these two sectors.

INFRASTRUCTURE IN CHINA On a number of economic indicators, India resembles China in 2000-05. Over this period,
AND INDIAANY LESSONS? China pursued an aggressive policy of infrastructure development, urbanization, and
export growth, which has made it the world's largest economy on a PPP basis. China's
GDP has expanded at a 10% CAGR, contributing a net increase of 30% of global GDP,
and China's share of total global GDP expanded from 4.5% in 2004 to 15% in 2015. If the
highest-level question is whether India's infrastructure today can match China's and
facilitate the development market "disruption model" we outline, the answer is: if all that
the disruption requires is a phone, then the answer is "yes."

EXHIBIT 6: India is far behind China in EXHIBIT 7: railroads EXHIBIT 8: air travel
infrastructure build and usage like
highways

Length of Highway per Sq. Railway Goods Transported Air Freight Transported per
0.50 Km of Land Area per Capita Capita
15
0.40 2000
0.30 10
1500
km

ton-km

ton-km

0.20 1000
5
0.10 500

0.00 0 0
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014

1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013

China India China India China India

Source: Government websites and Bernstein Source: Government websites and Bernstein Source: Government websites and Bernstein
analysis. analysis. analysis.

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(Can the China miracle be repeated? The sectoral focus in India is following China's lead
from a decade-and-a-half ago: improving infrastructure, increasing the manufacturing
mix (although mostly import substitution), and broad efforts at easing the business
environment (see Exhibit 6 to Exhibit 8). The approval of the Goods and Services Tax
(GST), efforts to tweak labor laws, introduction of the Contract Disputes Act,
commencement of ease of business rankings for states, and reducing FDI caps in some
sectors are key areas of policy progress.

EXHIBIT 9: shipping EXHIBIT 10: and electricity EXHIBIT 11: India is comparable to China
in clean water access

Container Port Traffic per Electric Power Consumption Access to Improved Water
0.15
Capita per Capita Source (% of Population)
20-Foot Equivalent Units (TEUs)

KWh per Capita 4,000 100%


0.10 3,000 90%

2,000 80%
0.05
1,000 70%

0 60%
0.00

1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

China India China India China India

Source: Government websites and Bernstein Source: Government websites and Bernstein Source: Government websites and Bernstein
analysis. analysis. analysis.

India's rise may not be as fast as China's, and growth is likely to happen in spurts and
cycles, but we have no doubt that it will happen (see Exhibit 9 to Exhibit 11). Over the long
term, we do expect infra build and manufacturing to accelerate, but we see less scope for
India to emerge as a manufacturing-exports-led economy over the next decade. We see
the development of some industries such as defense manufacturing though, as India
continues to push for import substitution.

As India continues to see macro growth, rising per capita incomes coupled with
urbanization should continue to aid consumer discretionary, including autos (shift to
premium focus) and consumer electricals/durables. Telecom services (Bharti, a key pick)
should continue to grow, while e-commerce will develop, providing opportunities in its
supply chain (including logistics). Construction will provide opportunities, but we see
building products and consumer electricals as a better way to play that. In manufacturing,
apart from the emergence of a new manufacturing supply chain in the defense sector, we
expect opportunities to eventually emerge for ports and freight operators.

THE INEVITABLE RISE OF China and India operate in a different regulatory framework. Banks in China are subject to
FINTECH IN INDIA AND CHINA strong regulatory influence on pricing and volumes. Even private-owned banks face
challenges in maintaining the independence of their day-to-day operations. Indian banks,
however, are free to price their loans and expand their volumes.

The two markets went through a period of rapid credit expansion leading to an eventual
credit slowdown. China expanded credit rapidly in the last six years, with credit-to-GDP

12 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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already reaching 200% of GDP now. The growth of credit was also heavily skewed
toward public sectors (local governments and state-owned enterprises), where leverage
has become unsustainably high. India, on the other hand, expanded system credit at
almost a 21% CAGR over the last decade-and-a-half. The consequences of rapid credit
expansion in India have been significant corporate credit stress and choking of corporate
credit growth.

EXHIBIT 12: Comparison of FinTech companies with traditional financial institutions

30.0%
Small Loan Company

Lending (RMB936bn/
USD140bn)
Typical MSE Lending
cutoff
20.0%
Gray/Private Lending
Credit Card (RMB10tn/USD1.5tn)
(RMB3.6tn/
17.5% USD500bn)
Internet Bank Loan Coverage
(Today): Shadow Banking
15.0% RMB27bn /USD4bn (RMB19tn/USD2.8tn)
P2P Lending
(RMB680bn/
USD100bn)
12.5%
Interest Rates (%)

Webank Loan Coverage (Future)

10.0%
Scenario-Based MSE Lending
Lending (RMB19.3tn)
7.5%
(RMB14bn/
USD2bn) Large Corporate Lending
(RMB53.7tn/USD7.9tn)
5.0%

Banking Channel
2.5%
Non-Banking Channel
0.0%
0 7.5K 15K 75K 1M & Above
Average Loan Amount (USD)

Source: Wangdaizhijia, CBRC, iResearch, corporate reports, and Bernstein estimates and analysis.

With corporate growth slowing down, the next growth horizon is consumer retail lending.
Low credit penetration in India is driven by the fact that a huge base of population (~500
million estimated) is below certain income thresholds that are typically not targeted by
banks. In China, further headroom for growth exists in consumer lending due to the
under-serviced household sector, the need to rebalance the economy to a consumption-
driven growth model, and an improving credit infrastructure with private investments. In
this context, we believe the rise of FinTech companies is inevitable in both markets, but
with different near-term opportunities.

FinTech in China will be more credit led versus India, where payment will be the main
theme in coming years. In China, where basic banking coverage is high and the e-payment
market structure has matured (dominated by Alipay and Tenpay), future growth
opportunities for tech players will focus on providing complementary value-add services
such as MSE and consumer lending (see Exhibit 12). However, in India, the immediate
opportunity for the new entrants is providing microcredit, payments, and financial

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inclusion to a large segment often ignored by banks. The new, niche business models are
focused on consumer credit (e.g., small finance banks providing microfinance and small
ticket loans), while the payments within the FinTech space could have a material impact
on traditional banking.

China banking has been highly regulated with two interesting characteristics: 1) high
government ownership, with state-owned banks accounting for ~40% of total market
share; and 2) strong government influence through loan quota, pricing controls, and
frequent policy guidance. This means that even the privately owned banks in China are
subject to significant government influence on their day-to-day operations.

In India, system leverage reflected by bank credit-to-GDP looks much lower relative to
China (55% of GDP versus China at 200% of GDP). However, the number does not reflect
the period of rapid credit expansion that India underwent in the last decade-and-a-half at
almost a 21% CAGR. This translated to significant overleveraging of corporate balance
sheets, resulting in significant credit stress within the banking system. While similar to
China, state-owned banks still dominate ~75% of system credit. However, the regulatory
landscape in India is significantly liberalized: 1) there are no pricing controls across loans
and deposits; and 2) policy guidance is aimed at providing a framework to govern the
banks and their policies (including accounting policies). However, there is a strong focus
on financial inclusion and providing loans to the priority sectors such as agriculture and
financially excluded customer segments.

THE FUTURE OF ENERGYAND Advanced batteries are enabling revolutions in both transportation and energy. Not only
THE LONG TWILIGHT OF are batteries the major component driving the adoption of EVs, they also allow
CARBON
renewables penetration to grow from today's current low base. EVs are faster, cleaner,
better, and will in the next 10 years also be cheaper than fossil-fuel-powered cars.
Today, EVs, particularly from Tesla, are starting a high-end disruption of the auto industry,
and as battery costs fall, we believe that disruption will continue down to the low-end.
While the losers in this disruption are obvious, the list of winners is more difficult. We
believe that the winners include battery makers, and the battery supply chain, new-
entrant EV makers, and forward-looking utilities that embrace EVs and renewable
technologies. Losers, we believe, include traditional car OEMs and auto-parts suppliers
that will be forced to either disrupt themselves and render obsolete their combustion
engine technology and assets, or fight the inevitable EV trend, and thus be disrupted by
new EV entrants.

In terms of the impact on demand for fossil fuels and other sources of energy supply, our
conclusion is that, given the size of the gasoline-fueled base and the scale of EV
production today, over the next 10 years, the impact on oil, natural gas, and electricity
demand is minimal (see Exhibit 14 and Exhibit 15). The multiple to put on fossil fuel
producers, given that things are only going one direction, is the entirety of the demand.
We are valuing the long twilight.

14 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 13: The coming peak in global energy demand: Peak coal in 2020, peak oil 2030-35, and peak energy in 2050-60
1400
PeakOil
Energy Demand, (Quadrillion Btu)

203035
1200 1.5%
Efficiency
PeakCoal
1000 202025
2.0%
800 Efficiency

600
2.5%
Efficiency
400 2015

200

0
1820 1850 1880 1910 1940 1970 2000 2030 2060 2090

1.5% Energy Eff. 2.0% Energy Eff 2.5% Energy Eff

Source: BP Statistical Review, IEA, World Bank, IMF, Smil (1994), Maddison (2007), and Bernstein estimates (2016 and beyond) and analysis.

Coal demand has peaked, or is close to peak levels (see Exhibit 13). Despite the
renaissance for coal stocks in 2016 on a recovery in coal pricing, the outlook for the
commodity remains negative. Coal must be displaced from the energy mix if Paris
Agreement targets are to be met. Even without U.S. compliance with the Paris Agreement,
the brute force of the economics suggests no positive outcome for the industry, unless
carbon capture technology is developed. At this stage, this looks like a remote possibility.
We would avoid coal.

Oil demand has yet to peak and we see another 15 years of demand growth, with a peak
in the early to mid-2030s. While EVs are a threat, there remains considerable uncertainty
around adoption, and over the next 10 years, the impact is likely to be minimal. Moreover,
even if gasoline peaks in the mid-2020s on fuel-efficiency measures, oil demand for
petrochemicals and jet travel will continue to drive overall growth. Over the next five years,
we expect oil prices to increase, which will be good for oil stocks that have low costs and
organic growth. Longer term, peak oil demand will be a negative for OPEC producers with
long reserves life and owners of marginal assets with long reserves life such as oil sands.
One risk to oil demand is that of long reserves life owners seeking to accelerate
production to avoid the risk of getting stranded. While this is a risk, we have yet to see this
behavior.

The growth outlook for natural gas is positive over the next 30 years, with demand likely to
double. Gas cannot be the long-term solution (given carbon emissions), but it can act as a
bridge to a low carbon future. The biggest risks to gas are battery technology improving to
a point where renewables can become reliable sources of energy, or countries ignoring
the Paris Agreement and, therefore, coal not being displaced. Shale has transformed the
supply outlook in North America and potentially for LNG, which could lead to structurally
low prices, and over time, a break with the oil linkage. Low-cost gas supplies, downstream
gas volume plays, and LNG infrastructure companies (regas terminals and shipping) could
be winners.

ASIA 2017: THE NEW ECONOMY WON. WHAT NOW? 15


BERNSTEIN

EXHIBIT 14: Currently, fossil fuels (coal, oil, and gas) account EXHIBIT 15: Oil took 30 years and natural gas took 68 years
for 80% of energy demand to go from 1% to 10%
600 100%

90%

500
80%

70%
400

60%

300 50%

40%

200
30%

20%
100

10%

0 0%

Biomass Coal Crude Oil Natural Gas Biomass Coal Crude Oil Natural Gas
Hydro Nuclear Solar,Wind Hydro Nuclear Solar,Wind

Source: BP Statistical Review, Smil (1994), Maddison (2007), and Bernstein Source: BP Statistical Review, Smil (1994), Maddison (2007), and Bernstein
analysis. analysis.

Solar and wind are technologies where costs continue to fall and energy conversion
efficiencies continue to increase. The problem with these renewable energy sources has
been threefold: cost, intermittency, and scale. In terms of cost, solar and wind are
approaching the levelized cost of energy in most major markets. The intermittency
problem of renewables is largely resolved in a world of 1.6 billion electric vehicles. In that
environment, there is power "demand" (whether in the form of usage or storage) 24x7.
Intermittency is irrelevant. The real problem for renewables today is scale.

VALUATION METHODOLOGY See the disclosure appendix for valuation methodologies for the stocks included in this
Blackbook.

RISKS See the disclosure appendix for risks for the stocks included in this Blackbook.

INVESTMENT IMPLICATIONS See the "investment implications" sections at the end of each chapter in this Blackbook.

16 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

THE OLD ECONOMY AND THE NEW


The New Economy won the war and lost the battle in Asia in 2016

2016 is the year when the New Economy "won" in Asia. The observations that China is
slowing structurally, that the economy is transitioning to services, and that consumption is
the key driver for economic growth going forward have become market orthodoxy. You
simply cannot pick a fight with anyone over the notion that China's decade-and-a-half
period of elevated, energy-intensive, credit-intensive, industrial-focused growth is over.
Tencent is now China's largest publicly listed company. China Mobile is No. 2. There are
half a billion 4G subscribers in China, ~25 million in India and counting.

With its largest growth engine shifting down, Asia's rate of economic development will
inevitably slow and its commodity and energy intensity will fall structurally and irreversibly.
The labor market in China will continue its shift to cities and to services. Manufacturing as
a source of employment in China has peaked. China is now spending more on robots each
year than either Japan or the United States.

The Asian consumer's desire for entertainment, apparel, transport, credit, financial
security, information, and pizza will drive public equity market investment opportunities in
Asia just the way it does in the developed world to a far greater extent than the
contents of the Five-Year Plan (any Five-Year Plan). The Asia Blue Chips now reflect this
reality. Tencent, Alibaba, AIA, China Life, HDFC, Samsung, and TSMC among others
are plays on the Asian consumer more than on Asian manufacturing capabilities.

The paradox is that it wasn't Narendra Modi's election in March 2014 that turned views on
Asia's appetite for reform. It wasn't the IPO of Alibaba in September 2014 that convinced
equity investors that China is a developed, or at least a modern, economy. It wasn't the
queues at stores around the world to buy the Samsung Galaxy S6 in April 2015 that
ended questions about the capability of Asia (outside of Japan) to build brands and
technology for which consumers globally will pay a premium.

Counterintuitively, the capitulation occurred in a year where the Old Economy roared back
and the New Economy in Asia stumbled: exploding Samsung handsets (not exploding
handset sales; exploding handsets); capital flight paranoia in China; the election of an Old
School political strongman in the Philippines; and the overnight cancellation of billions of
dollars' worth of hard currency in India in an attempt to "smoke out" the beneficiaries of
the black economy. The solidification of the New Economy as the driving force in Asia
just as it is in the rest of the world occurred during a period where the policy intent of
the Chinese government is less clear than it has been in a decade or more and during a
year in which commodities rallied.

The debate about the transition in China's economy to services and consumption has
ended. However, overweighting Chinese services and consumption-exposed stocks at

THE OLD ECONOMY AND THE NEW 17


BERNSTEIN

the expense of all others has been an inferior investment strategy this year. In 2016, the
New Economy won the war but lost the battle.

The year began with a collapse in equity markets globally brought on in large part by
continuing concern about the stability of the Shanghai equity market, the RMB, and the
Chinese economy in general. In the first quarter, the unprecedented outflows of foreign
currency from China led to the inference that China's reliance on credit-fueled growth
was now unsustainable. Those outflows slowed in March. The solution was: more credit. A
massive credit expansion in the first quarter found its way into steel rebar, construction
activity, and property prices. The industrial economy stabilized. So did sentiment across
Asia.

EXHIBIT 16: What worked in 2016 by sector (within the top 300 stocks by market cap in MSCI ACWI Asia ex-Japan)

40% 38%

35%

30%

25%

20% 18%

15%
12%
9% 8%
10% 7%
4% 4% 3%
5%

0%
-1%
-5% -2%

Source: Bloomberg L.P., MSCI, FactSet, and Bernstein analysis.

The second half of 2016 in Asia has been defined by in no particular order
Samsung's exploding lithium ion batteries, Philippines President Roderigo Duterte's
campaign of extrajudicial violence and his rotation toward China, succession uncertainty
in Thailand after the King's death in October, a Chinese property market "bubble," and the
extraordinary measures being taken in India by the BJP to reduce corruption and the black
economy by cancelling hard currency.

In short, as we sit here in Hong Kong at the end of 2016, we may be talking about the New
Economy. But this still doesn't feel like Mountain View.

18 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

This chapter is set out in seven parts, specifically:

The Old Economy rally in 2016 and the health of the Asian consumer

What our factor valuation suggests about Asia in 2017

Old Economy outperforms, but is it cheap? What to own in 2017

No, seriously, it's over: The New Economy wins (and loses)a long-term study

Risk #1: A surprise from China

Risk #2: A surprise from the United States

Can we talk about the New China yet?

THE OLD ECONOMY RALLY IN 2016 AND THE HEALTH OF


THE ASIAN CONSUMER

Two seemingly unconnected dynamics have defined Asia in 2016. First, the rally in
materials and in commodity producing markets (Australia and Indonesia). Second, the
strength of the consumer in Asia's largest markets (China, India, South Korea, and
Indonesia).

The rallies in oil, coal, iron ore, and copper this year demonstrate that the Old Economy in
general and commodities in particular are not "dead yet." Since January, iron ore prices
have increased 80% to US$78/ton; coal prices have increased 117% to US$110/ton;
and oil prices have increased 67% to US$47/barrel from a low of US$28/barrel in
February. The twilight in which the Old Economy now finds itself as a consequence of
falling energy and commodity intensity in Asia should presumably involve a derating in
historical multiples over time. After all, the super-cycle (led by demand from China for just
about everything from 2005 to 2012) is now over. But that does not preclude the kind of
sharp mean reversion we have seen over the last nine months.

THE OLD ECONOMY AND THE NEW 19


BERNSTEIN

EXHIBIT 17: What worked in 2016 by country (within the top 300 stocks by market cap in MSCI ACWI Asia ex-Japan)

25%

20%
20%
17%
15% 15%
15%

10%
9%
10%

6%
5% 5%
5%
3%

0%

-2%
-5%
TH ID AU TW CN IN KR PH HK SG MY

Source: Bloomberg L.P., MSCI, FactSet, and Bernstein analysis.

Across the 300 largest Asia stocks in the MSCI All World Index (equally weighted), the
sectors that performed the best in 2016 (through the middle of November) were
materials and energy (see Exhibit 16). The best-performing stocks in these sectors were
Fortescue (materials), South 32 (materials), Vedanta (materials), PTT E&P (energy), Bharat
Petroleum (energy), and Shenhua (energy).

By market, Thailand, Indonesia, and Australia stand out based on the 300 largest Asia
ex-Japan stocks in the MSCI All World Index (equally weighted) (see Exhibit 17). Indeed,
none of these markets is exactly a reflection of the New Economy or the rise of the Asian
consumer.

Of course, Asia is going to be consuming oil, coal, iron ore, copper, and natural gas in
larger and larger volumes for years. China will continue to add 800 million tons of steel to
its capital stock each year. India's infrastructure plan remains ambitious, as we outline in
this Blackbook. At the same time, even as markets have become comfortable with the idea
that there is no return to 2011, all of the Old Economy sectors rallied in 2016.

That simply leads to the question: now what?

On a 10-year view, Indonesia, the Philippines, Thailand, India, and Malaysia have been the
best-performing equity markets regionally. Over the long, long term, equity market
performance in emerging Asia reflects none of: GDP growth differentials; the
sophistication of the consumer; or the number of high-quality/high ROIC businesses
domiciled in the country and listed on the exchange (see Exhibit 18).

20 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 18: Asia 10-year total return (dividends reinvested)

10-Year Total Return 10-Year Annualized Return


325%
14.6% 16.0%
275% 12.8% 14.0%
11.2%
225% 12.0%
175% 8.4% 8.0% 10.0%
7.2%
290% 8.0%
125% 5.9%
234% 5.0% 5.0%
188% 4.6% 4.4% 6.0%
75% 3.1%
125% 116% 4.0%
101% 77%
25% 63% 62% 57% 54% 36% 2.0%
-25% 0.0%

TWSE Index Taiwan

HSI Index Hong-Kong

AS51 Index Australia


FBMKLCI Index Malaysia
SENSEX Index India

FSSTI Index Singapore


PSEI Index Philippines

SET Thailand Index

SHCOMP Index China

KOSPI Index S. Korea

MXAPJ Index MSCI Asia


JCI Index Indonesia

(Ex- Japan)
Source: Bloomberg L.P. and Bernstein analysis.

Year-to-date, the Indonesian market is, once again, one of the best performers next to
Thailand (see Exhibit 19). The Shanghai Composite lags. The rank order again reflects
in large part the performance of commodities over the course of the year.

EXHIBIT 19: Asia year-to-date return (dividends reinvested)


20% 17.9%
14.9%
15% 11.9%
10%
6.1% 5.4% 4.9%
5% 2.2% 1.9% 1.0% 0.3%
0%
-1.1%
-5%
-4.5%
-10%
TWSE Index Taiwan

HSI Index Hong-Kong


MXAPJ Index MSCI Asia (Ex-

AS51 Index Australia

FSSTI Index Singapore

NKY Index Japan


SET Thailand Index

PSEI Index Philippines


JCI Index Indonesia

SENSEX Index India

KOSPI Index S. Korea

FBMKLCI Index Malaysia


Japan)

Source: Bloomberg L.P. and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 21


BERNSTEIN

Yet the performance of materials and energy in 2016 sits at odds with the overarching
impression of the largest markets in Asia in 2016. Each month, we track consumer
sentiment and the growth in demand for consumer products and services in China, India,
Indonesia, and South Korea. This is the second dynamic playing out in Asia ex-Japan this
year: the strength of the Asian consumer.

We believe that the growth rates and momentum reflected in our monthly snapshots
demonstrate the underlying mood in the market. Are airline passenger volumes increasing
in China? How about online sales of cosmetics in South Korea? Two-wheeler sales in
Indonesia and point-of-sale card transactions in India, in our view, provide a direct insight
into the services economy and the consumer.

Throughout the year, the Asian consumer has gone from broadly resilient to outright
strong (see Exhibit 20). The New Economy as measured by smartphones, e-commerce,
card transactions, and air travel is booming throughout Asia.

We set out Exhibit 20 as a mosaic of high-frequency data on the Asian consumer from
(largely) non-governmental sources. The idea behind compiling this data (movie box
office, airline passenger volumes, 3G and 4G subscriber growth) is that it reflects
discretionary spending by consumers in these markets, and therefore, the mood of the
consumer about their individual economic position. In consumption-driven economies,
that's what matters.

Over the course of the year, the trend has been broadly positive and improving. The green
dots are advancing. To the extent that there is noticeable weakness anywhere, it is
Indonesia (two-wheeler sales, airline passenger volumes, and hotel occupancy are all
down year-over-year).

22 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 20: Asia consumer metrics


Monthly
Reporting Metrics Country Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Jul 16 Aug 16 Sep 16 Oct 16
Housing Sales Price Index Korea
Two-Wheelers Sales India
Retail Sales Index Indonesia
Airline Passengers China
Shanghai Airport Flights China
100 City Resi Prop Prices China
Chinese Tourist Arrivals Korea
Retail Sales Korea
Total Online Sales Korea
Online Sales: Cosmetics Korea
Online Sales: Travel Arrangements Korea
Consumer Credit India
Airline Passengers India
Card Transactions (POS) Indonesia
Card Transactions (POS) India
Car Sales Indonesia
Car Sales China
Bank Total Credit India
Airline Passengers Indonesia
Cards Addition Indonesia
Hotel Occupancy Rate (%) Indonesia
3G Mobile Additions India
Consumer Confidence China
China Mobile 4G Mobile Subs China
Movie Box Office China
Weekend Movie Box Office Korea
Cards Addition India
Car Sales India
Non-Manufacturing PMI China
Consumer Confidence Index Korea
Two-Wheelers Sales Indonesia
Car Sales Korea
Source: Bloomberg L.P., Haver, China NBS, RBI, Bank Indonesia, Statistics Korea, company filings, and Bernstein analysis.

Meanwhile, we also track Old Economy metrics in these four markets. Our key metrics
include power demand, excavator sales, industrial production, manufacturing PMI, and rail
volumes. Exhibit 21 essentially captures the industrial metrics that five years ago in
emerging Asia markets and 40 years ago in developed markets were considered to
reflect the economic reality: manufacturing, construction, and industrial demand.

Today, these sectors are certainly still important. However, in China, something like
70-80% of growth comes from the services sector. In India, that number is in the 60-70%
range. Across Asia ex-Japan, the figure is roughly 70%. In short, in emerging Asia, the
industrial economy is not determinative of the economic outlook. The consumer and the
services sectors are.

The Old Economy in Asia over the course of 2016 improved markedly, specifically in
China and Korea. The improvement in industrial metrics in China was far from organic. It
was a function of the spike in credit formation growth in the first quarter, which found its
way into construction and commodities over the course of the year. By our measure, the
Old Economy largely stood still in India and Indonesia (see Exhibit 21).

THE OLD ECONOMY AND THE NEW 23


BERNSTEIN

EXHIBIT 21: Asia industrial metrics


Monthly
Reporting Metrics Country Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Jul 16 Aug 16 Sep 16 Oct 16
Electricity Generation India
Manufacturing PMI Indonesia
Total Social Financing
YTD flows
China
Industrial Production YoY Indonesia
Power Production Korea
New Housing Starts YoY China
Power Production China
Excavator Sales China
Truck Unit Sales China
New Housing Starts YoY Korea
CPI India
Trucks Sales India
PMI India
BOK Manufacturing Survey Korea
Exports: Ships Korea
Manufacturing PMI China
BOK Non-Manufacturing Survey Korea
Corporate Credit India
Railway Freight China
Exports India
Truck Unit Sales Korea
Exports Indonesia
Export Trade USD YoY China
Import Trade USD YoY China
Export Trade USD YoY Korea
Import Trade USD YoY Korea
Exports: Electronics & Electronic
Products
Korea
Imports India
IP Growth India
Imports Indonesia
Commercial Vehicle Sales Indonesia
Source: Bloomberg L.P., Haver, China NBS, RBI, Bank Indonesia, Statistics Korea, company filings, and Bernstein analysis.

WHAT OUR FACTOR VALUATION SUGGESTS ABOUT ASIA IN


2017

Our assertion that the New Economy has won in Asia (and our dismissal of the Old
Economy) is arguably premature in a year when the best-performing market was Thailand
and the best-performing sectors were materials and energy.

The reason for our conviction is really a function of five things: first, long-term stock
market performance in Asia by sector (see Exhibit 23 and Exhibit 26); second, sources of
economic growth across the region (see Exhibit 43); third, falling energy intensity (see
Exhibit 42); and fourth, the sources of profit growth in the public equity markets across
Asia (see Exhibit 57 and Exhibit 58).

In short, the war between the Old and the New Economy is over. Emerging Asia will never
have a traditional "industrialization" phase where the majority of economic output comes
from manufacturing, construction, and industry. Since the largest economies in Asia are

24 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

now through that phase, or (like India) are unlikely to ever enter it, it is now all about
services.

However, the fifth and primary gauge that we use to judge the reality that the New
Economy won is that the Old Economy/New Economy debate had precisely no impact on
the key stock market controversy of 2016 which is: mean reversion among commodities.
The transition of Asian economies toward services and consumption and the rising
penetration of mobile Internet usage among citizens in emerging markets in Asia
continued unimpeded. It just wasn't the or even a dominant dynamic in terms of stock
market performance this year.

Over the last 10 years in China, the New Economy has consistently outperformed.
Viewing long-term performance in Chinese equities based solely upon index performance
gives a fairly dreary impression of investing during what has been the most dynamic time
in economic growth in China ever. The number of people living in poverty in China fell from
almost 700 million people (60% of the population) in 1990 to 15% (200 million) in 2005
and less than 2% today. The developmental economic statistics are incredible in terms of
the alleviation of human suffering in one generation. The returns from Chinese equity
indices are far more prosaic, on a number of levels.

Over the last decade, MSCI China, the Hang Seng China Enterprises Index, and the
Shanghai Composite have achieved annualized returns of 4.2%, 2.2%, and 3.9%,
respectively (see Exhibit 22).

EXHIBIT 22: Total return for MSCI EM, MSCI China, HSCEI, and SHCOMP from the end of 2006 until now (with dividends
reinvested) (December 31, 2006 = 100)

250
MSCI EM MSCI China HSCEI SHCOMP

200

150
150 146

124
100 121

50

0
Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

Source: Bloomberg L.P. and Bernstein analysis.

However, if you approach the same data from a slightly different perspective, you see a
very different pattern.

THE OLD ECONOMY AND THE NEW 25


BERNSTEIN

Entertain for a moment the following counterfactual. What if, 15 years ago, China's
National Development and Reform Commission (NDRC) and State-Owned Assets
Supervision and Administration Commission (SASAC) had determined that none of
China's state-owned enterprises (SOEs) should be publicly listed? In short, what if the
wave of SOE IPOs that began in the early 2000s and continues today had never
happened?

The Chinese government certainly did not need the cash from the SOE IPOs. There was a
clear intent for China to overinvest and to accept depressed returns on invested capital
for some extended period of time while it built out its hard infrastructure nationwide.
Therefore, there were good reasons for the government to decide against listing the oil,
gas, coal, power, steel, cement, and bank sectors (to name just a few).

At the top of that list would be the cumulative hit to the reputation of corporate China as a
result of all of those poor capital allocation decisions and miserable return profiles, in the
name of national service. There is a universe where that long-term damage could well
have been enough to dissuade the NDRC from ever approving the wave of IPOs from
Chinese SOEs. It is not, however, this universe.

If that approach (no SOE IPOs) had been adopted, non-SOEs and New Economy sectors
would dominate the Chinese equity market, and our discussion about China. The
"Commanding Heights" the asset-heavy, debt-heavy, slow-growing, labor-intensive
sectors that represent the bulk of Chinese public markets and indices would not exist
as investment "opportunities." And in that circumstance, the performance of Chinese
equity markets and indices would be very different.

EXHIBIT 23: China New versus Old Economy, SOE versus non-SOE (December 29, 2006 = 100)

450
Non-SOE
New Economy
400
SOE
350 Old Economy
322
SHCOMP
HSCEI 321
300

250

200 179
178
150 145
125
100

50

-
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16

Note: Includes Chinese stocks >US$500 million market cap as of 2006-end listed in HK and NY. Stocks given equal weighting starting at 2006-end.

Source: Bloomberg L.P. and Bernstein analysis.

26 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

We have calculated the performance of the Old Economy versus the New Economy (and
SOEs versus non-SOEs) in China over the last 10 years. We only included stocks that
were listed in 2006 in our analysis (Tencent is in; BABA is out). The New Economy and the
non-SOEs outperform the Old Economy by a wide margin and have roughly trebled in
value over the last 10 years (see Exhibit 23).

In short, if this had been the approach that SASAC had adopted in 2000, we would be
having a very different conversation about the Chinese equity market. For a start, the
"Chinese economic miracle" might still be a thing. Instead, all we can say is that quite
emphatically the New Economy won, in terms of equity market performance and (as we
detail later) in terms of the transition of the Chinese economy towards services and the
consumer.

The services sector is now over half of the Chinese economy and it represents over 70%
of GDP growth. The services sector accounts for 50% more jobs in China than the
industrial economy. These are transitions within the structure of the economy that have
occurred in the last five years and where the transition, once made, is not reversed.

As goes China, so goes the rest of the region. China represents 62% of GDP across the
broader Asia ex-Japan region (including India, Malaysia, Indonesia, Taiwan, Vietnam,
Singapore, the Philippines, Hong Kong, Thailand, and South Korea) (see Exhibit 24).

EXHIBIT 24: Share of Asia GDP (2015) EXHIBIT 25: Share of Asia GDP growth (US$ terms; 2015)
Taiwan, Philippines, Vietnam,
3% Indonesia, Malaysia, 1%
Vietnam, Hong Kong, 1%
5% 2%
1% 3%
Singapore,
2% India,
Philippines,
12%
2%
Hong Kong, India,
2% 13%
Thailand,
2%
Korea,
8%

China, 62%

China,
81%

Note: Includes only those economies that grew in US$ terms.

Source: Haver and Bernstein analysis. Source: Haver and Bernstein analysis.

Even with that level of "market share," China was a "share gainer" in 2015 and will be
again this year, given the average rate of growth in the region. In 2015, China captured
81% of GDP growth share in the region. China, Hong Kong, the Philippines, Vietnam, and
India were the economies on a US$ basis that grew in 2015 (see Exhibit 25).

THE OLD ECONOMY AND THE NEW 27


BERNSTEIN

A similar trend in terms of outperformance of the New Economy and non-SOEs is clear
across Asia. However, the dispersion is nowhere near as great, which does not reflect well
on Chinese SOEs. The New Economy stocks and the non-SOEs from within the MSCI Asia
ex-Japan (on an equal weighted basis) outperform the Old Economy and the non-SOEs
(see Exhibit 26).

EXHIBIT 26: MSCI Asia-Pacific ex-Japan constituents total return, end of 2006 until now (equal weighted, New versus Old
Economy; SOEs versus non-SOEs) (December 31, 2006 = 100)

250

224
225
217
211
200
209

175

150

125

New Economy
100
Non-SOE

75 SOE
Old Economy
50
Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

Source: Bloomberg L.P. and Bernstein analysis.

That outperformance from high-growth, high-ROIC companies (tech, Internet, consumer


discretionary, insurance, and healthcare) has taken a backseat this year, at least since the
summer across Asia.

We track, on a monthly basis, the performance of seven factors across the 300 largest
Asia-domiciled stocks in the MSCI All Country World Index. We rank those stocks by
factor (P/E and P/B representing Value; FCF yield and dividend yield representing
Income; ROE representing Quality; long-term growth representing Growth; and 12-month
price movement representing Momentum).

We then evaluate the performance of the 60 stocks with the most favorable investment
characteristics, given the factor involved (lowest P/E for Value) against the 60 stocks with
the least favorable investment characteristics (lowest ROE for Quality). Essentially, we
calculate the performance of a long/short portfolio that owns the top quintile and is
"short" the bottom quintile for each factor, rebalanced quarterly.

Over the last 10 years in Asia, Quality and Growth have outperformed (along with FCF
yield). Between 2014 and 2015, Quality and Growth outperformed Value and Income (see
Exhibit 27). Through October year-to-date, these two factors have underperformed
Income and Value (see Exhibit 28).

28 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 27: Momentum, Growth, and Quality outperformed Value and Income from January 2014 to December 2015

Annualized returns (LHS) Return risk ratio (RHS)


10.0% 1.0

8.0% 0.8

6.0% 0.6

4.0% 0.4

2.0% 0.2

0.0% 0.0

-2.0% -0.2

-4.0% -0.4

-6.0% -0.6

-8.0% -0.8

-10.0% -1.0
Momentum Long term ROE Dividend Yield FCF Yield Price to book 12m FPE
growth

Source: MSCI, FactSet, and Bernstein analysis.

The massive underperformance of Momentum (which simply chases what has worked for
the last 12 months) reflects the fact that we are in the midst of a change in sentiment
across the market right now. In short, we believe that the growth bubble in Asia is at risk.

EXHIBIT 28: What worked in 2016 by factor

Annualized returns (LHS) Return risk ratio (RHS)


25.0% 2.5

20.0% 2.0

15.0% 1.5

10.0% 1.0

5.0% 0.5

0.0% 0.0

-5.0% -0.5

-10.0% -1.0

-15.0% -1.5
FCF Yield Dividend Yield Price to book 12m FPE Long term ROE Momentum
growth

Source: MSCI, FactSet, and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 29


BERNSTEIN

Along with calculating factor performance each month, we also calculate factor valuation.
To do this, we look at the ratio of the P/B multiple of the median stock in the top quintile
for a given factor and the P/B multiple of the median stock in the bottom quintile. For a
Value factor like P/E, the median stock in the top (most attractive) quintile will always have
a lower P/B multiple than the median stock in the bottom quintile. The Factor valuation
ratio will, therefore, always be below 1. For a factor like Growth, the factor valuation ratio
will always be above 1. Factor valuation is less focused in the absolute value of the ratio
than in how it moves over time.

When Value is out of favor, the "cheap" stocks will generally exhibit depressed valuations
relative to history, and the "expensive" stocks (the bottom quintile for a Value factor) trade
at elevated valuations relative to history. The factor valuation ratio will, therefore, be low
relative to history. The tech boom of the late 1990s is the clearest example of a period
where Value was out of favor and Growth was where the market focused.

Another example of that kind of market: right now. Exhibit 29 reflects factor valuation for
Growth and Value over the last 26 years in Asia. Currently, Growth is expensive relative to
its history in Asia (the darker green line; see the online version for colors) and Value is
cheap (the lighter green line). In fact, the dispersion between Growth and Value right now
is as high as it has been at any time since the tech boom and bust of the late 1990s and
early 2000s.

EXHIBIT 29: Value-Growth divergence (P/B versus five-year EPS growth factors)

6.0 0.3
Growth (LHS)
End of the tech bubble China
5.0 Value (RHS)
slowdown
Valuation of the Growth Factor

Valuation of the Value Factor


concerns;
China
4.0 devaluation 0.2

3.0

2.0 0.1

1.0 Onset of the financial crisis


Aftermath of the Asian financial crisis,
beginning of the "dot-com" bubble
0.0 0.0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16

Source: MSCI, FactSet, Bloomberg L.P., and Bernstein analysis.

All that said, one of the reasons why energy and materials have been the two best-
performing sectors in Asia over the last 12 months is because that divergence has started
to close this year. The crocodile jaws were widening between late 2014 and early 2016.
They are now closing.

30 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

In China and across Asia, that has meant that, this year, the New Economy (telecom,
technology, consumer, and other service-related sectors) has underperformed the Old
Economy (materials, energy, banks, real estate, and other industrial-related sectors), as
shown in Exhibit 30. Stock market performance in Asia and globally has been turbulent
this year. Markets almost everywhere collapsed in January, and rallied from the early
summer. Call it the Brexit rally, but emerging markets benefited from a rotation out of
Europe.

Over the course of 2016, the Old Economy outperformed the New Economy in China and
across Asia (see Exhibit 31) in a break from the 10-year trend. We do not as we set out
at the beginning of this chapter believe that this implies that the footing of Asian
economies is moving back to energy-intensive, commodity-intensive activities. It does
suggest that valuations had reached extremes in divergence at the start of 2016 (Tencent
good, oil bad), and that these valuations are now mean reverting to some extent.

Over the entire period, the Shanghai Composite has underperformed, and while still up
some 30% compared to the end of 2014 it saw a sharper sell-off in January and a more
muted recovery over the summer.

EXHIBIT 30: China Old Economy versus New Economy, SOE versus non-SOE in 2016 (total return, dividends reinvested)
(December 31, 2015 = 100)

110

102

100 101
100
99
97
92
90

Old Economy
HSCEI
80
Non-SOE
SOE
New Economy
SHCOMP
70
Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16

Note: Includes Chinese stocks >US$500 million market cap as of 2015-end listed in HK and NY. Stocks given equal weighting.

Source: Bloomberg L.P. and Bernstein analysis.

The answer may be as simple as the fact that foreign investors remain burned by the
Shanghai stock suspensions in the summer of 2015 and domestic retail investors are
chasing opportunities in the Chinese real estate market at present.

THE OLD ECONOMY AND THE NEW 31


BERNSTEIN

EXHIBIT 31: MSCI Asia-Pacific ex-Japan constituents total return: 2016 year-to-date (equal weighted, New versus Old
Economy; SOEs versus non-SOEs) (December 31, 2015 = 100)

115

110
109

105 105
103

100 100

95
Old Economy
Non-SOE
90 SOE
New Economy
85
Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16

Source: Bloomberg L.P. and Bernstein analysis.

More broadly, across Asia, as tumultuous a year as it has been, the Old Economy has
outperformed the New Economy clearly, but almost regardless of allocation
performance is positive.

What we believe we are seeing is simply reversion to the mean from the extremes in
valuation from earlier in the year. The delta between Growth and Value is closing, but
mainly through the fact that energy and materials have rallied.

We calculate across the seven factors that we track the delta between the current
valuation "percentile" for a given factor (that is, how cheap or expensive is that factor
relative to history) and the extreme valuation (that is, the 99th or the 1st percentile). In
short, we look at how far a factor is from being the most expensive or the cheapest it has
ever been. We then aggregate the results for the seven factors. If all factors are at the 50th
percentile, the score in Exhibit 32 would be 350. The expected "score" is, therefore, 175.

This summer, on this calculation, the seven factors were cumulatively at their most
extreme position in at least 20 years. Growth and Value were both in the top decile versus
history. Income and Value were both in their bottom decile versus history. Since that time,
factor valuations have started to revert.

This reversion year-to-date across Asia has largely benefited materials and energy. The
sector in Asia that has not benefited from the rotation from Growth and Quality into Value
and Income to the same extent is financials. Given the poor performance of financials in
much of the region over the last 10 years, banks may simply be the last option through
which the incremental investor will participate in mean reversion, once all the other
options are exhausted.

32 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 32: Magnitude of divergence between factor valuation percentiles

300

250

200

150

100
Magnitude of divergence between
valuation of factors was at its most
50 extreme this summer

0
Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16
Average +1 / -1 std dev

Source: MSCI, FactSet, Bloomberg L.P., and Bernstein analysis.

Even though the rotation out of the New Economy and into the older, stodgier parts of the
market is clear, there are exceptions. BAT (Baidu, Alibaba, and Tencent), on a combined
basis, continue to outperform both MSCI China and the Big 4 Chinese banks year-to-date,
despite the fact that Baidu is down ~12% through mid-November (see Exhibit 33).

EXHIBIT 33: BAT versus Chinese banks versus the MSCI China year-to-date total return (dividends reinvested)

30.0%
MSCI China Big 4 Banks BAT

20.0%

10.0% 10.7%
5.1%

0.0% 3.0%

-10.0%

-20.0%

-30.0%
Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16

Source: Bloomberg L.P. and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 33


BERNSTEIN

Chinese banks are up for the year but, so far, the rotation into Value and Income has, to a
large extent, eluded financials.

OLD ECONOMY OUTPERFORMS, BUT IS IT CHEAP?

For the last few years, there has been something tribal about the New Economy/Old
Economy debate globally. Back in 2012, when Peabody was forecasting that China would
import 1 billion tons of coal by 2020 and Canadian oil sands were the price-setting
source of oil globally, the view that the Chinese economy (and the Indian economy after it,
and the Indonesian and Vietnamese economies after it) would continue to develop on an
energy- and commodity-intensive footing took on a religious fervor.

To suggest that the Chinese economy might either slow or transition away from energy-
intensive industry activity to services was interpreted as reflecting an uncharitable
skepticism about developmental economics in general and Chinese and Indian economic
policymaking in particular.

As we prepare to close the books on 2016, what is clear is that this year you did not have
to believe that Chinese steel installed stock would reach the U.S. levels by 2020 to make
money investing in Fortescue or BHP. You simply had to believe that the companies would
remain solvent long enough for the iron ore price to bounce. The "left for dead" consensus
at the start of the year across oil, gas, coal, and commodities, in general, was evidently
overdone.

EXHIBIT 34: MSCI Asia ex-Japan forward P/E by sector EXHIBIT 35: MSCI Asia ex-Japan P/B by sector

35.0x 8.0x 7.6x


32x 5-yr Average 5-yr Average
Current 7.0x Current
30.0x

6.0x
25.0x 5.2x
21x 20x 5.0x
20x
20.0x
16x 16x 4.0x
14x 3.2x
15.0x
12x 3.0x
11x
10x 2.2x
10.0x 2.0x 1.9x
2.0x 1.7x 1.6x
1.5x
1.2x
5.0x 1.0x

0.0x 0.0x

Source: Bloomberg L.P. and Bernstein analysis. Source: Bloomberg L.P. and Bernstein analysis.

As we point out elsewhere in this Blackbook, in the 19th century, it took decades for coal
to replace wood as the dominant energy source globally and a similar period of time in the

34 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

20th century for oil to replace coal. Even if electric vehicles do reach ~100% of additions
to the auto fleet by 2030 and oil consumption globally peaks at that time, oil demand will
continue to be measured in the tens of millions of barrels per day well into the 2040s, at
least.

There is a glide path associated with that kind of obsolescence in both the commodity and
equity markets. Said differently, there is a permanent impairment or derating that is
appropriate for these sectors if we now know how the story is going to end and roughly
when (albeit decades from now). But that doesn't preclude over- and under-shooting and
mean reversion along the way.

At present, oil and gas and metals and mining are trading broadly at their five-year
averages on a P/B basis in Asia. On a P/E basis, metals and mining is trading at almost
20x forward earnings. Yes, this is lower than the five-year average, but the five-year
average includes periods where the industry was completely shelled out and many
constituents within the index had negative earnings (and are excluded from our
calculation) or very low earnings, which served to flatten P/E multiples. Oil and gas is at its
five-year average on a P/E basis (see Exhibit 34 and Exhibit 35).

The obvious question is: why should these sectors be trading at anywhere near their
long-term averages? The largest growth market for energy globally over the last two
decades is now transitioning to services. Peak coal has already occurred globally. Peak oil
should be sometime between 2025 and 2035. The question of stranded assets is likely to
compel those sitting on fossil fuel reserves to maximize production (and minimize
stranded reserves), regardless of profit per barrel or per ton. As that reality sets in, the
sector should derate from its historical trading range. In Asia, oil and gas is currently at its
historical (five-year) trading range (see Exhibit 36). We, therefore, expect that while the
prospects for Income and Value in 2017 look good opportunities within the energy
sector will become more difficult to identify strictly based on mean reversion.

EXHIBIT 36: Oil and gas average P/B MSCI Asia-Pacific ex-Japan

2.8x

2.6x

2.4x

2.2x

2.0x

1.8x

1.6x

1.4x

1.2x
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Oil & Gas Average +1 STD -1 STD

Source: Bloomberg L.P. and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 35


BERNSTEIN

Within the metals and mining sector, the long-term prospects are only slightly less grim.
The valuations, however, are far more challenging after the run that the sector has had
this year in Asia.

The long-term "bull case" for metals and mining in Asia is premised on the low levels of
steel in terms of capital stock per capita in China and throughout Asia. The capital stock of
steel in the United States is something in the range of 12,000 kg/capita. In China, it is
roughly half that. But as China adds ~800 million tons of steel to its capita stock annually,
the rough math suggests that China will reach the U.S. levels of capital stock within 10
years. There is no other emerging Asian market that has any chance of coming close.

The inference is that Chinese demand for iron ore and met coal will plunge sometime in
the middle of the next decade, in the best case scenario. Again, for resource producers,
this means that the payback on an additional ton of production capacity has to be less
than 10 years and that the risk of stranded assets, both as China switches to a
replacement level of demand or simply never reaches the U.S. installed stock, should
inform investment decisions immediately.

The prospects in terms of thermal coal, where demand growth is already negative, are
even worse. Leaving aside prospects for copper, nickel, lithium, etc., the risk that the
metals and mining sector presents as a vehicle to participate in a mean-reverting Value or
Income rally in 2017 is that the rally has already occurred in Asia.

EXHIBIT 37: Metals and mining average P/B MSCI Asia-Pacific ex-Japan

2.0x

1.8x

1.6x

1.4x

1.2x

1.0x

0.8x

0.6x
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Metals & Mining Average +1 STD -1 STD

Source: Bloomberg L.P. and Bernstein analysis.

Metals and mining stocks have rallied in Asia over the course of 2016 and are now trading
at close to one standard deviation above their long-term averages on a P/B basis (see
Exhibit 37). Given the New Economy transition in Asia that we describe elsewhere in this
chapter, we believe that continuing outperformance is unlikely.

36 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

Two sectors that traditionally offer dividend yield and low multiples on a P/B or P/E basis
(that is, Value and Income darlings) are utilities and financials.

Both the utilities and the financial sectors in Asia have largely been overlooked over the
past six months. The obvious reason to avoid these sectors now is the same as the reason
to avoid them a year ago: rising U.S. interest rates are likely to force up dividend yields
within bond-proxy sectors like utilities and financials. In China, non-performing loan
concerns are perennial.

The first counterargument is that all this was true a year ago and so is already priced in.
Second, FCF yield and dividend yield have been the best-performing factors in Asia over
the last 10 months. FCF yield was the best-performing factor in Asia between 2006 and
2015. Over the last quarter century, FCF yield was the third-best-performing factor with
an annualized return of ~7%. Many utilities look attractive on this basis in Asia.

And, if unconvinced by the yield argument, the best-performing factors in Asia over the
last 25 years were the Value factors: P/B and P/E. Both utilities and financials look cheap
on these metrics at present.

Utilities across MSCI Asia ex-Japan are currently more than one standard deviation below
their historical average. Unlike oil and gas and metals and mining, we see no reason for a
long-term derating of the utilities sector in Asia (see Exhibit 38).

EXHIBIT 38: Utilities average P/B MSCI Asia-Pacific ex-Japan

2.2x

2.0x

1.8x

1.6x

1.4x

1.2x
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Utilities Average +1 STD -1 STD

Source: Bloomberg L.P. and Bernstein analysis.

Financials are similarly more than one standard deviation below their long-term average
(see Exhibit 39).

THE OLD ECONOMY AND THE NEW 37


BERNSTEIN

EXHIBIT 39: Financials Average P/B MSCI Asia-Pacific ex-Japan

2.2x

2.0x

1.8x

1.6x

1.4x

1.2x
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Financials Average +1 STD -1 STD

Source: Bloomberg L.P. and Bernstein analysis.

The Best Ideas presented by our sector analysts who have contributed to this Blackbook
are from a sector allocation perspective constrained by sector coverage. Within this
list, CCB also appears in our factor analysis as being attractive on a one-year forward P/E
and P/B basis, Samsung Electronics is attractive on a P/E and FCF yield basis, and China
Unicom is attractive on a P/B basis (see Exhibit 40).

EXHIBIT 40: Bernstein Best Ideas Asia


Consensus Current P/B Dividend Bernstein
No. Long Ticker Sector Country
1-yr Fwd P/E Ratio Yield % Rating
1 CCB 939 HK Financials China 5.3x 0.8x 5.9 outperform
2 Wuliangye 000858 CH Staples China 16.0x 2.9x 2.3 outperform
3 Kotak Mahindra Bank KMB IN Financials India 23.2x 4.2x 0.1 outperform
4 Inpex 1605 JP Energy Japan 25.0x 0.6x 1.7 outperform
5 VA Tech Wabag VATW IN Utilities India 14.6x 2.7x 0.8 outperform
6 Keyence 6861 JP Technology Japan 27.6x 4.4x 0.2 outperform
7 Samsung Electronics 005930 KS Technology South Korea 8.9x 1.1x 1.3 outperform
8 China Unicom 762 HK Telecoms China 23.4x 0.8x 2.4 outperform
9 Jiangsu Hengrui 600276 CH Health Care China 30.9x 9.2x 0.2 outperform
Average 19.4x 3.0x 1.7
MSCI APxJ 12.6x 1.4x 3.0

Source: Bloomberg L.P. (as of the close at November 25, 2016) and Bernstein analysis.

We maintain a "focus list" that reflects, in part, confidence in Asia Blue Chips in an
environment of a healthy Asian consumer and a structural, long-term rotation to the New
Economy. We also include high-conviction thematic ideas that largely sit within the
consumer sector (see Exhibit 41).

In addition, we incorporate stocks in the focus list that follow the direction implied by our
factor analysis. Currently, that means dividend and FCF yielding stocks that are
inexpensive on a P/B and P/E basis versus their history and within the 300 largest Asia-

38 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

domiciled companies in the MSCI All Country World Index. At present, that means a clear
overweight toward financials China Life, AIA, Bank Mandiri, ANZ (not covered), CCB,
and ICBC) and utilities Huaneng Power, KEPCO, and China Resources Power (all
three not covered).

We are net neutral on energy between Shenhua (a "Short") (not covered) and PTT E&P.

EXHIBIT 41: Bernstein focus list


Consensus Current
Dividend Bernstein
No. Long Ticker Sector Country 1-yr Fwd P/B
Yield % Rating
P/E Ratio
Blue Chips
1 China Life 2628 HK Financials China 17.7x 1.7x 2.5 outperform
2 AIA 1299 HK Financials Hong Kong 16.9x 2.0x 1.6 outperform
3 Bank Mandiri BMRI IJ Financials Indonesia 11.9x 1.7x 2.4 outperform
4 Tencent* 700 HK Technology China 28.7x 10.0x 0.2 NA
5 Alibaba* BABA US Technology China 23.3x 6.4x 0.0 NA
6 Samsung Electronics 005930 KS Technology South Korea 9.1x 1.1x 1.3 outperform
Thematic
7 Wuliangye 000858 CH Staples China 16.1x 2.9x 2.3 outperform
8 Amorepacific Corp* 090430 KS Staples South Korea 25.9x 5.3x 0.4 NA
9 Sands China 1928 HK Discretionary China 25.1x 8.9x 5.4 market-perform
10 GCL-Poly* 3800 HK Technology China 7.0x 0.8x 0.0 NA
Factor Portfolio
11 Hyundai Motors 005380 KS Discretionary South Korea 5.4x 0.4x 1.5 outperform
12 PTT E&P PTTEP TB Energy Thailand 14.4x 0.9x 3.4 market-perform
13 ANZ* ANZ AU Financials Australia 11.5x 1.4x 8.2 NA
14 CCB 939 HK Financials China 5.3x 0.8x 5.9 outperform
15 ICBC 1398 HK Financials China 5.1x 0.8x 6.1 outperform
16 MediaTek 2454 TT Technology Taiwan 12.6x 1.6x 4.8 market-perform
17 ASE 2311 TT Technology Taiwan 11.5x 1.7x 4.7 outperform
18 China Resources Power* 836 HK Utilities China 7.3x 0.9x 6.8 NA
19 Huaneng Power* 902 HK Utilities China 7.5x 0.7x 11.9 NA
20 KEPCO* 015760 KS Utilities South Korea 3.9x 0.4x 6.7 NA
Average 13.3x 2.5x 3.8
MSCI APxJ 12.7x 1.4x 3.0

Consensus Current
Dividend Bernstein
No. Short Ticker Sector Country 1-yr Fwd P/B
Yield % Rating
P/E Ratio
1 Great Wall 2333 HK Discretionary China 6.1x 1.3x 0.0 underperform
2 ANTA* 2020 HK Discretionary China 17.7x 5.4x 2.9 NA
3 China Resources Beer 291 HK Staples China 25.6x 3.5x 0.0 underperform
4 China Shenhua* 1088 HK Energy China 10.8x 0.9x 2.4 NA
5 Asian Paints* APNT IN Materials India 34.9x 15.5x 0.9 NA
Average 19.0x 5.3x 1.2
MSCI APxJ 12.7x 1.4x 3.0

* Not covered by Bernstein, all estimates in the above table are Bloomberg consensus.

Note: See recent reports on Asian Insurance (Asian Insurance: The Trumpflation Trade - Which life insurer would benefit the most?), South East Asian Banks
(Indonesian banks Q3 16 PEP: growth still weak, but asset quality stable and outlook positive), Samsung (Samsung: Putting the cash hoard to use - Investing in
artificial intelligence and the car of the future), Sands China (Global Gaming: Macau's inflection is in full swing. Looking ahead, the growth prospects are
promising; staying positive on the sector), Asian Autos (The Long View: Ride sharing in China - opportunities, challenges, and Chinese consumer attitudes), Asian
Semiconductors and Semiconductor Equipment (The Long View: "Made in China 2025" - How much does it take?) for important disclosures and analyst
certifications.

Source: Bloomberg L.P. (as of the close at November 25, 2016) and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 39


BERNSTEIN

We acknowledge that we could have attempted to avoid China and still satisfied the
conclusion from our factor analysis to overweight Value and Income. However, as we
describe here, it is not clear to us that simply avoiding companies domiciled in China does
much to solve China risk across Asia. And if the search is for high yield and stocks trading
at depressed P/E and P/B multiples, the conclusion is, once again, China.

NO, SERIOUSLY, IT'S OVER: THE NEW ECONOMY WINS (AND


LOSES)

Early in this chapter, we made the assertion that the New Economy won in Asia. We
believe that this is axiomatic from the way that the stocks across the region have traded
over the last 10 years and the evolution of China toward services and consumption over
the last few years. But it is also true when you look across Asia, in general.

The services sector became the largest part of the Chinese economy in 2013. Services
made up more than 50% of the Chinese economy in 2015. There is a tendency to believe
that China is leading the way in this respect in Asia and that other smaller markets will
follow China's course of industrialization.

However, China is not the "early adopter" of industrialization. China is largely the
exception. Industrial activity and manufacturing only become the largest part of China's
economy in the 1960s. And China had a famously conflicted relationship with the
allocation of capital by market forces for another 30-odd years after that. During this
period, Taiwan, Korea, Hong Kong, and Singapore moved through the industrialization
period and embraced services.

EXHIBIT 42: Pan-Asia agriculture/industry/services GDP share (1967-2015)

60% 0.30

0.29
50%
0.28

0.27
40%
0.26

30% 0.25

0.24
20%
0.23

0.22
10%
0.21

0% 0.20

Energy Intensity (RHS) Agriculture Industry Services

Source: World Bank and Bernstein analysis.

40 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

China began the industrialization process in full in the 1990s, and industrial activity as
the dominant share of Chinese economic activity started to fade only in the last few
years. The implication is: Asia as a whole is not going to have an "industrialization
phase" where the largest component of the regional economy is industrial activity. Korea,
Taiwan, Hong Kong, Singapore, and now China have moved through that period. India
may never get there. The rest of the regional economy Vietnam, Thailand, the
Philippines, Indonesia, Malaysia are too small to fight against the tide of the services
sector. Services and consumption will only gain share within the regional economy.

Again, the New Economy in Asia and most other places won.

There are a variety of implications of the fact that the services sector now drives the
largest share of the emerging Asian economy. As recently as 2011, that was not the case
(see Exhibit 43). For current purposes, the most significant is the implication of energy
and commodities.

Energy and commodity intensity will continue to fall across Asia. Asian oil, gas, and coal
consumption is unlikely to fall in aggregate terms any time soon, but the rate of growth
will slow as the means of energy production become more efficient. More to the point, the
services sector is simply a far less energy-intensive source of economic activity compared
to manufacturing, construction, or the industrial economy in general.

EXHIBIT 43: Pan-Asia agriculture/industry/services GDP growth share (1968-2015)

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Agriculture Industry Services

Source: World Bank and Bernstein analysis.

THE OLD ECONOMY AND THE NEW 41


BERNSTEIN

RISK #1: A SURPRISE FROM CHINA

The focus list we have constructed (see Exhibit 41) assumes a benevolent economic
environment in Asia over the course of 2017. Given that the consumer in emerging Asia's
four-largest markets looks healthy (see Exhibit 20) and commodity prices have returned
to a level where the tail risk from unserviceable loans made to oil or coal producers sitting
on the balance sheets of ill-disciplined Asian banks has now faded, the simplest
explanation for a view of Asia in 2017 without macro shocks of any kind is: why not?

The alternate interpretation is: the expectation of a period of "smooth sailing" in Asia is
simply the triumph of hope over recent experience.

Equity market volatility over the last two years has been a function of the "Short Bull
Market" in Shanghai, a sell-off from mid-summer 2015 in the wake of the Shanghai stock
suspensions, the RMB devaluation in August 2015, foreign currency outflows from China
between November 2015 and January 2016, and more RMB devaluations in January
2016 (see Exhibit 44).

In these environments in Asia, there are simply few places to turn. We favor pairwise
country correlations as a means of gauging market stress across Asia. In short, when
markets sell off across Asia, they all sell off (see Exhibit 44).

EXHIBIT 44: Average pairwise country correlation and MSCI Asia ex-Japan

0.6 Onset of the financial crisis 700


China slowdown
Average pairwise country concerns; China
correlation (LHS) devaluation
600
0.5 MXAPJ (RHS)

500
0.4
Correlation

Long-term 400

Index
average(pair
0.3 wise country
correlation) 300

0.2
200
Sovereign
0.1 debt crisis in
Europe 100

0.0 0
Sep-00

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Sep-13

Sep-14

Sep-15

Sep-16

Source: Bloomberg L.P. and Bernstein analysis.

Over the almost two years beginning in September 2014 until the early part of this
summer, China was under a constant barrage of economic, market, and financial stress.
The "Short Bull Market" began in September 2014, at the same time as the Chinese
property market was turning. The "bull" market lasted through July 2015, when the

42 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

Shanghai stock market turned and the exchange regulators started suspending stocks
rather than permitting bearish sentiment to erase all of the gains of the previous nine
months, and in the absence of an institutional investor base that might be expected to
step in.

EXHIBIT 45: Key market events in China over the last two years (December 31, 2013 = 100)
Stock market
300.0 Episodes of
colllapse
capital flight
Stock market
250.0 rally between
Sep'14 - Jul'15 Reacceleration in
credit growth
200.0

150.0

100.0

Currency
50.0 devaluation
Property market decline announcement

0.0
Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16

MSCI China SHCOMP

Source: Bloomberg L.P. and Bernstein analysis.

The following month (August 2015), the RMB depreciation began. At that point,
consensus thinking became that Chinese policymakers had taken leave of their senses.
The domestic stock market continued to soften and foreign currency outflows began to
pick up (see Exhibit 46).

THE OLD ECONOMY AND THE NEW 43


BERNSTEIN

EXHIBIT 46: China foreign currency reserve flows

150

100

50
US$ B

-50

The period betweeen Nov '15 -


-100
Jan '16 saw aggregate outflows
of US$295bn

-150
Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Jan-11

Sep-11
Nov-11
Jan-12

Sep-12
Nov-12
Jan-13

Sep-13
Nov-13
Jan-14

Sep-14
Nov-14
Jan-15

Sep-15
Nov-15
Jan-16

Sep-16
Mar-11
May-11

Mar-12
May-12

Mar-13
May-13

Mar-14
May-14

Mar-15
May-15

Mar-16
May-16
Source: PBOC, Haver, and Bernstein analysis.

Foreign currency outflows hit a peak over the three months from November 2015 to
January 2016.

The policy response to currency outflows and a real danger of capital flight from China
was threefold: drain RMB liquidity outside China so as to make shorting the RMB more
difficult for U.S. and European hedge funds; create two-way volatility in the value of the
currency so as to create uncertainty in the minds of Chinese corporations and residents
seeking to move funds out of China or simply leave funds out of China and extend credit to
the industrial economy so as to change economic sentiment domestically. In combination,
it worked. Net foreign currency outflows have fallen back to somewhere between -$30
billion and are a positive number over the last six months. On a base of $3.1 trillion, that is
not a near- or even a medium-term risk.

The massive credit impulse in China in the first quarter eventually found its way to the
commodities complex, to construction, and to the property market. Property prices in
China have now been rising steadily since the first quarter of 2015 (see Exhibit 47).

44 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 47: Residential property price movement

14,000 Residential property prices declined 2.8% 20.0%


annualized between Jan '14 and Mar '15
12,000 15.0%

10.0%
10,000
5.0%
8,000
0.0%
6,000
-5.0%
4,000
-10.0%

2,000 -15.0%

0 -20.0%
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep
13 13 13 13 13 13 14 14 14 14 14 14 15 15 15 15 15 15 16 16 16 16 16

100 City Resi Prop Prices (RMB/sq.m) (LHS) YoY Growth (RHS)

Source: Haver and Bernstein analysis.

In short, the risk of a Chinese financial crisis is present at all times in Asia. That said, as we
exit 2016, that risk seems lower than a year ago and certainly lower than nine months
ago. Yet it would be foolish to dismiss the possibility altogether.

Two things are clear.

First, there is nowhere to hide in Asia from a true Chinese financial crisis. China is ~80% of
economic growth in the region. Chinese near misses over the last few years have seen
spikes in pairwise correlations and fund flows out of Asia. Buying Australian banks,
Korean cosmetics producers, or Taiwanese tech companies will not help. It is all
interconnected.

Second, the market across Asia bounces back from near misses, quickly. Over the last two
years, we have seen no sign of a "penalty box" (in the ice hockey sense of the term). Asian
markets go up or they go down. A spike in fears around China will cause Asian markets to
fall. There is no less of a controversial statement in 2017. But if you are bearish on China
by which we mean you are expecting a true financial crisis then you are, by definition,
bearish on Asia too.

THE OLD ECONOMY AND THE NEW 45


BERNSTEIN

RISK #2: A SURPRISE FROM THE UNITED STATES

It would be tantamount to professional malpractice to write a "year ahead" report at the


end of 2016 without mentioning that U.S. President-elect Donald Trump makes good
copy (as the New York media has known for years). Now, his ability to move tabloids at
newsstands in New York subway stations is transitioning to an ability to move markets.

Never before has the United States been led by an individual with so little political,
economic, diplomatic, or foreign policy experience. How could we resist dedicating a few
pages to what might happen.

First, there is good news in all of this. When measured through the perspective of the U.S.
Misery Index (oil price, inflation, interest rates, and unemployment), the United States is
currently either below or significantly below long-term averages dating back to 1980 (see
Exhibit 48). Accordingly, the need for an immediate set of policy changes once President
Trump is sworn in similar to TARP in 2008, or the American Recovery and Reinvestment
Act of 2009 seems unnecessary. Said differently, he could do nothing.

EXHIBIT 48: U.S. Misery Index, 1980-present


10% 100

9% 90

8% 80

Oil price( US$ / barrel)


7% 70

6% 60
4.7%
5% 43.41 50

4% 40

3% 30
1.8%
2% 1.5% 20

1% 10

0% 0
Oil Price (RHS) Inflation Interest Rate Unemployment

+/-1 Current Average

Source: Bloomberg L.P., and Bernstein estimates and analysis.

The risk, however, to Asian markets is not from changes in U.S. fiscal, monetary, trade, or
foreign policy that are painful but necessary, given market conditions.

Rather, the risk is a "surprise" from U.S. trade or foreign policy that has implications in
Asia. Any forecast in November 2016 about what the President-elect might do in January
or during the course of 2017 is flawed due to the lack of any political track record,

46 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

consistent ideology, or coherent policy statements in which to judge likely actions and
fidelity to past statements once in office.

EXHIBIT 49: Relationship between average pairwise country correlation and S&P VIX 500 in 2016

0.60 Average pairwise country correlation (LHS) S&P 500 VIX (RHS) 30

0.55 Pairwise correlations


in Asia have started to 25
rise over the last 4
weeks
0.50

20

0.45

15
0.40

0.35 10

Jul-16
Feb-16

Mar-16

May-16

Aug-16

Sep-16

Oct-16

Nov-16
Jan-16

Apr-16

Jun-16

Source: Bloomberg L.P. and Bernstein analysis.

Markets globally are (at November 15) reacting to the assumption that President-elect
Trump will embark upon fiscal stimulus in the United States, maintain existing trade and
military relationships in Europe and Asia, and be able to cope with whatever geopolitical
events in Asia or globally that occur or are manufactured to test the new President.

Let's hope so.

The less benign interpretation is that four years is a long time. Each Presidency is
confronted with surprise events in or from parts of the world or domestic constituencies
that few forecast ahead of time. It is those events currently unknown that we are
going to spend most of the next 12 months discussing when it comes to U.S. trade,
economic, and foreign policy. We, like everyone else, just don't know what they are.

A further risk (currently discounted) is that, with an apparent mandate to break


longstanding trade and military relationships in Asia and elsewhere, President-elect
Trump follows through. Any Asian statesman or woman (or at least any North Korean or
Chinese one) worth his or her salt will almost certainly be agitating to manipulate events in
such a way as to place Trump at odds with his stated policies, the Republican Congress,
traditional U.S. allies in the region, and 70 years of post-World War II relations in Asia.

What could go wrong?

We are in no position to comment on the geopolitical risk that a change in the nature of
longstanding U.S. alliances in East Asia might create. Clearly, it is in China's interests if

THE OLD ECONOMY AND THE NEW 47


BERNSTEIN

U.S. influence in the region declines. There is an obvious fault line between the stated
policies of the President-elect and the longstanding arrangements between the United
States and Japan, Korea, and Taiwan, respectively. How that plays out is unclear. What is
also unclear is the new administration's ability to compartmentalize trade, territorial, and
diplomatic disputes with China. This is a cornerstone of modern U.S. foreign policy and
statesmanship in general.

What is clear is that the key risk to the regional economy in this part of the world is a
disruption to trade flows because of import quotas or tariffs imposed by the new
administration on markets that are deemed to be "stealing" U.S. jobs.

Asia ex-Japan currently represents something in the area of ~27% of global trade (see
Exhibit 50). The EU represents one-third. Other markets comprise roughly one-quarter of
global trade. The United States is less than 10%.

EXHIBIT 50: Share of global gross exports EXHIBIT 51: Global gross exports (1995-August 2016)

20.0
Jan - Aug Sep - Dec
18.0
Others 16.0
Indonesia
23%
1% EU
35% 14.0
Thailand
1%
12.0
US$ Trillion

Russia
2% 10.0
India
2% 8.0
Taiwan
2% 6.0
Singapore
2% China 4.0
Hong US 13%
Kong 2.0
Japan 9%
3%
4% 0.0
Korea
3%

Source: IMF, Bloomberg L.P., and Bernstein analysis. Source: WTO and Bernstein analysis.

Global trade has been falling since 2014, in part due to the declining value of
commodities, in part due to the on-shoring of manufacturing, and in part due to the
strength of the U.S. dollar in recent years, which has served to reduce the value of (for
example) French wine or Korean cosmetics when measured in U.S. dollars.

Across Asia, South Korea is the market that stands out in terms of risk from global trade.
Almost 20% of Korean GDP is linked to exports. For a nation of 48 million that produces 8
million cars annually, and half the world's ships and smartphones, trade is not
surprisingly important (see Exhibit 52). For China, gross exports are less than 10% of
GDP. For the United States, it is less than 5%. Chinese exports total roughly $2 trillion per
year (see Exhibit 53).

48 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 52: Gross exports (US$) and as a percentage of GDP EXHIBIT 53: Gross Chinese exports (1990-October 2016)
(2H2015-1H2016)

Gross Exports as a % of GDP 2.5


6.0 35% Jan - Oct Nov - Dec

5.0 30%
2.0

25%
4.0
US$ Trillion

1.5

US$ Trillion
20%
3.0
15%
1.0
2.0
10%

1.0 5% 0.5

0.0 0%
Japan

India

Indonesia
China

US

Korea
EU

0.0

Source: WTO, Haver, Bloomberg L.P., and Bernstein analysis. Source: Bloomberg L.P. and Bernstein analysis.

The contours of what a trade dispute might look like are unclear. U.S. and Chinese
combined exports to one another are roughly half a trillion dollars annually. The notion
that China's trade surplus represents China "winning" in terms of global trade reflects a
willful ignorance of the nature of global supply chains and the benefits to foreign
companies of low-cost Chinese manufacturing, together with the scale and infrastructure
benefits of operating in China.

In short, as was demonstrated in 2016, the risk of the worst case scenario when it comes
to China is likely to get priced in at various times during the year. It is naive to simply state
that "cooler heads will prevail." Cooler heads have not prevailed so far. However, it is
unnecessarily fatalistic to assume that every Chinese manufactured product to the United
States is hit with a ~40% tariff from January 21, 2017.

Just like everyone else, we have no ability to forecast the details of the new
administration's trade or economic policies. What is clear is that the risk of a trade dispute
between China and the United States and of efforts from China to pressure the new
administration to act on various inflammatory statements about relationships with
traditional allies in Asia are higher in 2017 than they were in 2016.

The United States and China are geopolitical rivals, along with important trade partners,
and counterparties to significant foreign direct and indirect investment. The relationship is
always going to be a little fraught. But whatever the risks here in recent years, they have
not fallen.

THE OLD ECONOMY AND THE NEW 49


BERNSTEIN

EXHIBIT 54: China Exports to the United States/United States exports to China (1995-September 2016)
450 25%

400

350 20%

300
15%
US$ Billion

250 China Exports to US

200
US Exports to China 10%
150
% of Total China Exports
100 5%
% of Total US Exports
50

0 0%
1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

LTM 2016
Source: Bloomberg L.P., Haver, and Bernstein analysis.

CAN WE TALK ABOUT THE NEW CHINA YET?

One of the real surprises of first-half results among the 1,800 Chinese-domiciled
companies that we track was the profit share contribution from Chinese Internet
companies. We track earnings results for ~1,800 companies with market capitalizations
of greater than US$1 billion that are China-domiciled and listed in Shanghai, Hong Kong,
or New York; plus obvious China "plays" like the Macau gaming stocks.

In the first half of 2016, Internet companies represented 3% of the US$7 trillion in market
cap that we follow and one-third of the profits (see Exhibit 55 and Exhibit 56). Viewed
from one perspective, the Internet will eat the world.

Of course, it is possible to quibble that materials (6% by market cap; 32% of profits in the
first half) has a similarly out-sized effect in China. And in the first half of 2016, this is true.
However, as we outlined earlier, we do not think that the rebound in metals and mining in
2016 is sustainable. On the other hand, a platform for 1.3 billion people to communicate,
be entertained, be educated, and purchase goods and services in a faster and more
convenient fashion than ever before in the history of civilization has been possible, in a
market still growing at 5-7% annually, has some legs.

50 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 55: Profit pool (1H2016) share by sector for China EXHIBIT 56: Profit growth (1H2016-1H2015) share by sector
for China
Materials, IT (Ex Health- Includes only those sectors which had
Consumer care, postive net income growth (1H16 vs.
2% Internet),
Staples, 2% 1H15), ex BABA one-off
2% 2%
Energy, Health
Internet, 1% Care,
Other, IT (Ex
2% 8%
0% Internet),
Utilities, 10%
4% Internet,
33%
Telecom,
5%

Consumer Consumer
Discr, Staples,
6% 17%
Financials,
64%
Industrials,
9%

Materials,
32%

Note: Excludes one-off gain for BABA in 1H2015.

Source: Bloomberg L.P. and Bernstein analysis. Source: Bloomberg L.P. and Bernstein analysis.

The split is even more profound outside of China. Across the MSCI Asia-Pacific ex-Japan,
the Internet names accounted for more than 50% of earnings in the first half of 2016. In
fact, only four sectors improved profitability in Asia in the first half of 2016: healthcare,
materials, utilities, and the Internet. In short, less than 25% of the market cap accounted
for 100% of profits across the MSCI Asia-Pacific ex-Japan in the first half of 2016 (see
Exhibit 57 and Exhibit 58). There is no greater reflection of the fact that the New Economy
has "won" in Asia ex-Japan than the fact that across the region all of the profit pool
went to four sectors, and the Internet and healthcare accounted for ~70% of the profits.

For the last few years, as part of this annual exercise, we have encouraged our analysts to
identify the Chinese companies that they believe represent true competitive threats
globally.

In 2014, across our consumer analysts (autos, staples, beverages, luxury goods, IT
hardware, and telecom), we identified Lenovo and Xiaomi as competitive threats to non-
Chinese incumbents globally. In 2015, across our tech, capital goods, and healthcare
analysts, when we looked for Chinese companies that could "out-innovate," we identified
Jiangsu Hengrui, SMIC, Hua Hong, China Mobile, Shanghai Electric, and Hollysys (see
Exhibit 59). This group on an equal-weighted basis has outperformed MSCI China by
~350bps over the last 12 months.

This year, Euan McLeish, our Asia Beverages Analyst, and Laura Nelson Carney, our Asia
Healthcare Analyst, cast a wider net in the search for quality in Asia among their coverage,
and what the implications are, more broadly. We are not giving up on the notion of

THE OLD ECONOMY AND THE NEW 51


BERNSTEIN

innovative, quality companies in China. We are simply broadening our gaze in this annual
endeavor consistent with the firm's broader push into Asia.

EXHIBIT 57: Profit pool (1H2016) share by sector for MXAPJ EXHIBIT 58: Profit growth(1H2016-1H2015) share by sector
for MXAPJ
Includes only those sectors which had postive Net Income
growth (1H16 v 1H15), ex one-off gains/losses for BABA,
Consumer
Energy Staples Internet Health BHP, Vedanta, South 32, Rio Tinto, and Fortescue
3% 2% Care
2% 1% Health
Utilities Care Utilities
4% 17% 1%

Materials
4%
Financials
Telecom 45%
6%

Industrials Internet
7% 52%

Real Materials
Estate 30%
8%

Consumer IT (ex
Discr Internet)
8% 10%

Note: Excludes one-off gains/losses for BABA, BHP, Vedanta, South 32, Rio
Tinto, and Fortescue.
Source: Bloomberg L.P. and Bernstein analysis.
Source: Bloomberg L.P. and Bernstein analysis.

The final piece in terms of the New Economy "winning" in Asia is that Asia's largest
economy starts producing things (specifically technology) that the rest of the world wants
to buy not simply because they are cheaper than the alternative but because they are
better.

We continue to wait for China's "Sony Walkman" moment. That is the missing piece in our
view that the New Economy won the war in Asia. We are not going to predict a Chinese-
designed gadget as the stocking stuffer of choice for Christmas 2017. However, the
signs from Chinese companies like NextEV and its electric vehicles (private; see
Exhibit 61 and Exhibit 62), DJI and its commercial and personal drones (private; see
Exhibit 60), and BYD (see Exhibit 63) have never been better.

52 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

IN SUMMARY

1. In Asia, the New Economy finally "won" in 2016. Measured by long-term stock market
performance, sources of economic growth across the region, falling energy intensity, and
the sources of profit growth in the public equity marketsthe Old Economy/New
Economy war is over. Emerging Asia will never have a traditional "industrialization" phase
where the majority of economic output comes from manufacturing, construction, and
industry. Since the largest economies in Asia are now through that phase or (like India) are
unlikely to ever enter it, it is now all about services.

2. That does not mean that the equity value of the Old Economy will fall monotonically
each year. Energy and materials were the two best-performing sectors in Asia in 2016.
The rally in materials and energy this year reflects both the recovery in the underlying
commodity prices since the first quarter and mean reversion within the sectors regionally.

EXHIBIT 59: 12-month return for MSCI China versus basket EXHIBIT 60: DJI Phantom 2above Kennedy Town in Hong
of "out-innovators": Jiangsu Hengrui, SMIC, Hua Hong, Kong
China Mobile, Shanghai Electric, and Hollysys
15.0%
"Out-Innovators"
10.0% MSCI China

5.0% 4.7%

0.0% 1.1%

-5.0%

-10.0%

-15.0%

-20.0%

-25.0%
Jul-16
Nov-15
Dec-15
Jan-16

Jun-16
Feb-16
Mar-16
Apr-16

Aug-16
Sep-16
Oct-16
Nov-16
May-16

Source: Bloomberg L.P. and Bernstein analysis. Source: Private collector with permission.

3. Quality and Growth continue to look extraordinarily expensive in Asia. Value and Income
continue to look extraordinarily cheap. But the gap has closed since mid-year. The
materials and energy stocks were the primary beneficiaries of this shift in the second half.

4. We believe that the historically high gap between Quality and Growth and Value and
Income will continue to close. We believe that owning financials and utilities are a better
way to participate in the mean reversion in 2017, rather than chasing energy and miners.
Compared to historical valuation multiples, financials and utilities remain at or more than
one standard deviation below the long-term trend. Energy and miners are at or above
long-term average valuation multiples.

5. The Asian consumer continues to look strong. The profit pool in Asia is dominated by
the Internet and healthcare. The Asian consumer's desire for entertainment, apparel,

THE OLD ECONOMY AND THE NEW 53


BERNSTEIN

transport, credit, financial security, information, and pizza will drive public equity market
investment opportunities in Asia. The Asia Blue Chips now reflect this reality. Tencent,
Alibaba, AIA, China Life, HDFC, Samsung, and TSMC among others are largely plays
on the Asian consumer more than on Asian manufacturing capabilities.

EXHIBIT 61: NextEV Formula E Vehicle EXHIBIT 62: NextEV Formula E Vehicle

Source: Company materials, with permission. Source: Company materials, with permission.

6. The risks to Asia in 2017 reflect a little of the old (a financial collapse in China) and the
new. The "new," in this instance, means: a trade war between the United States and China;
or elevated risk premiums due to the changes in relations between Taiwan, South Korea,
and Japan and the United States, should the President-elect proceed with statements
made on the campaign trail about cost reimbursement from east Asian allies for the U.S.
military presence in Asia, arming Japan with nuclear weapons, and extracting better
"deals" from U.S. trade partners.

EXHIBIT 63: Denza - The new version (BEV) is using a 62KWh LFP pack and has a range >320km; pre-subsidy MSRP is
RMB416k and the post-incentive price is RMB306k

Source: BYD Denza with permission.

7. Attempting to avoid these risks and invest in Asia is simply not possible. It is not clear to
us that owning an Asia security of a company that is not domiciled in China does much to

54 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

solve China risk or U.S. trade policy risk. These are risks, but not actionable ones unless
the action is to take Asia ex-Japan exposure to zero.

8. The other lesson from 2016 is that the market across Asia bounces back from near
misses. Over the last two years, we have seen no sign of a "penalty box" (in the ice hockey
sense of the term). Asian markets go up or they go down. A spike in fears around China
will cause Asian markets to fall. There is no less of a controversial statement in 2017. But
if you are bearish on China by which we mean you are expecting a true financial crisis
then you are, by definition, bearish on Asia too.

9. We maintain a focus list that reflects, in part, confidence in Asia Blue Chips in an
environment of a healthy Asian consumer and a structural, long-term rotation to the New
Economy. We also include high-conviction thematic ideas that largely sit within the
consumer sector.

10. In addition, we incorporate stocks in the focus list that follow the direction implied by
our factor analysis. Currently, that means dividend and FCF yielding stocks that are
inexpensive on a P/B and P/E basis versus their history. At present, that means a clear
overweight toward financials (China Life, AIA, Bank Mandiri, ANZ, CCB, and ICBC) and
utilities (Huaneng Power, KEPCO, and China Resources Power). We are net neutral
Energy between Shenhua (a "Short") and PTT E&P.

THE OLD ECONOMY AND THE NEW 55


BERNSTEIN

56 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

THE SEARCH FOR QUALITY CONTINUES


What can booze and drugs teach us about Quality companies in
Asia?

OUR QUEST FOR THE HOLY GRAIL

Quality has proven more elusive to investors in Asia than in developed markets. The
longstanding gripe about investing in Asia where are the companies with rapid earnings
growth, high ROIC, good management teams, large competitive advantages, and strong
balance sheets? has, in 2016, narrowed down to: I cannot possibly own any more
Tencent (700.HK, not covered).

Bernstein has historically searched for Quality companies globally and in Asia using three
different quantitative screening approaches (summarized in Exhibit 64). We noticed that
these approaches yield a number of interesting false positives and false negatives and
tried to learn something from them. Firm-wide, our quant Quality tools for Asia are
arguably unreliable for one of four reasons: we screen too narrow a "hunting ground" (only
the MSCI All Country World Index), we eliminate companies without a long financial
history, the numbers look great but products or services sold are of questionable Quality
or ethics, and/or we ignore the reality that Quality in emerging Asia looks different than in
developed markets.

We believe that Quality companies need to have achieved durable profitability and
sustainable competitive advantages. For many companies in Asia (and emerging markets
more broadly), the ability to capture economic rents is tied to local dynamics such as
commodity demand and favorable regulation. Those rents and the resultant high
returns can disappear faster in Asia than in ROW. As a result, identifying high-Quality
stocks in Asia is more challenging than in developed markets, where firms have
established wider and deeper competitive moats.

In this chapter, we propose a new cross-sector, seven-dimension framework and


screening tool for identifying Quality in Asian companies (a combination of quantitative
and qualitative fundamental factors) and use three example sectors (Asia-Pacific
pharmaceuticals, healthcare services, and alcoholic beverages) to explore what Quality
looks like in Asia.

By recognizing and embracing what's unique about operating in Asia and applying both
quantitative and qualitative fundamental filters, we hope to sharpen the search for Quality
companies and to we hope unearth hidden gems that you might not have heard of.

THE SEARCH FOR QUALITY CONTINUES 57


BERNSTEIN

This chapter is set out in seven parts, specifically:

A review of our previous attempts to capture Quality in Asia

False positives and false negatives abound what can we learn from them?

Pharmaceuticals what's in Quality Asian drugs?

Healthcare services what do Quality hospital operators look like in Asia?

Beverages what makes Quality tipple?

Where to invest? Results from our revised Quality-in-Asia quant screeninghappy


hunting

Investment implications

A REVIEW OF OUR PREVIOUS ATTEMPTS TO CAPTURE


QUALITY IN ASIA

QUALITY IN ASIA HAS PROVEN The longstanding gripe about investing in Asia where are the companies with rapid
MORE ELUSIVE THAN IN earnings growth, high ROIC, good management teams, large competitive advantages, and
DEVELOPED MARKETS
strong balance sheets? has, in 2016, narrowed down to: I cannot possibly own any more
Tencent.

Why search for Quality companies via quantitative approaches? Multi-factor quantitative
models for stock selection have been explored by many successful funds investing in
Quality and other strategies. One of the most famous factor models is the "magic formula"
by Joel Greenblatt.1 Factors refer to quantitative metrics that can be extracted from
financial statements (e.g., sales, net income, EBITDA margins, R&D ratio of revenue, and
net debt ratio) and used as proxies for certain desirable characteristics of the underlying
company. For example, Growth can be assessed by revenue CAGR or net income CAGR,
Profitability by margins, Returns by ROE or ROIC, and Liquidity by net debt ratios.

Bernstein has historically screened for Quality companies in Asia using three different
quantitative factor screening approaches (summarized in Exhibit 64; more details on each
of them can be found in the appendix at the end of this chapter). In this chapter, we
explore: 1) Bernstein's historical screening approaches using Quality factors to find
investable targets, 2) what we can learn from Asian false negatives and false positives
generated by these global approaches, and 3) whether we can embrace what's different
about Asian companies in how we look for Quality.

1
https://www.magicformulainvesting.com/.

58 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 64: Summary of Bernstein's historical efforts to screen for Quality in Asia
European Equity Strategy US Quantitative Research Asia-Pacific Equity Strategy
Inigo Fraser-Jenkins Ann Larson Michael Parker
Global quant Markets Size Bernstein global quant Markets Size Regional quant Markets Size
Quality proxy Quality model parameters Quality factor screening
(ranking based on 6 factors) (sequential filters)
Latest ROE MSCI All Latest ROE MSCI All Net debt to assets below 30% MSCI Market cap
> USD 1 B
All World (all > USD ROE volatility All World (all > USD Free cash flow positive Asia Ex-
Index 1.2 B cap) Index 1.2 B cap) Japan
Index
One-year sales growth Non-operating income or loss of
less than 20% of operating income

Latest net margins ROIC materially higher than the


cost of capital

Sequential trend stability


of ROE

Net Cash Ratio Volatility


(Net Cash Ratio = [Cash &
Equivalents Short-Term
Debt Long-Term
Debt]/Market Cap)

Source: Bernstein analysis.

FALSE POSITIVES AND FALSE NEGATIVES ABOUND WHAT


CAN WE LEARN FROM THEM?

While quantitative screening tools are very helpful in narrowing the universe of potential
quality companies to consider, they are also imperfect; so, simply picking stocks based on
predefined metrics is not without pitfalls. The devil is always in the detail for example,
certain factors can carry positive or negative meanings at different growth stages of a
company or under different market conditions, even within the same market. This means
that generalization, while useful as a screening tool, has the potential to create false
positive or false negative signals. Take net-debt ratios as an example for a growing
company, a reasonable level of debt funding can boost production expansion and be a
positive; however, when financial markets tighten, leverage can create a large burden and
become a negative. False positive or false negative signals are common in any quant-
based screening model (not just for Quality).

In this chapter, we do not seek to replace the use of Quality factor models, but to explore
what can be learned from the false positive and false negative results they generate to
help us arrive at a more nuanced definition of Quality that is specific to the uniqueness of
Asian markets.

Our typical quant Quality screening criteria (strong balance sheet, low debt, high ROIC,
and little associate income) generate either false positive (doesn't really resemble
anyone's common sense idea of quality) or false negative (commonly known Quality
companies that somehow evade the factors used in quant Quality screens) stock
recommendations. Why?

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BERNSTEIN

Firm wide, our Quality tools for Asia are arguably unreliable for one of four reasons:

We use too narrow a hunting ground (we only look at stocks already inside the MSCI
All Country World Index and the regional Asian factor analysis only considers
companies with a market cap above US$1 billion);

We demand for too long a historical dataset (we exclude stocks where historical data
on a number of factors is unavailable, yet some of the best Quality businesses in Asia
are newer than in developed markets);

Our selection criteria (strong balance sheet, low debt, high ROIC, and little associate
income) generates stock recommendations like Huabao (a Chinese PLA tobacco
additives company) or Dong-E-E Jiao (a "traditional" medicine company making
products derived from donkey skin and urine that lack evidence for efficacy) that do
not really resemble anyone's idea of quality; and

We overlook or ignore the reality that Quality in emerging Asia looks different to
Quality in developed markets (e.g., some Quality companies in growth phases choose
to make temporary trade-offs between growth and ROIC, addressable markets in
Asia can witness much higher growth than in developed markets, and robust risk
mitigation strategies are even more important in Asia).

In general, the companies that score well on Quality parameters, both qualitative and
quantitative, are the ones that have achieved sustainable profitability and competitive
advantages. The ability to capture economic rents in emerging markets is often tied to
dynamics (commodity demand and favorable regulation) that can change quickly. Those
rents and the resultant high returns can quickly disappear. As a result, we believe
identifying high-Quality names is more challenging in Asia than in developed markets,
where firms have established competitive moats that can be more sustainable.

Exhibit 65 summarizes the price performance and quant screening quintiles by using two
of Bernstein's historical quant Quality screening approaches for top healthcare stocks
(Asia-Pacific pharmaceuticals and healthcare services combined) and Exhibit 66 shows
the data for the Asia-Pacific consumer staples sector (including beverages).

Here, we highlight some of the notable false positives and false negatives arising in
traditional quant screens that stand out to us and discuss what we can learn from them.
The remainder of this chapter will focus on a discussion of what Quality looks like in these
three example sectors Asia-Pacific pharmaceuticals, healthcare services, and
beverages.

NOTABLE FALSE NEGATIVES Pharmaceuticals


(NOT EXHAUSTIVE)
Jiangsu Hengrui Medicine Company (600276.CH, outperform). Hengrui is one of the
largest pharma companies in China and appears in the top Quality quintile in
Bernstein's global quant Quality model. However, it was knocked out of Bernstein's
regional factor-based Quality screening tool (which screens only the top 300 stocks

60 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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in the MSCI ACWI Asia ex-Japan). Based on a fundamental analysis, we think that
Jiangsu Hengrui is the highest-Quality pharmaceutical company in China by a wide
margin. It has a stronger portfolio of products in the market, deeper and more
innovative pipeline, deeper bench of overseas experience in its management and key
talent, strong balance sheet and consistency of returns (ROIC far higher than WACC),
margin expansion, and earnings growth. It has the second-largest pharma sales
force in China, competitive advantages in several therapeutic areas in China
(including oncology), has been growing its ANDA generics business in the United
States, and has been free from the type of sales corruption and corporate
governance scandals that have rocked many of its peers.

CSPC Pharmaceutical (1093.HK, outperform). CSPC is included in the MSCI World


and appears in the top quintile in Bernstein's global quant Quality model, but was
also knocked out of Bernstein's regional factor-based Quality screening tool (which
screens only the top 300 stocks in the MSCI ACWI Asia ex-Japan). In our view, CSPC
is one of the stronger "old guard" Chinese generic pharmaceutical companies.
Despite rising pricing pressure and policy uncertainty, demand for medicine is
accelerating and the majority of drugs consumed will continue to be generic drugs
made by domestic manufacturers. CSPC has demonstrated its ability to consistently
churn out new generic drugs every year, steadily expand margin expansion (via a mix
shift), and maintain an ROIC that is multiples higher than its WACC. CSPC has also
avoided the type of sales corruption or corporate governance scandals that have
negatively affected many pharma companies in China.

Kalbe Farma (KLBF.IJ, market-perform). Kalbe is included in the MSCI World and
screened into the top quintile in Bernstein's global quant Quality model, but was also
knocked out of Bernstein's factor-based Quality screening tool (which screens only
the top 300 stocks in the MSCI ACWI Asia ex-Japan). It is a well-run business that has
faced a challenging external environment this year (with the rollout of universal
health insurance forcing its pharma mix to shift toward more low-margin products
and slower recovery of domestic consumption affecting growth in its consumer
health and nutritional businesses). While pharmaceuticals is only about a quarter of
Kalbe's revenue (consumer health, nutritional products, and distribution make up the
rest), Kalbe has sustainable advantages in both its scale (with the largest market
share of the Indonesian drug market at 11%, compared to its closest peer with 5%)
and the depth and breadth of its distribution reach (which is hard to replicate in an
archipelago of 17,000 islands with weak national transport infrastructure). Kalbe has
been investing for the future, beyond the end of the rollout of the JKN universal
healthcare scheme by building plants to manufacture generic oncology drugs and by
bringing biosimilars to Indonesia.

Healthcare services

Bumrungrad Hospital (BH.TH, market-perform) appears in the global quant Quality


model but not in our regional factor-based screening. It is a well-managed Premium
hospital in ASEAN. Until this year, it has historically delivered 25% earnings growth
every year (except during the GFC), driven by smart management, steadily growing
revenue intensity per patient, and price increases. This year, Bumrungrad faces

THE SEARCH FOR QUALITY CONTINUES 61


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headwinds from weak oil price and global macroeconomic outlook and slowing
patient volumes from the Middle East. A new CEO (who was previously running a
hospital group in the UAE) has just taken the helm at Bumrungrad in September.

Mitra Keluarga (MIKA.IJ, not covered). Mitra Keluarga doesn't appear in the
Bernstein's global Quality model or in the factor-based Quality tool. It is the largest
(by market cap) and best Quality of the Indonesian hospital operators. It is a family-
run business focused on building community-based hospitals in Jakarta and
Surabaya, designed to serve the population living within a few kilometer radius of
each facility. It has steadily grown (though far slower than its local rival, Siloam) and
expanded its margins to the highest in the world of any major hospital operator (34%
EBIDTA margin).

Alcoholic beverages

Kweichou Moutai (600519.CN, outperform). Moutai screens favorably in the top


quintile of Bernstein's global quant Quality model, but was knocked out in Bernstein's
factor-based Quality screening tool (which screens only the top 300 stocks in the
MSCI ACWI Asia ex-Japan). In our view, Moutai is the highest-Quality spirits company
in Asia-Pacific. It focuses on the high-margin, rapid-growth, Ultra Premium baijiu
segment in China, and has unparalleled brand equity and best-in-class consumer
awareness across the nation. The company has sustained more than 70% EBIT
margin over the last five years and this is the highest margin among all major liquor
companies globally.

Yibin Wuliangye (000858.CN, outperform). Wuliangye also screens favorably in the


top quintile of Bernstein's global quant Quality model, but was knocked out in
Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan). Wuliangye earns a world-class EBIT margin
(38% in 2015) and offers a granular portfolio of intrinsically differentiated Ultra
Premium brands extending down to the Standard segment. The company has a clear
and sensible growth strategy leveraging on its strong brand equity and a deep
distribution network. In addition to the Ultra Premium regular Wuliangye brand,
Premium/Standard products also contribute meaningfully to both the top line and
the bottom line, making the company well positioned to capture the consumption
upgrade of middle class consumers in China.

NOTABLE FALSE POSITIVES Pharmaceuticals


(NOT EXHAUSTIVE)
Sihuan Pharmaceutical (460.HK, market-perform): Sihuan screens into the second
quintile in both the Bernstein quant Quality model and Bernstein's regional
factor-based quant tool. We believe that Sihuan is a false positive in these screens
quant screens miss some of the reasons to be concerned about Sihuan's core
business. For instance, 95% of its revenue comes from neuro-protective drugs to
treat acute ischemic stroke (a therapeutic approach that is not used outside China).
The drug lacks robust evidence for efficacy in international medical literature (only
used in China, "named and shamed" for lacking evidence for efficacy in provincial

62 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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monitoring lists, and CFDA recently issued a warning about cerebroprotein


containing drugs). Further, Sihuan uses a high-compliance-risk third-party sales
model (that was under investigation before its lengthy 11-month trading suspension
began) and has had a number of clouds of corporate governance uncertainty
following it in the past. What lies ahead for Sihuan is highly uncertain it is hard to
see how the business could turn around organically. There are no (known)
meaningful catalysts on the near-term horizon for Sihuan.

Shanghai RAAS Blood Products (002252.CH, not covered). RAAS is the largest
healthcare company in China by market cap and screens favorably (second quintile)
in our global quant Quality model. Like other domestic plasma companies, RAAS has
enjoyed structural growth in past years due to long-term shortage in blood products
in China and strict regulations banning imports of foreign blood products (except in
certain shortage situations, including albumin). However, there has been some
uncertainty over corporate governance for decades. The controlling shareholder of
RAAS has been using shares of RAAS as collateral for loans to invest in other
businesses. Earnings have been historically volatile and often include large non-
recurring items. The founder, Kieu Hoang, is a Vietnamese Chinese who lived in the
United States. How he managed to gain access to the Chinese market in the 1980s
has been the subject of much (unsubstantiated) speculation. While this chapter
deliberately excludes discussion of valuation, in this case, it is worth pointing out that
RAAS trades at roughly double the multiple (70x P/E) of its closest competitors,
CBPO (33x P/E) and Hualan (41x P/E).

Dong-E E-Jiao (000433.CH, not covered). Dong-E also screens favorably (second
quintile) in the Bernstein quant Quality model and the regional factor tool. Dong-E is a
TCM company that manufactures a line of E-Jiao. E-Jiao, developed from donkey
skin, is marketed as a "blood enricher" and a nutritional supplement for women.
However, there is no clear evidence for efficacy of E-Jiao products and concerns
about counterfeit versions plague the market overall (and Dong-E E-Jiao specifically).
According to Shandong E-Jiao Trade Association, annual consumption of E-Jiao
products in China translates to 5,000 tons of donkey hides required to make them, or
about 4 million donkeys slaughtered per year. ChinaAg estimates the demand for
E-Jiao to be even higher equivalent to 10 million donkey skins a year. However,
only about 3,000 tons are available per year, and each year the supply dwindles.
Sometimes, the meat goes to waste because the skin is the most valued part of a
donkey. China's donkey population has fallen from 11 million in the 1990s to less
than 5 million today. It is estimated that about 40% of E-Jiao products in circulation
in China are fake. Horse hide is the closest genetic substitute and difficult for
consumers to distinguish, but a feared counterfeit because TCM doctors believe that
it can induce miscarriages in pregnant women (though there is no robust clinical
evidence of this either). Dong-E E-Jiao raises its own donkeys and is the producer of
the most prestigious, premium-branded E-Jiao products. Local media report that
Dong-E E-Jiao has raised its prices 16 times in the last decade (translates to a 23%
CAGR in price) and is trying to launch other products to diversify its revenues (e.g.,
donkey meat hot pot and donkey meat steamed buns).

THE SEARCH FOR QUALITY CONTINUES 63


BERNSTEIN

Healthcare services

China Resources Phoenix Healthcare Group (1515.HK, market-perform). Phoenix


also screens favorably (first quintile) in the Bernstein's quant Quality model and
regional factor-based tool. However, we believe it to be a false positive for a few
reasons. Phoenix has historically (since IPO, though not before) adopted an old
asset-light model to manage hospitals in the Beijing area and which was popular with
investors (many called it "the Four Seasons of hospitals in China") and enabled it to
grow quickly. But it has run into serious headwinds recently. IRRs of its new "invest-
operate-transfer" (IOT) projects are much lower than the original ones and there have
been many delays in newer projects (e.g., Baoding). The turnarounds are based on
squeezing hospitals on costs for better financial efficiency, not improving the clinical
quality of healthcare provided. Phoenix had difficulty in maintaining a continued
stream of new IOT projects and has been relying heavily on drug sales, which is an
increasingly uncertain position to be in as the government cracks down further on
hospitals making too much money from drug sales. Earlier this year, Phoenix
announced a reverse-merger with another large hospital group (China Resource's
hospital group), which doubles its bed count, and acquired two more hospitals from
CITIC Medical. Significant uncertainty exists on the future profitability of the merged
entity. Corporate governance question marks have lingered around Phoenix for a few
years, but may be at least partly alleviated by the merger. Only one member of the
group-level management and board (the founder) has meaningful hospital
management experience.

Alcoholic beverages

China Resources Beer (291.HK, underperform). CRB ranked in the second quintile in
Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan), but did not rank in the global quant Quality
model. CRB is the largest beer company in China by volume (1.4x the size of #2
Tsingtao), but its EBIT margin remains stubbornly low (7% in 2015) and its ROIC of
6% is below WACC. Management is primarily focused on extending its volume
market share lead over the short to medium term instead of enhancing margins, and
we expect continued reinvestment to result in broadly flat margins and ROIC less
than WACC over the medium term.

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EXHIBIT 65: Price performance and quant screening scores for the top Asia-Pacific healthcare companies (including both
pharmaceuticals and healthcare services)
Quality Quintile Quality Quintile Share Price Performance
Market Cap
Company (Bernstein Quality (Factor-based
($Bil) 2012 2013 2014 2015 YTD
Model) approach)
Takeda Pharmaceutical Co Ltd 34 2 3 14% 25% 4% 21% -24%
Astellas Pharma Inc 32 1 1 24% 61% 35% 3% -10%
Sun Pharmaceutical Industries Ltd 24 1 2 48% 54% 46% -1% -16%
Eisai Co Ltd 19 2 2 13% 13% 15% 73% -17%
Shionogi & Co Ltd 18 1 1 45% 59% 37% 76% -5%
Chugai Pharmaceutical Co Ltd 17 1 3 30% 41% 27% 43% -22%
Jiangsu Hengrui Medicine Co Ltd 16 1 na 12% 39% 9% 70% 10%
Daiichi Sankyo Co Ltd 16 3 4 -13% 45% -12% 49% -5%
Shanghai RAAS Blood Products Co Ltd 16 2 na 2% 249% 90% 76% -3%
Terumo Corp 14 2 3 -6% 49% 9% 37% 3%
Kangmei Pharmaceutical Co Ltd 13 2 na 17% 37% -13% 116% 6%
Sinopharm Group Co Ltd 12 2 na 30% -8% 23% 13% 13%
IHH Healthcare Bhd 12 1 5 nm 15% 25% 37% -5%
Olympus Corp 11 3 1 65% 100% 28% 12% -25%
Bangkok Dusit Medical Services PCL 10 1 2 38% 4% 46% 30% 0%
Lupin Ltd 10 1 1 37% 48% 57% 29% -21%
Kyowa Hakko Kirin Co Ltd 9 1 5 -10% 37% -2% 69% -12%
Fosun Pharma 8 1 na 23% 87% 8% 11% 2%
Dr Reddy's Laboratories Ltd 8 2 2 16% 39% 28% -4% 5%
Shanghai Pharmaceuticals Holding Co 8 3 na 0% 33% 12% 21% 1%
Searainbow Holding Corp 7 4 na 55% 120% 50% 7% 69%
Sumitomo Dainippon Pharma Co Ltd 7 2 4 18% 59% -29% 22% 27%
Aurobindo Pharma Ltd 7 1 1 122% 107% 189% 54% -12%
Cipla Ltd/India 7 2 3 29% -3% 56% 4% -16%
Tasly Pharmaceutical Group Co Ltd 6 1 na 32% 55% -4% 0% 0%
Beijing Tongrentang Co Ltd 6 3 na 27% 20% 5% 99% -29%
CSPC Pharmaceutical 6 2 na 30% 174% 12% 16% -1%
Cadila Healthcare Ltd 6 1 na 28% -10% 97% 2% 16%
Dong-E-E-Jiao Co Ltd 6 1 na -6% -2% -6% 40% 12%
Kalbe Farma Tbk PT 5 1 na 56% 18% 46% -28% 13%
Sino Biopharm 5 1 na 60% 66% 14% 51% -26%
Hualan Biological Engineering Inc 5 1 na -16% 36% 16% 32% 30%
Divi's Laboratories Ltd 5 1 na 42% 11% 41% 34% 6%
Hanmi Science Co ltd 4 2 na 89% 76% 28% 752% -33%
Bumrungrad Hospital PCL 4 2 na 59% 19% 61% 50% -12%
Sihuan Pharmaceutical Hldgs 2 2 na 24% 108% 47% -16% -56%
Phoenix Healthcare Group 2 na na nm nm 15% -37% 34%

Note: Highlighted stocks are under our coverage. For percentiles, 1 = high Quality, 100 = low Quality. For quintiles, 1 = high Quality, 5 = low Quality.

Source: Bloomberg L.P., MSCI, FactSet, and Bernstein analysis.

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BERNSTEIN

EXHIBIT 66: Price performance and quant screening scores for the top consumer staples (including beverages)
Share Price Performance
Quality Quintile Quality Quintile
Market Cap
Company (Bernstein Quality (Factor-based
($Bil) 2012 2013 2014 2015 YTD
Model) approach)

Japan Tobacco Inc 71 1 1 35% 40% -3% 34% -17%


Kweichow Moutai Co Ltd 58 1 na 8% -39% 62% 27% 42%
ITC Ltd 43 1 1 42% 12% 15% -11% 12%
Seven & i Holdings Co Ltd 35 2 4 14% 72% 4% 27% -22%
Hanjaya Mandala Sampoerna Tbk PT 33 2 2 54% 4% 10% 38% 1%
Hindustan Unilever Ltd 26 1 2 29% 9% 33% 14% -7%
Kao Corp 24 1 1 7% 47% 44% 31% -19%
Unilever Indonesia Tbk PT 23 1 2 11% 25% 24% 15% 8%
Wuliangye Yibin Co Ltd 19 1 na -14% -45% 37% 27% 26%
Amorepacific Corp 18 1 2 15% -18% 122% 87% -14%
Thai Beverage PCL 17 na na 61% 37% 28% 0% 36%
Asahi Group Holdings Ltd 16 3 4 9% 61% 26% 1% -5%
YILI 16 2 na 8% 78% 10% 15% 9%
CP ALL PCL 16 2 1 78% -9% 1% -8% 55%
Kirin Holdings Co Ltd 16 5 4 8% 50% -1% 10% 10%
Jiangsu Yanghe Brewery 15 1 na -13% -56% 94% 21% -1%
Wilmar International Ltd 15 4 5 -33% 2% -5% -9% 13%
MEIJI Holdings Co Ltd 13 3 2 17% 81% 63% 83% -12%
KT&G Corp 12 2 2 -1% -8% 2% 37% 1%
Aeon Co Ltd 12 5 5 -7% 44% -15% 54% -21%
LG Household & Health Care Ltd 11 2 1 35% -17% 14% 69% -20%
Ajinomoto Co Inc 11 1 2 24% 33% 47% 28% -29%
SHUANGHUI 11 2 na -17% 63% -33% -3% 9%
Shiseido Co Ltd 10 3 4 -14% 39% 0% 49% 13%
AMOREPACIFIC Group 10 2 3 83% -1% 115% 48% 1%
Uni-President Enterprises Corp 10 2 2 29% 7% -1% 14% 0%
Hengan International Group Co Ltd 9 1 1 -4% 31% -12% -10% -16%
Gudang Garam Tbk PT 9 1 1 -9% -25% 45% -9% 12%
President Chain Store Corp 8 1 1 -6% 33% 18% -16% 14%
FamilyMart UNY Holdings Co Ltd 8 3 2 14% 35% -5% 24% 21%
Indofood CBP Sukses Makmur Tbk PT 8 1 1 50% 31% 28% 3% 26%
Luzhou Laojiao Co Ltd 7 1 na -5% -43% 1% 33% 25%
China Resources Beer Holding 7 3 2 5% -8% -37% 2% 7%
Tsingtao Brewery Co Ltd 6 4 na 6% 43% -20% -33% -13%
Tsingtao Brewery Co Ltd 6 3 na -1% 48% -15% -21% -6%
United Spirits Ltd 4 3 na 286% 37% 7% 7% -34%
United Breweries Ltd 3 1 na 142% -17% 8% 13% -8%
Beijing Yanjing Brewery Co Ltd 3 4 na -16% 44% -1% 3% -8%
Emperador Inc 2 na na 83% 42% -3% -14% -20%
Sapporo Holdings Ltd 2 4 na -4% 58% 16% 4% 8%
Guangzhou Zhujiang Brewery Co Ltd 1 na na -7% 9% 35% 19% -13%

Note: Highlighted stocks are under our coverage. For percentiles, 1 = high Quality, 100 = low Quality. For quintiles, 1 = high Quality, 5 = low Quality.

Source: Bloomberg L.P., MSCI, FactSet, and Bernstein analysis.

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WHAT IS DIFFERENT ABOUT QUALITY IN ASIA?

If we take the earlier discussion as evidence that the nature of what Quality means in
emerging Asia is a little different from that in developed markets, the next question to ask
is how and why? What are the core set of differences that should color how we think
about what Quality means in Asia? We see at least five differences to point out:

Less mature industries and companies in Asia: Many companies (and industries) are
in growth phases of their development, which comes with trade-offs against what
would be defined as high Quality in mature companies elsewhere. This often means
trade-offs between ROIC and growth (either in scale or margins). For fast-growing
companies in Asia, sometimes management teams choose growth over margins.
Thus, we may see a period of contracted margins, when compared to peers in
developed markets. A simple generalization that overlooks this temporal trade-off
may lead to overlooking high-Quality companies.

Shorter histories of historical data in many companies: In some sectors and countries
in Asia (healthcare included), many of the largest companies are all less than five
years old. Global quant approaches often look for five years of historical data, which
knocks out many Asian companies (particularly in new economy sectors).

Quality management looks different from that in developed markets. Founders are
often still running the company, family members are often still involved and
professional management teams are less common than in developed markets. This
can mean that narrower diversity and depth of experience are the norm. Moreover,
the prioritization of management capabilities varies depending on the stage of
industry development.

Competitive differentiation can be more fleeting than in developed markets, given


the pace at which business models, products, and ideas are copied and improved
upon (particularly in China).

Strong balance sheets look different in Asia; in some sectors, many companies sit on
mountains of cash and carry little to no debt.

With this in mind, we took a blank sheet approach to create a new seven-dimension
checklist for what Quality looks like in Asia see Exhibit 67. We look for focused strategy,
quality of products/services, attractive addressable markets, earnings and financial
returns, capital structure and financial statements, management, and investors. The
relative importance of these seven dimensions varies considerably across sectors. We
define a few parameters to look for within each of the seven dimensions. Some of these
parameters can be assessed by quantitative analysis of proxy metrics (e.g., expanding
margins, balance sheet strength, and institutional ownership), while others cannot and
require fundamental analysis (e.g., size and growth of addressable market, strength of
brand, and clarity of growth strategy). A good way to approach the search for Quality is
broad quant-based screening of thousands of companies to narrow the field to dozens,
followed by judicious use of targeted fundamental analysis into very specific questions to

THE SEARCH FOR QUALITY CONTINUES 67


BERNSTEIN

avoid "boiling the ocean" and make maximal use of limited resources. This is an approach
that many investors take already; we hope to add incrementally to the discussion of what
minimal set of fundamental analysis is necessary on top of quant screening to arrive at the
most investable answers. We have deliberately excluded valuation from this discussion of
Quality.

EXHIBIT 67: What does Quality look like in Asiaand how to evaluate it? Our seven-dimension Quality framework
Quality of Parameters to assess Quant proxy we used Fundamental
analysis needed
Strategy Expanding margins (targeted mix shift) Increasing net income margin (2014-18E)

Clarity and focus of growth strategy



Optimized mix of products or service offerings

Strength of distribution reach

Exposure to and mitigation against key risks

Products or services Investment in future products 3 yr average R&D spend to net sales (201215)

Clear differentiation versus competitors

Affordability of products

Strength of brand and reputation

% of revenue from outside home market

Addressable market Consistent sales growth Net sales growth CAGR (2014-18E)

Size and growth of addressable market (s)



Market structure

Earnings and Earnings derived primarily from core business 3 yr average % of income from asc income (2012-15)
financial returns
ROIC > WACC 3 yr historical average ROIC / WACC (2012-15)

Strong FCF yield 3 yr historical average free cash flow yield (2012-15)

Capital structure and Balance sheet strength 3 yr average net debt to assets (2012-15)
financial statements
Optimized capital allocation

Clean and consistent revenue booking approach

Fair value of goodwill and intangible assets

Management Depth of relevant experience

Diversity

Higher founder ownership (if applicable)

Free from historical corporate governance scandals

Reasonable level of exposure to related transactions

Investors Savvier shareholders % institutional ownership

Foreign ownership

Source: Bernstein analysis.

68 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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PHARMACEUTICALS WHAT'S IN QUALITY ASIAN DRUGS?

INDUSTRY CONTEXT The pharmaceutical industry is highly heterogeneous across different markets in Asia.
Exhibit 68 and Exhibit 69 summarize how different macro drivers promote growth and
top-down cost containment measures impede growth in each market (or not). We think
the different regional markets can be bucketed into the three groups discussed here,
each with very different dynamics and outlook:

High-growth markets (e.g., China, Indonesia, India, and Vietnam). These markets tend
to have stronger macroeconomic growth, faster growing total health expenditure,
faster expansion of the middle class, and high out-of-pocket health expenditure (35-
60% of total health expenditure). These markets all have mandatory price cuts,
strong promotion of generics usage, and (so far) lack international reference pricing
or health economics ("cost-effectiveness") mindset in reimbursement-decision
making. All four will see major health reforms and health policy disruptions on the
near- to medium-term horizon. Our initial coverage focuses on China and Indonesia.

Large, mature, steady growth markets (e.g., Japan, Australia, and Korea). These
markets are characterized by stable, low single-digit pharmaceutical market growth,
weaker macroeconomic growth, lower out-of-pocket proportion of total health
expenditure (15-35%), and industry maturity. Government cost-containment
measures are more sophisticated, tending to include formal health technology
assessment (HTA) and pharmaco-economics in reimbursement decisions, mandatory
price cuts, and prescribing controls. Korea has an emerging biotech industry with
many investment opportunities.

Lower growth, stable, smaller markets (e.g., Taiwan, Thailand, Philippines, Malaysia,
Bangladesh, Hong Kong, and Singapore). These markets behave in between the two
categories discussed earlier. They tend to be less well developed because modest
pharmaceutical sales growth (4-11%) and small total market sizes (US$1-US$5
billion) make them less attractive for multinational pharma companies to invest in.
Healthcare systems in these markets vary in their maturity (Singapore, Taiwan, Hong
Kong, and Thailand are relatively mature while Philippines, Malaysia, and Bangladesh
are still changing and will see major reforms). Government cost-containment
measures tend to be simpler in nature (price cuts, patient contributions, and
promotion of generics).

The universe of pharma companies across Asia ex-Japan varies widely by size the
top 30 range from US$4 billion to US$30+ billion in market size (see Exhibit 73).

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EXHIBIT 68: Macro drivers for healthcare growth vary considerably by country our initial coverage focuses on high-growth
markets

* Represented as % of total health expenditure 2009-2014 (for reference the United States is 11% and France 7%).

Source: IMS Health, World Bank Health Expenditure database, WHO, Population Reference Bureau, World Population Data Sheet, and Bernstein analysis.

EXHIBIT 69: Government cost-containment measures (that can impede pharmaceutical growth) also vary across the region

Source: IMS Health, Ministries of Health, and Bernstein analysis.

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EXHIBIT 70: Asia-Pacific pharmaceutical companies by market cap


40
Market Cap (USD B)
35
Market cap (USD B)

30
25
20
15
10
5
0

Note: Our coverage companies are Jiangsu Hengrui, Kalbe Farma, CSPC, Sino Biopharm, and Sihuan Pharma.

Source: Bloomberg L.P. and Bernstein analysis.

DRIVERS OF QUALITY IN ASIAN Next, we discuss three of the seven key drivers of Quality described in Exhibit 67, that we
PHARMACEUTICAL COMPANIES think are among the most important, and what they mean in the context of Asian
pharmaceutical companies:

Quality of products/services: Investment in R&D pipeline, differentiation, portfolio;

Quality of earnings and financial returns (high and expanding margins), and

Quality of management.

The exercise is by no means exhaustive, but rather meant to provide a tour through
several sectors instead of a deep dive into one only we would be delighted to discuss
the other dimensions of Quality in pharma companies if you are interested.

Quality of products/services: Investment in R&D pipeline, differentiation, portfolio


The simplest, first-order, commonsense questions that come to mind in any discussion
about Quality of drug companies are the most important ones to focus on Is this
company selling drugs that actually work? Is it developing new medicines that really cure
diseases? Considering the Quality of a drug company's products has two layers in-line
portfolio of drugs already sold in the market and pipeline of future drugs in development.
Both are simple to evaluate in theory, but very difficult in practice.

In evaluating emerging market pharma companies' in-line portfolios of drugs already


being sold, we encourage investors to ask the question: "Are these drugs widely accepted
as clinically useful or essential, inside and outside the home market?" We think that one
proxy way to screen for a rough answer to this question is to assess the percentage that

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generics companies' portfolios overlap with the WHO Essential Drug List2 and observe a
wide spread across the big listed Chinese generic drug companies (see Exhibit 71).

EXHIBIT 71: Quality of in-line portfolio of drugs: Percentage of overlap by revenue with the 2015 WHO Essential Medicine's list
for major Chinese pharmaceutical companies

90% 83%
% of revenue from drugs in the
WHO Essential Medicines list

80%
70%
60%
50%
40% 36%

30%
21%
20% 14%
7%
10%
0%
0%
HEC Pharma Hengrui Sino Biopharm CSPC Sihuan 3SBio

Note: Our coverage companies are Jiangsu Hengrui, Sino Biopharm, CSPC, and Sihuan.

Source: WHO Essential Medicines List 2015 (most recent), IMS, and Bernstein estimates and analysis.

On the R&D side, there is no simple quantitative metric that can generalize the potential of
a pipeline or single product in development. R&D by itself bears failure risk and the
success rate of early-stage pipelines can be very low. When examining the value of the
pipeline assets, one should start by modeling the potential revenue of a given asset by
looking at addressable market, competitive landscape, novelty or differentiation of
mechanism of action, reason to believe clinical trial attrition is better (or worse) than
average, most likely pricing scenario, and affordability of out-of-pocket and/or clear path
to reimbursement. There is no simple numerical metric as a "rule-of-thumb" for the quality
of R&D assessment is a more nuanced process that involves interviewing doctors and
digesting all relevant academic literature. One measure is by outputs, which could be the
number of innovative regulatory filings investigational new drugs (INDs) or new drug
applications designated the highest innovative category. In China, the historical definition
of Category 1.1 (submission categories redefined a few months ago) meant most
innovative, first-in-the-world in China, not yet used anywhere else in the world (though
was used in a looser way in practice). Exhibit 72 and Exhibit 73 rank order Chinese
pharmacos by cumulative number of category 1.1 Investigational New Drug (IND) and
New Drug Application (NDA) submissions since 2007.

2
See http://www.who.int/medicines/publications/essentialmedicines/EML2015_8-May-15.pdf (2015 is the most recent
list available).

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EXHIBIT 72: Quality of pipeline: Number of Category 1.1 (most EXHIBIT 73: Quality of pipeline: Number of Category 1.1 NDAs
innovative) IND applications submitted in China submitted in China (2007-16 YTD)
(2007-16 YTD)

JiangsuHengrui 79 JiangsuHengrui 11

JiangsuHansoh 60 OtsukaPharma 5

Inst.MateriaMedica 41 ZhejiangXianju 4

ChiMed 27 JiangsuHansoh 4

Novartis 24 JiangsuNhwaSaide 4

Pfizer 23 HebeiMedicalUni 3

AstraZeneca 22 HarbinPharma 3

ZhejiangHisunPharma 21 AllistPharma 3

GDDongyangguang 20 SZChipscreen 2

SihuanPharma 19 ZhejiangBetta 2

QiluPharma 19 ZhejiangMed 2

SinoBiopharm 17 Simcere 2

SimcerePharma 13 AnhuiHuanqiu 2

Quintiles 13 HealthstarMedical 2

TIPRPharmaResponsible 13 TianjinChaseSun 2

HefeiSiuFung 11 FudanZhangjiang 2

Sanofi 10 HZZhongmeiHuadong 2

ShenzhenChipscreen 10 Novartis 2

CSPC 9 YangtzeRiver 2

LuyePharma 7 Kangzhe 2

Note: Red bars indicate Bernstein Asia-Pacific healthcare coverage companies. Note: Red bars indicate Bernstein Asia-Pacific healthcare coverage companies.
See the online version for colors. See the online version for colors.

Source: GBI, CFDA, and Bernstein analysis. Source: GBI, CFDA, and Bernstein analysis.

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EXHIBIT 74: Parameters to be considered in valuing innovative pharmaceutical pipeline assets

Source: Bernstein analysis.

Quality of earnings and financial returns (high and expanding margins)

While pharmaceutical margins can vary widely (from 5% to -95%), in general, it is a very
high-margin sector. Active pharmaceutical ingredient (API) and unbranded generic drugs
are the most commoditized products and command the lowest margins (typically single-
digit net margins). The newest and most innovative drugs sold in the United States (where
pricing is typically highest) earn the margins. Exhibit 75 summarizes the range of gross
margins for Asian pharma companies Jiangsu Hengrui is the highest at 87%. Continued
downward drug pricing pressure is a reality in all developed and emerging markets
(particularly for generics), even with Donald Trump elected as U.S. President.
Pharmaceutical companies in Asia often improve overall margins via mix shift adding
higher-margin new products to the portfolio. For example, CSPC had a gross margin of
47% in 2015 and is seeking to add 300 bps of gross margin (or 150 bps of net margin)
per year for each of the next three years via faster growth in sales of its oncology products
and launch of three new cancer drugs generic Iressa (gefitinib), generic Velcade
(bortezomib), and generic Abraxane (albumin bound paclitaxel). While absolute margins
can vary widely by type and category of drug, we look for steady margin expansion in
Quality Asian pharmaceutical businesses.

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EXHIBIT 75: Gross margins for Asia-Pacific pharmaceutical companies


100%
87%
90% 79% 76%
80% 70%
Gross margin (%)

69% 67% 66%


70% 63% 60% 59% 57%
60% 55% 52% 49% 48% 47%
50%
36% 35%
40% 29%
30%
20%
10%
0%

Note: Our coverage companies are Jiangsu Hengrui, Sino Biopharm, Sihuan Pharma, CSPC, and Kalbe Farma.

Source: Bloomberg L.P. and Bernstein analysis.

Among Asia's larger pharmaceutical companies, most generate ROIC well in excess of
their cost of capital as a result of the higher-margin nature of the industry. The best
Quality companies in Asia have both high margins and ROIC at least 2-3x their WACC
Jiangsu Hengrui, in particular. Exceptions to this include companies like Celltrion Inc
(068270.KS, not covered) and Hanmi Pharma (128940.KS, not covered) that have been
making large investments in R&D in recent years that bring ROIC down near or below
WACC (see Exhibit 76).

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EXHIBIT 76: Pharma companies that are shifting their product mix toward branded generics and innovative drugs can enjoy
both high margin and high ROIC

Pharma 3Y avg ROIC/WACC vs. Gross Margin


90%

Hengrui
80%
SinoBiopharm
Sun
Hanmi
70% Lupin
Sihuan
Cadila
Gross Margin (%)

Celltrion
60% Cipla Attractiveproduct
DrReddy's mixandvaluechain
Aurobindo
50%
Majorinvestments CSPC
Kalbe
in recentyears
40%

Tasly
Baiyunshan Massmarket genericsplayers
30%
sellinglowermarginprodcuts

20%
0.5 1.0 1.5 2.0 2.5 3.0
3Y avg ROIC/WACC

Source: Bloomberg L.P., corporate reports and presentations, and Bernstein estimates and analysis.

Can a Quality company run at slim or negative margins? We think the answer is yes, when
Quality comes from the depths of a world-class pipeline and a clear and deliberate trade-
off is made, investment in future growth traded off against current margins. These are
companies at the other end of the spectrum smaller, newer biotech companies
investing heavily in new R&D with few or no products yet launched post negative margins.
BeiGene (BGNE.NYSE, not covered) is a clinical-stage biotechnology company, based in
Beijing, targeting oncology. It is developing four clinical-stage innovative drugs a BTK
inhibitor for blood cancer, a PARP inhibitor for ovarian tumor, a RAF inhibitor for NSCLC,
and a PD-1 inhibitor for solid tumors and combinations. BeiGene will remain in clinical
stage for two more years with negative margin cash burned for R&D. We have
confidence in the quality of the pipeline, talent and potential of the company, though it will
keep losing money for a while. Genexine (096700.KS, not covered) is another example of
a Quality company spending a lot, temporarily, on R&D (see Exhibit 77 and Exhibit 78).

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EXHIBIT 77: Operating margins of BeiGene EXHIBIT 78: Operating margins of Genexine

0% 20%

-100% 0%

-20%
-200%
-40%
-300%
-60%
-400%
-80%
-500%
-100%

-600% -120%

-700% -140%
2013 2014 2015 2013 2014 2015

Source: Capita lIQ and Bernstein analysis. Source: Capital IQ and Bernstein analysis.

Quality of management
In Asian pharmaceutical businesses attempting to pivot from a historical focus on
generics to building innovative R&D capabilities, we think the single most-important
determinant of Quality is people. The potential ability of Asian biopharma companies to
innovate globally-relevant new medicines has been debated for several years now. While
we are seeing some evidence of progress, we cannot yet point to a single global
blockbuster drug that originated in Asia (outside of Japan). Pessimists continue to argue
that real innovation in drug discovery and development comes from an elusive, perfect
mix of factors that cannot be copied: Art (nuanced "drug hunter" judgment and
interpretation that can only come from decades of experience), serendipity (ability to
capitalize opportunistically on unexpected connections), science (vast armies of
technically proficient scientists and cutting-edge lab equipment), culture (a corporate
culture and incentive system that reward risk-taking, dissenting voices, space for
entrepreneurial connectivity between scientists), process (intelligently designed stage-
gates and cross-functional project team structure, celebration of fast failures, relatively
flat committee structures that disaggregate advisory and decision-making functions), and
Genexine (vibrant and interconnected scientific community of academics, startups, and
emerging companies).

We disagree. The only part of this equation that cannot be copied and learned is the
artbut it can be bought or hired. The most ambitious Asian pharma companies, large
and small, are stacking their senior and mid-level R&D ranks with staff with overseas
experience (known as "sea turtles" (haiku) in China). They understand both the leading-
edge best thinking and the intractable problems entrenched in how big pharma and
biotech discovers and develops new medicines. Historically, China's PhD "brain drain" was
more permanent than that of other countries the U.S. National Science Foundation
reported that 92% of Chinese PhD graduates were still living in the United States five
years after graduation (versus 81% for Indians and 41% for South Koreans). It isn't
possible to track the total number of pharmaceutical "sea turtles" in China, but recent

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BERNSTEIN

anecdotal evidence in several well-known examples are changing. Discussions with our
coverage companies suggest the trend may be reversing. For example, Dr. Xiaodong
Wang returned to China five years ago after a 25-year prestigious academic career in the
United States to run the National Institute of Biological Science (NIBS, a new institute of
the Chinese Academy of Science modeled loosely after the Howard Hughes Medical
Institute) and to co-found one of China's most innovative and exciting oncology biotech
companies, BeiGene. The company has attracted a star-studded cast of scientists with
impressive overseas resumes, including Dr. Howard Liang (now CFO and Head of
Strategy, formerly lead U.S. biotech analyst at Leerink and scientist at Abbott), Dr. Amy
Peterson (now Chief Medical Officer for Immuno-Oncology, formerly VP of Clinical
Development at Medivation, Medical Director at Genentech), and Dr. Jane Huang (now
Chief Medical Officer for Hematology, formerly VP and Head of Clinical Development at
Acerta Pharma, Medical Director at Genentech).

Take the example of Jiangsu Hengrui. Global Head of R&D, R&D COO, and Head of
Biology all have experience in top MNCs and have rich experience and in-depth
knowledge of how to conduct innovative R&D (see Exhibit 79). Over the years, Hengrui
has differentiated from peers by the ability to successfully execute R&D plans.

Within our coverage, Jiangsu Hengrui stands out as a great example. While Chairman Sun
hasn't worked in an MNC, he has been running Hengrui since 1990 (when he was 32
years old and it was a small factor) and has hired a deep bench of talent with overseas
experience to help him drive the business. For example, Dr. Lianshan Zhang returned to
China in 2012 to serve as Global Head of R&D and General Manager of Hengrui after a
career at Lilly and Marcadia Biotech in the United States. Similarly, Dr. Weikang Tao was
hired last year to serve as site head of Hengrui's Shanghai innovative R&D site after
spending more than a decade rising through Merck as a biochemist in the United States.
Together they have hired many returnees in R&D, all the way down to the project manager
level. The opportunity is to combine the best of the West with the speed and scale
arbitrage that China offers.

78 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 79: Jiangsu Hengrui has hired many R&D staff with MNC experience and technical degrees, including top brass

Source: Hengrui presentations and website, and Bernstein estimates and analysis.

QUALITY COMPANIES TO Next, we highlight a handful of pharma companies that we believe are higher Quality
HIGHLIGHT WITHIN AND based on a combination of quant screening outputs and qualitative fundamental analysis
BEYOND OUR COVERAGE
above it (see Exhibit 67):

Companies mentioned earlier in discussion on false negatives ARE:

Jiangsu Hengrui

CSPC Pharmaceutical

Kalbe Farma

Additional companies (not under our coverage) to highlight (not exhaustive):

Hanmi Pharmaceutical (128940 KS, not covered): Hanmi is included in the MSCI
World, so did appear in the top quality quintile in Bernstein's global quant Quality
model but was knocked out of Bernstein's factor-based Quality screening tool (which
screens only the top 300 stocks in the MSCI ACWI Asia ex-Japan). Recent scandal
not withstanding (accusations of insider trading made after Hanmi delayed
disclosure of the termination of a collaboration it had on a third-generation EGFR
lung cancer drug for 12 hours in October), Hanmi is one of the larger and higher
Quality pharmaceutical companies in Korea. It has invested for almost a decade
(much like Jiangsu Hengrui) in building robust innovative R&D capabilities and signed
five high-profile development and commercialization partnership deals with foreign
companies in one year.

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Pharma Engine (4162.TT, not covered) is a Taiwanese biotech company that has
been gathering steam since 2003 but gets knocked out of many Quality screens for
its size (US$805 million market cap) and shallower history of marketed products. It
was funded by TTY Biopharm and Taiwanese venture investors and IPO-ed in 2012
with only 12 employees. Its founder, Dr. Grace Yeh, has a long previous career in
academic science and at Millennium Pharmaceuticals in the United States. The
company adopts a lean "no research, development only" business model. It focuses
on the development of new drugs for the treatment of cancer and Asia-prevalent
diseases with only a few products. Its lead product Onivyde (liposome-formulated
irinotecan) is approved by USFDA for pancreatic cancer and is in development for
five other cancers. In addition to this, it is co-developing a radio sensitizing agent
PEP503 (crystalline hafnium oxide) globally with NanoBiotix as a class III medical
device.

Yichang HEC ChangJiang Pharma (1558.HK, not covered) is the dominant


manufacturer of oseltamivir, the front-line drug against influenza. HEC has a solid
product line, including yimitasvir phosphate for hepatitis C and an insulin product.
The company has demonstrated the ability to execute clinical trials and to launch
products in different regions. The recent joint venture with TaiGen provides further
evidence of the R&D quality of the company.

Luye Pharma Group (2186.HK, not covered) is a Chinese pharmaceutical formulation


company with overseas aspirations. Luye's primary technology platform is liposome-
and microsphere-formulated drugs; this type of formulation acts to extend
pharmacokinetics and reduce side effects. Luye has oncology, cardiovascular,
metabolism, and central nerve system products on the market in China and
psychiatry (microsphere-formulated second-generation antipsychotic risperidone) in
development in the United States. Luye has developed the liposome platforms over
the year and maintains a 50% market share of paclitaxel in China. It recently began
adding to its stable of formulation technology platforms with the acquisition of
Acino's patch business in July 2016 for US$274 million. We think that, historically,
Luye has been given too much credit by the market for being innovative, but that it is
a company narrowly focused on and good at formulation.

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HEALTHCARE SERVICES WHAT DO QUALITY HOSPITAL


OPERATORS LOOK LIKE IN ASIA?

INDUSTRY CONTEXT In most Asian countries, private hospitals currently represent a minority of total hospitals
(see Exhibit 83). However, measuring public-private mix by hospital count misrepresents
(overstates) the current contribution of private hospitals to the broader healthcare system
because public hospitals can be far larger than private. First Affiliated University Hospital
of Zhengzhou in Henan, the largest hospital in the world, has a staggering 7,000 beds and
10,000 in its plans (dwarfing the largest hospital in the United States, New York
Presbyterian Weill Cornell Medical Centre, which has 2,391 beds). In China, private
hospitals are 21% of total hospitals, but only 8% of total hospital beds. Earlier this year,
the Chinese government set a target to ensure that 20% of hospital beds in China be
private by 2020E.

Governments are increasingly looking to the private sector to meet overwhelming


demand and alleviate overburdened public hospitals. Exhibit 82 and Exhibit 83 present
our forecast for the growth of hospital beds by country and the mix of public and private
hospitals (by number of hospitals). In Indonesia, the introduction of a new Universal Health
Coverage scheme (JKN) has created a tidal wave of increased demand on Indonesia's
hospitals, and the government is looking to solve the problem by boosting the number of
private hospitals. Similarly in Malaysia, private hospital development projects are given
special fast-track status in being listed in the NKEA as Entry Point Projects (EPPs) to
receive government assistance. In Thailand, the private hospital industry is more mature,
and the leading players [such as Bangkok Dusit Medical Services] are investing in growing
their networks.

Exhibit 80 shows the various healthcare services companies by market capitalization.


Most of the Asian countries have lower number of doctors per 10,000 population as
compared to other countries (see Exhibit 81 and Exhibit 82). As per Exhibit 21, a higher
proportion of adult mortality is attributed to communicable diseases (i.e., preventable with
stronger healthcare services infrastructure) in Asia. Exhibit 85 to Exhibit 87 present the
breakdown of healthcare expenditure if it's public or private or via health insurance
plan.

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EXHIBIT 80: Asia-Pacific healthcare services companies by market cap

14
12
Market cap (USD B)

10
8
6
4
2
0

Note: Our coverage companies are IHH, Bangkok Dusit, Bumrungrad, and CR Phoenix.

Source: Bloomberg L.P. and Bernstein analysis.

EXHIBIT 81: Number of doctors per 10,000 population


35 33
28 High-income countries average
per 10,000 (2006-13)

30
Number of doctors

25
25 23
21
19
20
15
15 11 12 12
10 7
4
5 2
0
US UK China Japan Australia South India Indonesia Thailand Philippines Singapore Malaysia Vietnam
Korea*

Note: Our coverage countries are China, Indonesia, Thailand, Singapore, and Malaysia.

Source: WHO World Health Statistics and Bernstein analysis.

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EXHIBIT 82: Asia lags the United States and WHO EXHIBIT 83: A minority of hospitals are private in most Asian
recommended minimum hospital bed count per 10,000 countries
people

60 56
High income country average 100%
21% 24%
# of hospital beds per

50 31% 36% 30%


10,000 population

42 80% 44% 40%


38 60% 59%
40 35
29 60%
30 23
21 19 20 20 40%
17 17 79% 76%
20
13
69% 64% 70% 60%
56%
9 7 20% 40% 41%
10 5

0 0%

2006-2012 % public % private


2020E
High income country average

Note: Mix calculated by number of hospitals, not number of beds (if calculated
by number of beds, the percentage of private hospitals becomes smaller
because some public hospitals are far larger than private ones).

Source: NP Institute, GBI, China Statistical Yearbook, Ministry of Health of India, Source: NP Institute, GBI, China Statistical Yearbook, Australian Institute of
Ministry of Health and Family Welfare and Ministry of Health of Indonesia, Health and Welfare, Ministry of Health of India, Ministry of Health and Family
Ministry of Health of Malaysia, Frost & Sullivan, Ministry of Health of Singapore, Welfare and Ministry of Health of Indonesia, Ministry of Labor and Welfare of
World Bank, expert interviews, and Bernstein estimates and analysis. Japan, Ministry of Health of Malaysia, Frost & Sullivan, Ministry of Health of
Singapore, and Bernstein estimates and analysis.

EXHIBIT 84: In Asia, a higher proportion of adult mortality is attributed to communicable diseases (i.e., preventable with
stronger healthcare services infrastructure)
% of age standardized adult
mortality per 100,000 popl'n

100%

80%
65% 70% 72%
60% 77% 78% 76% 76% 76% 74%
85% 88% 86% 88%

40%

20% 24% 19%


11% 9% 18% 23% 19% 16% 16%
6% 7% 6% 4%
9% 7% 13% 8% 14% 11% 11% 8% 10%
0% 5% 5% 5% 5%
US UK China Japan Australia South India Indonesia Thailand Philippines Singapore Malaysia Vietnam
Korea

Injuries Communicable diseases Non-communicable diseases

Note: Red indicates communicable diseases (preventable with stronger healthcare infrastructure). See the online version for colors.

Source: WHO World Health Statistics and Bernstein analysis.

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EXHIBIT 85: Breakdown of total EXHIBIT 86: Percent of private EXHIBIT 87: Percent of private healthcare
healthcare expenditure: Public versus healthcare expenditure that is out-of- expenditure that is via a pre-paid health
private pocket insurance plan
Vietnam 55% Vietnam 83%
Vietnam
Malaysia 45% Malaysia 79%
Malaysia 8%
Singapore 67% Singapore 94%
Singapore 2%
Philippines 63% Philippines 84%
Philippines 7%
Thailand 22% Thailand 56%
Thailand 7%
Indonesia 62% Indonesia 76% Indonesia 2%
India 70% India 86% India 3%
South Korea 45% South Korea 79% South Korea 3%
China 44% China 79% China 3%

High income avg 39% High income avg 38% High income avg 19%
Australia 32% Australia 60% Australia 8%
Japan 18% Japan 81% Japan 2%
UK 17% UK 57% UK 1%
US 52% US 22% US 33%

Public Private

Source: WHO World Health Statistics and Bernstein Source: WHO World Health Statistics and Bernstein Source: WHO World Health Statistics and Bernstein
analysis. analysis. analysis.

DRIVERS OF QUALITY IN ASIAN Investors often use per-bed financial metrics as proxies for fundamental operating Quality
HEALTHCARE SERVICES (e.g., EV/bed, revenue per bed, and EBITDA/bed), though there are many caveats to how
COMPANIES
they are calculated and not all hospitals disclose enough information (see Exhibit 88). We
think that, while useful, these metrics don't tell the whole story. Here, we discuss three of
the seven drivers of Quality described in Exhibit 67 and what they mean in the context of
Asian hospital operators:

Quality of products/services exposure to medical tourism as a proxy for Quality of


clinical service offered,

High and expanding margins, and

Quality of management.

As discussed previously, the exercise is by no means exhaustive, but rather meant to


provide a tour through several sectors instead of a deep dive into one only we would be
delighted to discuss the other dimensions of Quality in hospital companies if you are
interested.

84 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 88: Commonly used proxy Quality measures in Asia-Pacific healthcare services companies (hospital operators)
Scale - bed Revenue / bed EBITDA / bed EV / bed
CIQ Ticker Ticker Company name EBITDA margin
count in 2015 (USD/ bed) (USD/ bed) (USD/ bed)

OUR COVERAGE
KLSE:IHH IHH IHH Healthcare Berhad 8,898 0.248 0.064 1.654 26%
SET:BDMS BDMS Bangkok Dusit Medical Services 7669 0.241 0.053 1.469 22%
SET:BH BH Bumrungrad Hospital 580 0.887 0.264 6.373 30%
SEHK:1515 1515 Phoenix Healthcare Group Co. Ltd 5800 0.030 0.005 0.184 16%

CHINA
SEHK:1515 1515 Phoenix Healthcare Group Co. Ltd 5800 0.030 0.005 0.184 16%
SZSE:300015 300015 Aier Eye Hospital Group Co., Ltd. 6000 0.085 0.019 0.914 22%
SEHK:3886 3886 Town Health International Medical N/A clinics only 1%
NasdaqGS:KANG KANG iKang Healthcare Group N/A clinics only 19%
SEHK:383 383 China Medical & HealthCare Group 9%
SEHK:1509 1509 Harmonicare Medical Holdings 561 0.209 0.039 0.338 19%
SEHK:2120 2120 Wenzhou Kangning Hospital 2185 0.020 0.006 0.135 28%
SEHK:2138 2138 Union Medical Healthcare N/A clinics only 34%
SEHK:722 722 UMP Healthcare Holdings N/A clinics only 9%
SHSE:600763 600763 Topchoice Medical Investment N/A clinics only 27%

THAILAND
SET:BDMS BDMS Bangkok Dusit Medical Services 7669 0.241 0.053 1.469 22%
SET:BH BH Bumrungrad Hospital 580 0.887 0.264 6.373 30%
SET:RAM RAM Ramkhamhaeng Hospital 25%
SET:VIBHA VIBHA Vibhavadi Medical Center 2107 0.076 0.020 0.575 26%
SET:CHG CHG Chularat Hospital Public 392 0.259 0.065 2.213 26%
SET:BCH BCH Bangkok Chain Hospital 2178 0.081 0.021 0.489 26%

MALAYSIA & SINGAPORE


KLSE:IHH IHH IHH Healthcare 8,898 0.248 0.064 1.654 26%
KLSE:KPJ KPJ KPJ Healthcare 2912 0.244 0.028 0.479 12%
SGX:BSL BSL Raffles Medical Group 200 1.662 0.340 8.838 20%

INDONESIA
JKSE:SILO SILO Siloam International Hospitals 4900 0.072 0.008 0.219 12%
JKSE:MIKA MIKA Mitra Keluarga Karyasehat 1725 0.103 0.034 1.698 33%
JKSE:SAME SAME Sarana Meditama Metropolitan 269 0.161 0.048 1.111 30%

INDIA
NSEI:APOLLOHOSP APOLLOHOSP Apollo Hospitals Enterprise 9215 0.098 0.013 0.320 12%
BSE:532843 532843 Fortis Healthcare 4700 0.140 0.005 0.284 9%

AUSTRALIA and SOUTH AFRICA


ASX:RHC RHC Ramsay Health Care 25000 0.262 0.036 0.538 14%
ASX:SHL SHL Sonic Healthcare N/A clinics, labs and hospitals 16%
ASX:HSO HSO Healthscope 4800 0.359 0.064 0.825 18%
ASX:PRY PRY Primary Health Care N/A clinics, labs and hospitals 22%
ASX:LHC LHC LifeHealthcare Group 12686 0.006 0.001 0.007 16%

USA
NYSE:HCA HCA HCA Holdings 44000 0.915 0.180 1.389 20%
NYSE:UHS UHS Universal Health Services 27482 0.337 0.062 0.600 18%
NYSE:THC THC Tenet Healthcare 22525 0.855 0.099 0.854 12%
NYSE:CYH CYH Community Health Systems 30000 0.651 0.076 0.629 12%
NYSE:DVA DVA DaVita HealthCare Partners 18%
NasdaqGS:LPNT LPNT LifePoint Health 8243 0.671 0.077 0.669 11%
NYSE:MD MD MEDNAX 22%

Source: Capital IQ, Bloomberg L.P., and Bernstein analysis.

Quality of products/services exposure to medical tourism (can be a proxy for Quality of


clinical offering)
In our view, Quality of clinical care should be the most important Quality driver even at the
company level. However, it is difficult to measure outside-in and objectively. Unlike the
United States and other developed markets, few private hospital companies in Asia
disclose robust clinical outcomes data, except in limited circumstances when it is useful
for marketing purposes.

Joint Commission International (JCI) accreditation is one proxy measure of clinical quality
that both patients (particularly overseas patients) and investors consider. It is a U.S.-
originated Quality framework accreditation process that is difficult to attain. Exhibit 89
summarizes the number of JCI accreditations by hospital companies. This is an indicator
of likely medical tourism. Having some non-zero and stable or growing proportion of

THE SEARCH FOR QUALITY CONTINUES 85


BERNSTEIN

revenue driving from medical tourism is another proxy Quality indicator to look for (see
Exhibit 90 to Exhibit 92).

EXHIBIT 89: JCI accreditations in listed private hospital operators in Asia

14 13
12
12
10
8 7
6 4 4
4 3
2 2
2 1 1
0 0 0 0
0

Note: Our coverage companies are IHH, BDMS, CR Phoenix, and Bumrungrad.

Source: JCI website and Bernstein analysis.

EXHIBIT 90: The share of revenue from Exhibit 91: The share of revenue from Exhibit 92: The share of revenue from
domestic versus international patients: domestic versus international patients: domestic versus international patients:
Bumrungrad Hospital Bangkok Dusit Medical Services IHH Healthcare

9%

35% 30%

65% 70%
91%

Revenue from Medical Tourism Revenue from Medical Tourism Revenue from Medical Tourism
Domestic Revenue Domestic Revenue Domestic Revenue

Source: Corporate reports and Bernstein analysis. Source: Corporate reports and Bernstein analysis. Source: Corporate reports and Bernstein analysis.

What does medical tourism really mean in Asia? Medical tourism is an arbitrage of Quality
and/or cost of healthcare across borders. Large cost savings for similar or higher Quality
of care than is available at home are possible (see Exhibit 93 and Exhibit 94).

86 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 93: How big is the healthcare cost arbitrage in Asia? Medical procedure cost savings normalized to pricing in top
private hospitals in the United States
0%

average cost in USA


Cost savings versus
-20% -25%
-30%
-40% -40%
-40% -45%
-50%
-40% -60%
-45% -65%
-60%
-60%
-65% -65%
-80% -75%
-80%
-100% -90%
USA Singapore Mexico Costa Rica South Thailand Taiwan Malaysia India
Korea

Source: Patients Beyond Borders, World Edition (2015), private correspondence with Patients Beyond Borders, Malaysia Healthcare Travel Council (MHTC), OECD,
and Bernstein analysis.

EXHIBIT 94: How big is the healthcare cost arbitrage in Asia? Average medical procedure costs by country
Common medical procedures - comparative 2014 average costs (USD)
Procedure US Singapore Mexico Costa Rica South Korea Thailand Taiwan Malaysia India

Coronary artery bypass graft - CABG 88,000 54,500 37,800 31,500 29,000 23,000 21,000 20,800 14,400

Valve replacement with bypass 85,000 49,000 34,000 29,000 33,000 22,000 18,000 18,500 11,900

Hip replacement 33,000 21,400 11,500 14,500 15,500 16,500 10,500 12,500 8,000

Knee replacement 34,000 19,200 12,800 9,500 15,000 11,500 12,000 12,500 7,500

Spinal fusion 41,000 27,800 22,500 17,000 18,000 16,000 18,000 17,900 9,500

IVF cycle, excluding medication 15,000 9,450 7,800 NA 7,500 6,500 4,800 7,200 3,300

Gastric bypass 18,000 13,500 13,800 11,200 12,500 12,000 13,000 8,200 6,800

4-implant porcelain dental bridge 23,000 12,000 8,500 9,500 10,500 10,500 9,500 7,800 7,200

Implant-supported dentures (upper and lower) 10,500 6,400 4,200 4,400 5,800 3,900 4,600 3,800 3,500

Full facelift 12,500 8,750 5,250 4,500 5,900 5,300 5,600 5,500 3,500

Rhinoplasty 6,200 4,750 2,800 3,400 4,700 4,300 3,500 3,600 2,800

Note: Costs vary based on location, materials and equipment used, and individual requirements. Figures are averages and reflect more common incidence of cost. All
figures are in US$. Estimates include all treatment-related costs but exclude travel and accommodation.

Source: Patients Beyond Borders, World Edition (2015), private correspondence with Patients Beyond Borders, MHTC Malaysia Healthcare, OECD, and Bernstein
analysis.

Quality of earnings and financial returns (high and expanding margins)

Asian hospitals can operate at a higher margin than U.S. peers (see Exhibit 95). One
important factor is that Asian hospitals don't face the same pricing pressure as U.S. peers,
because the mix of who is paying the bills is very different in Asia. The majority of revenue
for most Asian hospitals comes from patients paying out of pocket, for e.g., BDMS (see
Exhibit 96). However, in the United States, the majority of revenue comes from large
organized payers government and private, for e.g., HCA (see Exhibit 97). Group payers
have better negotiation power and bring pricing pressure to suppliers; whereas in Asia,
hospitals don't face the pressure from collective negotiation and can maintain a higher
margin.

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EXHIBIT 95: EBITDA margin of Asia-Pacific healthcare services companies and U.S. peers
40%
34%
35% 31%
EBITDA margin (%)

30% 26% 26% 25%


25% 22% 22% 21%
20% 20% 20%
20% 18% 17% 17% 16% 18% 17%
14% 13%
15% 11% 11% 12% 11% 10%
10% 8%
4%
5% 1%
0%

Note: Our coverage companies are Mitra Keluarga, Bangkok Chain, Aier, and Healthscope.

Source: Bloomberg L.P. and Bernstein analysis.

Fast-expanding hospitals face a trade-off between the pace of expansion and margins. In
Asia, the best Quality hospital companies can find alternative ways to maintain relatively
high margins while expanding the network by managing individual new properties tightly.
For example, IHH Healthcare Berhad, Bangkok Dusit Medical Services, and Mitra Keluarga
can turn new hospitals to EBITDA positive faster than U.S. peers. Mitra Keluarga sets their
internal target for each now hospital to break even within three months (while a global
norm is several years or longer). Some companies, such as Aier Eye Hospitals
(300015.CH, not covered), choose to incubate the newer hospitals while they mature to
profitability off the balance sheet of the listco.

EXHIBIT 96: In ASEAN, a majority of hospital revenues is EXHIBIT 97: In the United States, this looks very different:
derived from out-of-pocket payers: BDMS (64%) is a typical Only 7% of HCA revenue is from out-of-pocket payment
example

BDMS revenue mix by payor (%) HCA revenue mix by payor (%)

4% 3%

7%
8% 9%

21%
54%
64% 30%

Self-pay Private insurance


Contract Others Managed care Medicare
Social security Medicaid Self-pay

Source: Company filings and Bernstein analysis. Source: Company filings and Bernstein analysis.

88 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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Hospital businesses are asset- and capital-intensive and face more difficult trade-offs
between growth and margins against ROIC. Many of the region's larger hospital
companies currently generate ROIC below their costs of capital. The best Quality
companies in Asia have both high margins and ROIC at least 2-3x their WACC including
Bangkok Dusit Medical Services , Bumrungrad, Mitra Keluarga, and Aier Eye Hospital.
Others including China Resources Phoenix Healthcare Group (F), Siloam International
Hospital (SILO.IJ, not covered) and KPJ Healthcare (KPJ.MK, not covered) have invested in
expanding so aggressively that both ROIC and margins suffer (see Exhibit 98). IHH can be
argued to be an in-between case the business is well-run, and turnaround of each new
hospital added to the network is efficient but it expands by building and buying flagship
locations in capital cities that are very expensive, which significantly hurts ROIC.

EXHIBIT 98: Expanding hospital companies in Asia are asset- and capital-intensive businesses and face tougher trade-offs
between margin and ROIC than do pharmaceutical companies

Hospitals: 3Y avg ROIC/WACC vs. EBITDA Margin


40%

35%
MitraKeluarga

30% Bumrungrad

TopChoice BangkokChain
EBITDA Margin (%)

25% IHH
BangkokDusit
Aier
20% Primary
Phoenix Healthscope
Sonic Differentiated offering,
15%
Ramsay wellmanagedexpansion
Apollo
KPJ
10% Siloam Sacrificemargintoo much
todriverapidexpansion?
5%
Fortis
TownHealth
0%
-0.2 0.3 0.8 1.3 1.8 2.3 2.8 3.3
3Y avg ROIC/WACC

Source: Bloomberg L.P., corporate reports and presentations, and Bernstein estimates and analysis.

Quality of management
The structural drivers of growth in demand for private healthcare services are compelling
and sustained growing middle classes, rising incomes, aging populations, and
disproportionately high burden of chronic diseases and, therefore, attract many
speculators to set up hospital businesses in Asia, particularly in China. We see
management teams of investors and managers from other industries or groups of doctors
without hospital management experience as a red flag. Running a hospital business well is
very difficult we think high-Quality hospital operators need a strong professional
management team with deep experience in hospital administration. We observe a wide

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BERNSTEIN

mix of management quality in Asian hospital companies; with ASEAN companies tending
to have stronger management than Chinese peers. Exhibit 99 highlights a few examples.

EXHIBIT 99: Management profiles for some Asia-Pacific Healthcare Services companies

Source: Company filings and Bernstein analysis.

QUALITY COMPANIES TO Next, we highlight a handful of hospital companies that we believe are higher Quality
HIGHLIGHT WITHIN AND based on a combination of quant screening outputs and qualitative fundamental analysis
BEYOND OUR COVERAGE
above it (see Exhibit 67). Our top two picks in the hospital sector do appear in global quant
Quality screening approaches Bangkok Dusit Medical Services and IHH Healthcare
Berhad.

Companies mentioned in our earlier discussion of false negatives:

Mitra Keluarga

Bumrungrad Hospital

Additional companies to highlight:

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Sarana Meditama (SAME.IJ, not covered) currently operates three hospitals in the
Jakarta area, totaling around 500 beds. Management has a steady plan to build or
acquire five additional hospitals by 2018. Management is fully devoted to the
operation and has been running the hospitals at high efficiency. It has a clear
preference for greenfield expansion over acquisition.

Aier Eye Hospital (300015.CH, not covered) is not in the MSCI Index and is, thus,
excluded from both Bernstein's global quant Quality model and Bernstein's factor-
based Quality model. We have a positive view on Aier. Management wisely chooses a
niche market of combination of scalability and sophistication. Aier first invests and
incubates ophthalmology clinics in an industry-focused fund off-balance sheet,
before acquiring them when they are matured with positive cash flow. There is still
room for Aier to dive down to rural and less developed areas. Management has
demonstrated the ability to expand into new territory and manage a large network.

Wenzhou Kangning Hospital (2120.HK, not covered) manages one psychiatric


hospital in Wenzhou, Zhejiang province. The company is effectively running one site
with a few clinics. Kangning ranks high in the quant model due to fast revenue
growth in past years, high institutional holdings, and concentration on its main
business.

BEVERAGES WHAT MAKES A QUALITY TIPPLE?

INDUSTRY CONTEXT Asia-Pacific is the largest region in the global spirits industry (US$125 billion, 47% of
total retail sales value, RSV) and the second-largest region in global beer (US$194 billion,
31% of RSV) (see Exhibit 100 and Exhibit 101). Chinese baijiu alone accounts for 28% of
global spirits RSV, larger than the overall Americas spirits industry. Over the last 10 years,
Asia-Pacific has been, by far, the largest contributor to global growth, accounting for 51%
of total alcohol RSV growth between 2005 and 2015 (see Exhibit 102). We expect Asia-
Pacific to remain the key driver of global alcohol value growth over the medium term,
driven by rising consumer incomes across the region.

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EXHIBIT 100: Asia-Pacific spirits account for 47% of the EXHIBIT 101: Asia-Pacific beer accounts for 31% of the global
global spirits retail value beer retail value

Global Beer Retail Sales Value


(2015)

4% 12% Total APAC:


31%

29% 17%

38%

China APAC ex China Americas


Europe & CIS African & ME

Source: IWSR and Bernstein analysis. Source: Canadean and Bernstein analysis.

EXHIBIT 102: Asia-Pacific accounted for 51% of global value growth between 2005 and 2015

Incremental Alcohol Sales Value by Region (2005-15, US$bn)

%of 51% 30% 15% 4% 2% (3%) 100%


total
13.2 7.3 -8.4
44.9

89.2

296.3

150.1

Asia Pacific Latin America North America Eastern Europe Africa & ME Western Europe World

Source: IWSR, Euromonitor, and Bernstein estimates and analysis.

In addition to China, India and Japan are meaningful spirits markets and Japan, South
Korea, Vietnam, and Australia are scale beer markets (see Exhibit 103 and Exhibit 104).

92 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 103: China swamps other Asia-Pacific markets in EXHIBIT 104: but in beer, the value split is more broad
terms of spirits value across the region

APAC Spirits Retail Sales Value APAC Beer Retail Sales Value
(2015) (2015)
2%
4% 2% 7%
5%
4%
2% 8%

7% 42%
9%

13%
14% 59%

2% 15%
3% 3%

China India Japan

China Baijiu China Other India Thailand South Korea Vietnam

Japan Thailand South Korea Philippines Australia New Zealand


Australia Other Other

Source: IWSR and Bernstein analysis. Source: Canadean and Bernstein analysis.

Global alcohol industry consolidation has had a relatively low impact on the Asia-Pacific
region to date. In Asia-Pacific, only 14% of spirits RSV and 27% of beer RSV are
generated by global companies compared to global averages of 28% in spirits and 45%
in beer (see Exhibit 105 and Exhibit 106). Eleven out of the top 15 largest spirits and beer
companies in the region are listed and there are 36 Asia-Pacific-listed alcohol companies
with market caps more than US$500 million (see Exhibit 107 and Exhibit 108).

EXHIBIT 105: Global distillers are underrepresented in Asia- EXHIBIT 106: and the same holds for global brewers
Pacific

Share of Global Beer Companies


(2015 Retail Sales)

Global
Average:
45%

79% 1.7x

54%
47% 45%
27%

Africa & ME Americas Western Eastern Asia Pacific


Europe Europe

Source: Company financials, and Bernstein estimates and analysis. Source: Company financials, and Bernstein estimates and analysis.

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EXHIBIT 107: Eleven out of the top 15 spirits companies in Asia-Pacific are listed

Top 15 APAC-Domiciled Spirits Companies (2014 Net Sales, US$m)

5,361
4,776

3,250 3,112
2,350
1,739
909 848 813 789 782
430 335 327 307

Note: Blue shading denotes unlisted companies (see the online version for colors).

Source: Bloomberg L.P., corporate reports, and Bernstein estimates and analysis.

EXHIBIT 108: The largest listed brewers in Asia-Pacific operate in China

Top Asia-Pacific-Domiciled Brewers (2014 Net Sales, US$m)


4,714
4,433
3,972

3,186

2,129
1,961
1,477
1,282 1,227 1,204
971 838 747 661 640
468 406 305

Note: Excludes companies majority-controlled by global brewers. Blue shading denotes unlisted companies (see the online version for colors)

Source: Bloomberg L.P., corporate reports, and Bernstein estimates and analysis.

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DRIVERS OF QUALITY FOR In this section, we discuss in more detail how the fundamental Quality factors listed in
BEVERAGE COMPANIES IN ASIA- Exhibit 67 can help us to identify Quality beverage companies in Asia-Pacific. We focus on
PACIFIC
the following fundamental Quality factors:

Quality of strategy, which is underpinned by:

Quality of products/services for beverage businesses focused on Premium


consumer price points, and

Attractiveness of the market structure for beverage businesses focused on


Mainstream consumer price points.

Growth of addressable market

Quality of strategy
In our view, Quality of beverage companies is focused on growing in attractive markets
where they have relevant competitive advantages that allow them to earn superior and
sustainable margins.

Spirits companies in Asia-Pacific command the highest margins globally, whereas beer
margins in the region are relatively lackluster (see Exhibit 109 and Exhibit 110). In 2015,
the baijiu market leader Moutai commanded 73% EBIT margin compared to the 7% EBIT
margin for China Resources Beer, the largest brewer in China. We prefer spirits
companies in the region for this reason.

EXHIBIT 109: Asia-Pacific spirits companies have some of the highest EBIT margins globally
80% 73%

70%

60%
50%
50%
40%38%38%
40%
29%
30%
20%
20%
12%
9%
10% 5%
1%
0%

-10%

Note: Asia-Pacific spirits listed companies are shaded green (see the online version for colors).

Source: Bloomberg L.P., corporate reports, and Bernstein estimates and analysis.

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BERNSTEIN

EXHIBIT 110: whereas, beer EBIT margins are relatively low in the international context
45%

40%
36%
35%
32% 32%
30%

25%
20%
20% 19%
15% 15%
15% 13%
10%
10% 7% 7% 7% 6% 6% 6%
4% 4%
5%

0%

Note: Asia-Pacific beer listed companies are shaded green (see the online version for colors).

Source: Bloomberg L.P., corporate reports, and Bernstein estimates and analysis.

This pattern of superior margins for Asia-Pacific spirits companies translates into a
substantially higher ROIC. The weighted average3 ROIC for listed spirits companies in the
region is 20% compared to 6% for listed beer companies. The key driver of this
differential ROIC between alcohol segments comes down to the consumer price points
that the companies are targeting. In China, for example, the key spirits players focus on
the Premium, Super Premium, and Ultra Premium baijiu segments, while the brewers
focus on Mainstream beer. On a like-for-like basis (per liter of pure alcohol), the consumer
price of Ultra Premium baijiu (Moutai and Wuliangye's focus) is 16x higher than that of
Mainstream beer (China Resources Beer and Tsingtao's focus). As a result, the value chain
for most spirits companies is more attractive than for most beer companies (see
Exhibit 111).

3
Weighted average based on net sales.

96 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 111: The value chain for high-end spirits is significantly richer than for more Mainstream products like beer; this
underpins superior margins

2015 Average Retail Value per Liter of Pure Alcohol (RMB)

3,260

2,419

1,918

917
667 671
549
254 257 343
117 136 171 200
30

FABs
Value Baijiu

Premium Beer

S. Premium Baijiu
Huangjiu

Grape Wine

Brandy
Economy Beer

Mainstream+ Beer

U. Premium Baijiu
Low Price Baijiu

Standard Baijiu

Premium Baijiu

Whisky
Mainstream Beer

Note: Asia-Pacific Beverages covered categories are shaded green. See the online version for colors.

Source: IWSR, BPC, China NBS, Nielsen, and Bernstein estimates and analysis.

Relatively few listed beer companies or Mainstream-focused spirits companies in Asia


generate ROIC in excess of their cost of capital as a result of constrained value chains and
fragmented industry structures (see Exhibit 112). Exceptions to this include ThaiBev
(THBEV.SP, underperform) (the largest spirits company in Thailand) and SABECO (not
covered) (the largest brewer in Vietnam), which deliver attractive returns as a result of
local scale advantages. A strong industry structure and scale advantage are necessary
conditions for Mainstream-focused beverage companies to generate attractive returns.

The majority of high ROIC Quality beverage companies in Asia-Pacific compete in the
Premium spirits segments. Examples of Quality spirits companies are Moutai, Wuliangye,
and Jiangsu Yanghe Brewery (002304.CN, not covered) in Chinese baijiu. These
companies are able to command sustainably high consumer prices for their core products
as a result of a clear intrinsic product differentiation, which consumers value.

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EXHIBIT 112: Mainstream-focused companies operating in fragmented industry structures generate sub-standard economic
value added (EVA)

3yearavg.ROIC/WACCvs.Sales/L
200.0
30.0 Moutai

25.0
Wuliangye
Baijiu:Highly
Sales/L(USD)

20.0 attractivevalue
chain
Mainstreamplayersw/ Fenjiu
15.0 fragmentedmarket
Yanghe
structure
10.0 Gujing Mainstreamplayers w/
Distillery attractivemarket
HiteJinro Luzhou
5.0 ThaiBev structure
Sapporo Asahi Changyu Laojiao
ZhujiangBrewery Sabeco
CRB Tsingtao Habeco
0.0 UBL
Yanjing
0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x
ROIC/WACC

Note: Kirin, United Spirits, Chongqing Beer, and Swellfun have negative three-year-average ROIC and, thus, are excluded in the chart.

Source: Bloomberg L.P., corporate reports and presentations, Haver Analytics, and Bernstein estimates and analysis.

We use Moutai, Wuliangye, and Yanghe as examples of Quality Premium spirits


companies and ThaiBev and Saigon Alcohol Beer and Beverages Corporation (SABECO) as
examples of Quality Mainstream companies in order to explore the fundamental drivers of
Quality in the remainder of this chapter.

Quality of products/services intrinsically differentiated products are necessary to sustain


price premiums and margins over time

In order for a Premium-focused strategy to be sustainable over the long term, the product
offerings must be underpinned by real intrinsic differentiation that is clearly understood
by consumers (e.g., differentiated flavors and aroma, unique production process and raw
materials, and clear geographic provenance). The process of laddering product benefits is
often referred to as "Category Strategy" by the global alcohol companies. Brands that
display unique characteristics that cannot be replicated by competitors are able to
command Premium pricing sustainably, and these companies deliver superior margins
over the long term (see Exhibit 113).

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EXHIBIT 113: By communicating a ladder of product benefits to consumers, brand owners can justify sustainably high prices

Overtly drivingpremiumization
Increasinglyintrinsicdifferentiation thatjustifiesthehigherpriceinconsumers'mind,e.g.:
CATEGORYSTRATEGY...

Unique
Distinctstyles Superiorraw Differentiated
production Productaging
andflavors materials alcoholcontent
method

Clearcategorycodessoconsumersknowwhytheyarepayingupandwhat theygetfortheextra,e.g.:

Descriptorsthatmeansomethingand Visualcuesandpackagingthat
notjustahollow"Premium" communicatesproductbenefits

Source: Bernstein analysis.

In our view, Chinese baijiu is the most intrinsically differentiated beverage category in the
world. It is the only major alcohol type that is produced via solid-state fermentation (as
opposed to the liquid-state fermentation process used for almost all other alcohol types)
and the category is segmented into different aromas, which are as distinct from one
another as Scotch is from Tequila or Rum (see Exhibit 114).

EXHIBIT 114: The four main baijiu aromas are highly differentiated

Jiang Xiang Nong Xiang Qing Xiang Mi Xiang


(Sauce Aroma) (Strong Aroma) (Light Aroma) (Rice Aroma)

Flavor intensity Higher.....................................................Lower


Full fiery flavor
Bold, savory Crisp, light flavor
(think Tequilla) Mild and floral
Tasting note flavor, soy sauce like high alcohol
with nutty sweetness
fragrance Sake or Shochu
sweetness
Sorghum & rice
Key ingredients Sorghum only Multiple grains Rice
bran
Fermentation Stone lined pits Mud pits Clay pots Earthenware jars
Shanxi and North Guangxi,
Key province Guizhou Sichuan
China Guangdong
Wuliangye,
Fenjiu,
Luzhou Lao Jiao, Guilin Sanhua,
Key producers Moutai Niulanshan
Yanghe, Kiukiang
Erguotou
Shuijingfang
Consumer Aroma 29% 33% 38% 18%
preference
Source: Bernstein 2016 China Alcohol Consumer Usage and Attitudes survey and Bernstein analysis.

The level of intrinsic product differentiation in baijiu escalates as the consumer price point
increases (see Exhibit 115). Low-end and value baijius (91% of industry volumes) are
normally made of industrially produced alcohol with added flavors and are packaged in
basic containers. These products command low consumer prices and generate low

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BERNSTEIN

margins. Ultra Premium baijius at the other end of the spectrum (0.2% of industry
volumes) are often produced in heritage cellars that can be 600+ years old, contain
significant amounts of aged liquors that add character, smoothness, complexity, and
balance to the aroma and flavor and are presented in elaborate and appealing packaging
(see Exhibit 116). Ultra Premium baijiu companies can command EBIT margins of
c.40-70%.

EXHIBIT 115: Intrinsic differentiation and product benefits ladder up across the baijiu process spectrum and justify higher
price points

Source: IWSR, corporate reports and websites, and Bernstein estimates and analysis.

Moutai and Wuliangye are by far the most well-known Ultra Premium baijiu brands and are
two of the highest-Quality alcohol companies in the region. In the 2016 Bernstein
Chinese Alcohol Consumer Usage and Attitudes survey, Moutai and Wuliangye recorded
national Spontaneous Awareness scores more than 2x the next brand. This reflects their
unique product characteristics, sustainable competitive advantages, and, in our view,
places them among the highest-Quality beverage companies in the region.

Yanghe is another high-Quality baijiu company. While the Yanghe brand scores lower in
terms of national Spontaneous Awareness than the likes of Moutai and Wuliangye, it has a
strong following at the regional level. In its home province of Jiangsu, Yanghe has a
Spontaneous Awareness score of 45% compared to its national score of 11% (see
Exhibit 117 and Exhibit 118). The Yanghe products do not have the same heritage as
Moutai and Wuliangye, but they are clearly differentiated in terms of standout blue
packaging, unique bottle shape, and a more modern and active approach to consumer
marketing. Yanghe mainly competes at Standard and Premium consumer price points,
where its offerings have strong brand equity compared to Moutai and Wuliangye's brands
at the same price points. Yanghe's Ocean Blue brand achieved a higher brand equity
score than the key competitors in the Premium segment (see Exhibit 119 to
Exhibit 121).

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EXHIBIT 116: Yanghe's Premium brand, Ocean Blue, is differentiated from competitor products by its unique packaging

Source: Company websites, Jiuxian.com, and Bernstein analysis.

EXHIBIT 117: Moutai and Wuliangye are by far the strongest EXHIBIT 118: Yanghe has strong awareness in its home
brands in consumers' minds at the national level province of Jiangsu

Spontaneous Awareness Yanghe Brand Spontaneous


(all alcohol consumers) Awareness by Province

70% 45%

60%

28%
26% 24%
23% 22% 20%
20% 20% 19% 19%
27%
21% 19%
16% 14%
13% 11%

Source: Bernstein 2016 China Alcohol Consumer Usage and Attitudes survey. Source: Bernstein 2016 China Alcohol Consumer Usage and Attitudes survey.

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EXHIBIT 119: Moutai and Wuliangye are EXHIBIT 120: Yanghe and Luzhou Lao EXHIBIT 121: Luzhou LaoJiao has the
the strongest Ultra Premium brands Jiao are the strongest Premium brands strongest Standard brand

Super & Ultra Premium Baijiu Premium Baijiu Brand Equity Standard Baijiu Brand Equity
Brand Equity
110
112 103 104 102 98
97 90
91

97
96

Moutai Wuliangye Luzhou Laojiao


Moutai Wuliangye Luzhou Laojiao Yanghe Moutai Wuliangye Luzhou Laojiao Yanghe

Note: Scores are indexed as average score = 100; Note: Scores are indexed as average score = 100; Note: Scores are indexed as average score = 100;
brands for Super and Ultra Premium segments are: brands for the Premium segment are: Wangzi of brands for the Standard segment are: Yingbin of
Fetien of Moutai, Wuliangye, and Guojiao 1573 of Moutai, Wuliangchun (250) of Wuliangye, Tequ of Moutai, Wuliangchun (60) of Wuliangye, Touqu of
Luzhou Laojiao; Yanghe doesn't have a Super or Luzhou Laojiao, and Ocean Blue of Yanghe. Luzhou Laojiao, and Daqu of Yanghe.
Ultra Premium offering.
Source: Bernstein 2016 China Alcohol Consumer Source: Bernstein 2016 China Alcohol Consumer
Source: Bernstein 2016 China Alcohol Consumer Usage and Attitudes survey. Usage and Attitudes survey.
Usage and Attitudes survey.

Attractiveness of market structure: Market consolidation and scale advantage are


necessary conditions for a profitable Mainstream-focused strategy
In Mainstream beverage segments, the value chains are constrained by relatively low
consumer prices. This means that a lean cost structure and an ability to leverage fixed
costs across large volumes are necessary conditions in order to generate attractive
margins. Exhibit 122 compares industry EBIT margins versus market concentration
(measured by the Hirschman Herfindahl Index) for 41 beer industries around the world.
Firstly, as displayed by the red (big) circle in Exhibit 122, there are no examples of
fragmented beer industries with high margins. Secondly, there is a clear relationship
between higher industry concentration and higher industry margins.

Highly concentrated alcoholic beverage industries in Asia-Pacific include the Philippines,


Australia, South Korea, Vietnam, Thailand, and India in beer and Thailand in Mainstream
spirits.

Companies operating in consolidated Mainstream markets with high relative market


shares command higher margins than their smaller competitors. In more fragmented
Mainstream alcohol markets, such as Chinese beer, Indian beer, and Indian spirits,
margins are lower.

102 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 122: Scale and market concentration are necessary conditions for a profitable Mainstream strategy

Beer EBIT Margin % vs Market Concentration for 41 Markets (2014)


45
HighlyConcentratedMarket>1,800HHI
40 Philippines
35
No
30 countries Australia
EBIT margin %

25
here
SouthKorea
20 Vietnam
Japan
15
Thailand
10

5 China'15 India
China'10
China'12
-
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
Market Concentration (HHI)

Source: Plato, Canadean, and Bernstein estimates and analysis.

EXHIBIT 123: Market leaders with high market shares relative to the #2 players generate superior margins in Mainstream
beverages

Monopolymarkets Duopoly markets Competitivemarkets


#1EBITmargin 50% 47% 36% 30% 15% 21%(1) 20% 13% 12% 10% 9% 7%
#ofMajorPlayers 1 1 2 2 2 4 3 4 4 3 5 5

3.5x
10.0x
ThaiBev SanMiguel
5.0x
3.0x
(Relativemarketshares:#1vs.#2)

UnitedSpirits

2.5x UnitedBrewery
HiteJinro
BoonRawd

2.0x Emperador
Oriental CRB
CUB Brewery Sabeco
1.5x (ProForma) Asahi

1.0x

0.5x

0.0x
Thailand Philippine Australia South Thailand Japan Philippine Vietnam South India Beer India China Beer
Spirits Beer Beer Korea Beer Beer Spirits Beer Korea Spirits
Beer Spirits

Note: (1) Asahi margins reflect full malt beer focus; (2) relative market share is defined as #1 player's market share divided by #2 player's market share.

Source: IWSR, Canadean, and Bernstein estimates and analysis.

THE SEARCH FOR QUALITY CONTINUES 103


BERNSTEIN

ThaiBev (spirits) is the only listed Mainstream beverage player in Asia-Pacific that has
been able to translate its spirits clear scale advantage into attractive margins. The
remaining four players in monopoly or duopoly markets identified in Exhibit 123 are
owned by either global beverage companies (CUB in Australia beer and Oriental
Breweries in South Korea beer) or local conglomerates (San Miguel beer in the Philippines
and Boon Rawd in Thailand beer). Other listed Mainstream-focused beverage companies
in Asia-Pacific generate low margins with the exception of Asahi and Emperador, but
these companies generate ROIC below WACC (see Exhibit 112).

ThaiBev is the largest beverage company in Thailand and its profitability is driven by
Mainstream spirits, which accounted for 83% of net profit (excluding associates) in 2015.
In spirits, it commands an 87% volume market share which affords it strong leverage with
distributors and retailers. It has an unparalleled production footprint with 18 distilleries
compared to the next-largest competitor with only one (see Exhibit 124 and Exhibit 125).
This comprehensive production grid results in a low cost-to-serve that cannot be
replicated at the product price point. We like ThaiBev's current strategy, which focuses on
spirits and, to a growing extent, beer. However, its Vision 2020 strategy is targeting a
pivot to non-alcoholic beverages which we expect to dilute its ROIC and may bring its
Quality status into question.

EXHIBIT 124: ThaiBev is clearly the national leader in spirits EXHIBIT 125: ThaiBev has an unparalleled spirits production
footprint in Thailand

Spirits Industry
Volume and Value Share (2015)

1% 9% 8%
1% 2%
2% 4%
7%

87%
79%

Volume Value

ThaiBev Diageo
United Wine & Distillers Pernod Ricard
Other

Source: IWSR, corporate reports, and Bernstein estimates and analysis. Source: Company websites and presentations, and Bernstein analysis.

SABECO is the largest brewer in Vietnam with a 38% national market share (see Exhibit
126), which is 1.7x the next-largest player, Heineken. The company's stronghold is the
south of Vietnam where it has a c.44% share and is c.2.2x the size of Heineken. SABECO's
strong Saigon Red, 333, and Saigon Special brands dominate the Mainstream segment
and, given its scale, they are must-stock brands for distributers and retailers. In our view,
this scale advantage is sustainable and is the key driver of SABECO's attractive margins

104 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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(13% EBIT margin) and sustained high ROIC (c.34% average in 2013-15). SABECO is
89.6% state-owned and is expected to IPO in either late 2016 or early 2017.

EXHIBIT 126: SABECO is the largest brewer in Vietnam with a 38% market share

Vietnam Beer Market Share (2015)

Others
14%

Carlsberg
8% SABECO
38%

HABECO
17%

Heineken
23%

Source: Canadean, and Bernstein estimates and analysis.

Size and growth of addressable market


A strong outlook for consumer demand enables beverage companies to sustain or
enhance margins either by increasing prices or increasing sales volumes and leveraging
fixed costs. In our view, the highest-Quality companies are focused on growing price
points and geographies.

Based on the proprietary Bernstein Global Spirits Affordability Model, we forecast strong
volume growth for Premium and above Chinese baijiu with a 11-15% volume CAGR
through 2020 compared to the overall industry 0.7% CAGR. We expect these growth
dynamics to underpin the Quality baijiu names, including Moutai, Wuliangye, and Yanghe.

Based on our Global beer Affordability Model, we forecast strong growth of Premium
Chinese beer with an 8% CAGR through 2020 compared to overall industry growth of 2%
in the same period, rapid growth across beer price points in Vietnam, and more modest
growth in other countries. Despite the attractive Premium beer growth dynamics in China,
we do not expect this to translate into meaningful margin enhancement in the short to
medium term. In Vietnam, we expect attractive growth to enhance margins and ROIC for
SABECO and Hanoi Beer Alcohol and Beverage Joint Stock Corp (HABECO) in beer.

Our Global Beer and Spirits Affordability models are based on the insight that demand for
a given price point of spirits or beer increases when it takes less than 30 minutes of work
to earn enough money to afford a standard serving. Exhibit 127 and Exhibit 128 show this
relationship for spirits and Exhibit 129 and Exhibit 130 illustrates this for beer. On
average, Standard spirits are already highly affordable in all of the major Asia-Pacific

THE SEARCH FOR QUALITY CONTINUES 105


BERNSTEIN

countries and, hence, we forecast lackluster growth for the segment. Mainstream beer,
Premium spirits, and Premium beer, however, are currently unaffordable to the average
person in many emerging Asian countries (and we expect rising incomes to drive the
growth of these segments).

EXHIBIT 127: Standard spirits are affordable in China and EXHIBIT 128: but Premium spirits are unaffordable for the
major Asia-Pacific countries average person and we expect Premium to grow as
affordability increases

Standard Spirits Affordability Premium Spirits Affordability


90 countries 2000-2014 89 countries 1999-2014
1
7
0.9
THA 30 minutes threshold
6 0.8

Per Capita Consumption(L)


Per Capita Consumption (L)

30 minutes threshold
0.7
5
0.6
4 0.5
0.4
3
0.3 KOR
2 0.2 JPN
0.1 THA
1 PHL
CHN 0
JPN CHN
0 15 30 45 60 75 90 105 120
0 KOR PHL IND
- 15 30 45 60 75 90 105 120 Minutes of work to earn a standard serving

Minutes of work to earn 40 mililiters of spirits

Note: (1) A standard serving is 40ml of spirits (30ml for China); (2) we include Note: (1) A standard serving is 40ml of spirits (30ml for China); (2) India is
Standard and below segments of Thai Spirits in the calculation to reflect the fact 341 mins/0.0 L and is off the chart.
that low-price spirits is the Mainstream segment in Thailand.
Source: IWSR, the United Nations, and Bernstein estimates and analysis.
Source: IWSR, the United Nations, and Bernstein estimates and analysis.

106 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 129: Mainstream beer is not affordable yet in most EXHIBIT 130: Similarly, Premium beer is only affordable in
Asia-Pacific countries Japan so far

Mainstream Beer Affordability Premium Beer Affordability


75 Countries, 1999-2014 69 Countries, 1999-2014
120 50

45
30 minutes threshold 30 minute threshold
100 40
Per capita consumption (L)

Per capita consumption (L)


35
80
30

60 25

20
THA
40 15
CHN VNM
10
20 KOR KOR VNM
PHL 5 JPN
JPN THA PHL IND
- IND - CHN
- 15 30 45 60 75 90 105 120 135 150 165 180 - 15 30 45 60 75 90 105 120 135 150 165 180 195 210 225 240 255
Minutes of work to earn a bottle (500ml) Minutes of work to earn a bottle (500ml)

Source: Canadean, UN, Nielsen, Canback, and Bernstein estimates and Source: Canadean, UN, Nielsen, Canback, and Bernstein estimates and
analysis. analysis.

HIGHEST-QUALITY COMPANIES Next, we highlight a handful of alcoholic beverage companies that we believe are higher
WITHIN AND BEYOND OUR Quality based on a combination of quant screening outputs and qualitative fundamental
COVERAGE
analysis.

Quality companies mentioned in the earlier discussion of false negatives:

Kweichou Moutai

Yibin Wuliangye

Additional Quality Chinese baijiu companies (non-exhaustive):


Jiangsu Yanghe Brewery (002304.CN, not covered). Yanghe ranks very favorably (top
quintile) in Bernstein's global quant Quality model but was knocked out in Bernstein's
factor-based Quality screening tool (which screens only the top 300 stocks in the
MSCI ACWI Asia ex-Japan). Yanghe is the third-largest Chinese baijiu company with a
focus on its home Jiangsu province. After launching its "Blue Classic" brand in 2003,
the company has been growing its top line rapidly at a 37% CAGR during 2005-15,
incentivized by its management's shareholding (22% ownership by management).

Shanxi Xinghuacun Fen Wine (600809.CN, not covered). Fen Wine is not included
either in the top Quality quintile in Bernstein's global quant Quality model or in
Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan). The company generates a ROIC of 12% and
has an EBIT margin of 18%. Fen Wine was designated one of the four National
baijius in China during the First National Tasting in 1952. Based in Shanxi, the
company has more than one century of baijiu production history and is now the
leading baijiu player in its home province with a focus on the mid- to high-end baijiu.

THE SEARCH FOR QUALITY CONTINUES 107


BERNSTEIN

Yantai Changyu Pioneer Wine (200869.CN, not covered). Changyu is not included
either in the top Quality quintile in Bernstein's global quant Quality model or in
Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan). The company generates a ROIC of 13% and
has an EBIT margin of 29%. Changyu is a leading alcoholic beverages company in
China, mainly producing and selling locally produced grape wine and brandy
products. The company has one of the highest consumer awareness among
domestic grape wine brands and owns extensive distribution networks nationally.

Anhui Gujing Distillery Company (200596.CN, not covered). Gujing Distillery is not
included either in the top Quality quintile in Bernstein's global quant Quality model or
in Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan). The company generates a ROIC of 12% and
has an EBIT margin of 16%. Gujing Distillery is a leading baijiu company and is one of
the eight National baijius in China with a strong presence in its home Anhui province.
Its signature baijiu Gujinggong has a strong aroma (Nong Xiang) which is the same
aroma as Wuliangye.

Non-China Quality alcoholic beverage companies (non-exhaustive):


Saigon beer-Alcoholic Beverages Corporation (SABECO) (non-public, not covered).
Sabeco is expected to IPO in 1Q2017, so is not included either in the top Quality
quintile in Bernstein's global quant Quality model or in Bernstein's factor-based
Quality screening tool. As the largest beer company in Vietnam with c.38% market
share (1.7x the second-largest player Heineken), Sabeco enjoyed rapid growth
over the past few years, driven by a large population of young people and rising
income levels. SABECO's strong Saigon Red, 333, and Saigon Special brands
dominate the Mainstream segment and, given their scale, they are must-own stock
brands for distributers and retailers. In our view, this scale advantage is sustainable
and is the key driver of SABECO's attractive margins (13% EBIT margin) and high
ROIC (c.34% average in 2013-15).

Thai Beverage Public Company (THBEV.SP, underperform). ThaiBev is not included


either in the top Quality quintile in Bernstein's global quant Quality model or in
Bernstein's factor-based Quality screening tool (which screens only the top 300
stocks in the MSCI ACWI Asia ex-Japan). The company generates a ROIC of 14% and
has an EBIT margin of 25%. ThaiBev is Thailand's largest alcoholic beverages
company with an 87% market share in spirits and a 40% market share in beer.
ThaiBev's extensive spirits production footprint and distribution networks create a
very high entry barrier for potential rivals and, as a result, the spirits division
generates a sustained 50% EBIT margin. However, the company's current focus on
the attractive spirits and beer industries may be in jeopardy given its Vision 2020
strategy to derive more than 50% of revenues from non-alcoholic drinks by 2020.

108 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

WHERE TO INVEST? RESULTS FROM OUR REVISED


QUALITY-IN-ASIA QUANT SCREENINGHAPPY HUNTING

Based on our above analysis of what differentiates quality companies in emerging Asia
(and where and how that is different than in developed markets), we attempted to
translate our seven dimensions of Quality (see Exhibit 67) into a Bloomberg-based quant
screening tool that screens for eight Quality parameters as proxies across 12 markets in
Asia, evaluating all companies with a market cap above US$500 million. Exhibit 131
summarizes the parameters and markets we screened.

Exhibit 132 and Exhibit 133 summarize the results (companies scoring in the top and
bottom Quality quintiles) for the three sectors we have mainly focused on in this chapter
Asia-Pacific Beverages, Healthcare Services, and Pharmaceuticals. We will publish the
results of a broader screen across all sectors in a future report.

These results are not an absolute snapshot of Quality (i.e., they may still contain some red
herrings), but we believe they provide a better shortlist by which we can begin a targeted
and an efficient layer of fundamental analysis to look into the other dimensions of Quality,
which can only be assessed by fundamental analysis.

EXHIBIT 131: Quality factors and markets considered


Revised Asia quality parameters Markets Size
(score based on at least 7 of 8 factors)
Net sales growth CAGR (2014-18E) Hong Kong Thailand market cap
above
Increasing net income margin (2014-18E) Shenzhen Vietnam USD 500 M

3-yr average R&D spend to net sales (2012-15) Shanghai Philippines

3-yr average % of income from asc income (2012-15) India Singapore

3-yr historical average ROIC / WACC (2012-15) Malaysia South Korea

3-yr historical average free cash flow yield (2012-15) Indonesia Japan

3-yr average net debt to assets (2012-15)

% of institutional ownership

Note: Estimates are taken from Bloomberg L.P.

Source: Bernstein analysis.

THE SEARCH FOR QUALITY CONTINUES 109


BERNSTEIN

EXHIBIT 132: Results: Companies scoring in the top two Quality quintiles Asia-Pacific pharmaceuticals
Market Cap
Ticker Company (USD M) Quintile Ranks
600519 CH Equity Kweichow Moutai Co Ltd 58,487 1
HEIM MK Equity Heineken Malaysia Bhd 1,230 1
600809 CH Equity Shanxi Xinghuacun Fen Wine Factory Co Ltd 2,926 1
200596 CH Equity Anhui Gujing Distillery Co Ltd 3,123 1
603369 CH Equity Jiangsu King's Luck Brewery JSC Ltd 2,442 1
600197 CH Equity Xinjiang Yilite Industry Co Ltd 972 1
000568 CH Equity Luzhou Laojiao Co Ltd 7,078 1
000858 CH Equity Wuliangye Yibin Co Ltd 19,244 1
600779 CH Equity Sichuan Swellfun Co Ltd 1,232 2
000799 CH Equity JiuGui Liquor Co Ltd 1,041 2
FNH MK Equity Fraser & Neave Holdings Bhd 2,121 2
002646 CH Equity Qinghai Huzhu Barley Wine Co Ltd 1,310 2
002304 CH Equity Jiangsu Yanghe Brewery Joint-Stock Co Ltd 15,195 2
2593 JP Equity Ito En Ltd 3,245 3
200869 CH Equity Yantai Changyu Pioneer Wine Co Ltd 3,148 2
000080 KS Equity Hite Jinro Co Ltd 1,300 3
CAB MK Equity Carlsberg Brewery Malaysia Bhd 1,048 2
TWE AU Equity Treasury Wines 5,917 2
603919 CH Equity Jinhui Liquor Co Ltd 1,444 2
033920 KS Equity Muhak Co Ltd 574 3
THBEV SP Equity Thai Beverage PCL 17,125 3
2579 JP Equity Coca-Cola West Co Ltd 3,332 3
600199 CH Equity Anhui Golden Seed Winery Co Ltd 811 3

Note: Highlighted stocks are covered by Bernstein.

Source: Bloomberg L.P., and Bernstein estimates and analysis.

EXHIBIT 133: Results: Companies scoring in the top two Quality quintiles Asia-Pacific healthcare services
Market Cap
Ticker Company (USD M) Quintile Ranks
300015 CH Equity Aier Eye Hospital Group Co Ltd 5,042 1
MIKA IJ Equity Mitra Keluarga Karyasehat Tbk PT 3,034 1
600763 CH Equity Topchoice Medical Investment Corp 1,572 1
1515 HK Equity Phoenix Healthcare Group Co Ltd 2,043 1
SILO IJ Equity Siloam International Hospitals Tbk PT 859 1
4694 JP Equity BML Inc 1,153 1
2120 HK Equity Wehzhou Kangning Psychiatric 361 1
BH TB Equity Bumrungrad Hospital PCL 3,779 1
4544 JP Equity Miraca Holdings Inc 2,740 2
1509 HK Equity Harmonicare 488 2
RHC AU Equity Ramsay 10,950 2
1099 HK Equity Sinopharm Group Co Ltd 12,933 2
RFMD SP Equity Raffles Medical Group Ltd 1,885 2
9729 JP Equity Tokai Corp/Gifu 605 2
300244 CH Equity Zhejiang Dian Diagnostics Co Ltd 2,648 2
000963 CH Equity Huadong Medicine Co Ltd 5,335 2

Note: Highlighted stocks are covered by Bernstein.

Source: Bloomberg L.P., and Bernstein estimates and analysis.

110 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 134: Results: Companies scoring in the top two Quality quintiles Asia-Pacific beverages
Market Cap
Ticker Company (USD M) Quintile Ranks
600519 CH Equity Kweichow Moutai Co Ltd 58,487 1
HEIM MK Equity Heineken Malaysia Bhd 1,230 1
600809 CH Equity Shanxi Xinghuacun Fen Wine Factory Co Ltd 2,926 1
200596 CH Equity Anhui Gujing Distillery Co Ltd 3,123 1
603369 CH Equity Jiangsu King's Luck Brewery JSC Ltd 2,442 1
600197 CH Equity Xinjiang Yilite Industry Co Ltd 972 1
000568 CH Equity Luzhou Laojiao Co Ltd 7,078 1
000858 CH Equity Wuliangye Yibin Co Ltd 19,244 1
600779 CH Equity Sichuan Swellfun Co Ltd 1,232 2
000799 CH Equity JiuGui Liquor Co Ltd 1,041 2
FNH MK Equity Fraser & Neave Holdings Bhd 2,121 2
002646 CH Equity Qinghai Huzhu Barley Wine Co Ltd 1,310 2
002304 CH Equity Jiangsu Yanghe Brewery Joint-Stock Co Ltd 15,195 2
2593 JP Equity Ito En Ltd 3,245 3
200869 CH Equity Yantai Changyu Pioneer Wine Co Ltd 3,148 2
000080 KS Equity Hite Jinro Co Ltd 1,300 3
CAB MK Equity Carlsberg Brewery Malaysia Bhd 1,048 2
TWE AU Equity Treasury Wines 5,917 2
603919 CH Equity Jinhui Liquor Co Ltd 1,444 2
033920 KS Equity Muhak Co Ltd 574 3
THBEV SP Equity Thai Beverage PCL 17,125 3
2579 JP Equity Coca-Cola West Co Ltd 3,332 3
600199 CH Equity Anhui Golden Seed Winery Co Ltd 811 3

Note: Highlighted stocks are covered by Bernstein.

Source: Bloomberg L.P., and Bernstein estimates and analysis.

INVESTMENT IMPLICATIONS

ASIA-PACIFIC We rate two stocks outperform: Jiangsu Hengrui Medicine Company (12-month target
PHARMACEUTICALS price RMB57.0) and CSPC Pharmaceutical (12-month target price HKD8.6). We rate
three stocks market-perform (two pharmaceuticals and one hospital company): Sino
Biopharmaceutical (1177.HK, 12-month target price, HKD5.8), Sihuan Pharmaceutical
(460.HK, 12-month target price HKD1.8), and Kalbe Farma (KLBF.IJ, 12-month target
price IDR1,460). More broadly, we like companies with strong management teams which
have experience in managing multinational companies; deeper and more patient-focused
R&D; a wide portfolio of in-line products; products sold outside of the home market,
including in developed markets; and better clarity on growth strategy.

ASIA-PACIFIC HEALTHCARE We rate two stocks outperform: Bangkok Dusit Medical Services (BDMS.TB, 12-month
SERVICES target price THB28.2) and IHH Healthcare Berhad (IHH.MK, 12-month target price
MYR7.5). We rate two stocks market-perform: China Resources Phoenix Healthcare
Group (1515.HK, 12-month target price HKD11.0), and Bumrungrad Hospital (BH.TB,
12-month target price THB184.0). More broadly, we like companies with strong
management teams which have deep experience in running hospitals; wide service

THE SEARCH FOR QUALITY CONTINUES 111


BERNSTEIN

offerings and a strategic footprint; clinical services and outcomes that are genuinely
approaching (or striving to reach) global standards; and better clarity on growth strategy.

ASIA-PACIFIC BEVERAGES We rate two stocks outperform (both baijiu spirits companies): Wuliangye Yibin
(000858.CH, 12-month target price RMB57.3) and Kweichou Moutai (600519.CH,
12-month target price RMB410.9). We rate four stocks underperform: China Resources
Beer (291.HK, 12-month target price HKD12.3), Tsingtao (168.HK, 12-month target
price HKD25.0/600600.CH, 12-month target price RMB22.0), ThaiBev (THBEV.SP, 12-
month target price SGD0.78), and Kirin Holdings (2503.JP, 12-month target price was
raised to JPY1,423 on November 24, 2016). We rate one stock market-perform: Asahi
(2502.JP, 12-month target price JPY3,515.1). More broadly, we like Premium-focused
companies with intrinsically differentiated brands; Mainstream-focused companies with
scale advantage; management teams which are pursuing profit enhancement, and
markets with attractive value growth prospects.

112 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 135: Valuation table: Asia-Pacific pharmaceuticals


20161117 Rel.Perf. Price Market 12Mavgtrading EPSCAGR EV/EBITDA P/E PEGRatio Div FCF
ticker 30D YTD LTM Market Value($m) Volume(USD) 1417E 2015 2016E 2015 2016E 2015 2016E Yield(% Yield(%)
BERNSTEINcoverage(ourestimates)
KalbeFarma KLBFIJ 15.9% 10.6% 8.1% 1,460 5,109
JiangsuHengrui 600276CH 2.2% 11.9% 6.4% 45.8 15,658
SihuanPharma 460HK 10.3% 56.1% 56.3% 1.9 2,479
SinoBiopharm 1177HK 6.9% 23.9% 18.6% 5.4 5,131
CSPCPharma 1093HK 2.6% 0.5% 13.6% 8.0 6,211

BERNSTEINcoverage(consensus)
JiangsuHengrui 600276CH 2.2% 11.9% 6.4% 46 15,658 39,923,171 25% 38.9x 31.5x 49.3x 38.7x 1.54 1.23 1.68
KalbeFarma KLBFIJ 15.9% 10.6% 8.1% 1,460.0 5,109 4,881,745 13% 22.1x 19.5x 34.2x 29.9x 2.43 2.15 2.15
CSPCPharma 1093HK 2.6% 0.5% 13.6% 8.0 6,211 11,658,111 21% 17.1x 14.8x 28.0x 22.8x 0.87 0.72 1.38
SinoBiopharm 1177HK 6.9% 23.9% 18.6% 5.4 5,131 15,710,341 12% 11.9x 10.5x 21.7x 19.5x 0.93 0.82 0.96
SihuanPharma 460HK 10.3% 56.1% 56.3% 1.9 2,479 15,431,075 3% 4.4x 5.8x 8.9x 8.9x 3.47
Chinabiopharma(consensus)
Sinopharm 1099HK 8.2% 11.9% 6.6% 34.8 12,414 17,957,803 17% 10.5x 9.4x 23.0x 18.5x 0.92 0.81 1.33 12.42
YunnanBaiyao 000538CH 4.7% 3.6% 36,506,102 11%
ShanghaiPharm 2607HK 6.7% 15.4% 9.9% 19.4 7,591 4,327,985 12% 13.0x 11.6x 16.1x 14.4x 1.37 1.23 0.97
ShanghaiFosunPharma 2196HK 1.9% 6.7% 2.8% 24.0 8,242 5,256,154 18% 29.7x 26.5x 22.2x 17.6x 1.14 0.99 0.41
Tasly 600535CH 8.9% 1.4% 5.2% 40.3 6,345 28,239,400 9% 19.4x 20.6x 28.1x 28.2x 0.13
GuangzhouBaiyunshan 874HK 1.8% 14.5% 9.6% 18.8 5,720 2,395,322 5% 17.0x 19.0x 16.5x 16.3x 0.00 8.68
ShandongDongEEJiao 000423CH 2.9% 14.5% 20.2% 59.9 5,702 71,394,364 13% 19.5x 17.4x 23.9x 21.7x 1.68
Huadong 000963CH 5.0% 10.5% 5.1% 73.4 5,192 26,351,493 18% 19.2x 16.3x 28.2x 25.4x 1.93
TonghuaDongbao 600867CH 0.6% 3.0% 7.6% 23.3 4,827 21,214,331 29% 50.5x 37.8x 67.4x 52.1x 0.40
CMS 867HK 0.0% 11.2% 20.0% 12.7 4,072 6,136,546 23% 25.8x 18.5x 26.8x 20.8x 0.86 0.71 1.65 3.76
SichuanKelun 002422CH 5.0% 6.3% 2.7% 17.4 3,652 17,387,677 35.6x 1.09
ShandongWeigao 1066HK 1.2% 3.6% 12.6% 5.1 2,966 3,497,515 9% 11.0x 10.7x 17.0x 17.8x 1.45
Livzon 1513HK 0.4% 23.3% 30.3% 46.0 3,209 770,520 19% 19.7x 15.9x 25.9x 21.9x 1.23 2.56
3SBio 1530HK 2.1% 27.8% 14.1% 7.9 2,563 7,383,733 25% 29.7x 18.5x 28.6x 24.2x 0.00 2.56
Luye 2186HK 6.6% 38.4% 30.0% 5.0 2,136 6,015,223 13% 12.7x 12.2x 18.1x 16.5x 0.67 0.58 0.00 1.88
ChiMed HCMUS 5.0% 11.4% 11.4% 12.0 1,451 774,349
Beigene BGNEUS 13.4% 53.8% 53.8% 36.9 1,219 3,007,266 118% 0.00
Bloomage 963HK 5.8% 35.4% 24.2% 12.4 580 1,262,613 18% 16.1x 11.8x 19.3x 17.9x 0.25 4.24
Lee'sPharma 950HK 2.2% 27.8% 28.2% 7.0 532 494,034 6% 11.5x 12.4x 17.1x 17.6x 1.53
FudanZhangjiang 1249HK 5.5% 12.4% 7.8% 4.4 141 38,778 0.00
Taiwan(censensus)
OBI 4174TT 19.9% 58.2% 47.0% 274.0 1,473 17,735,706 23% 1.23
ScinoPharm 1789TT 7.3% 26.5% 24.1% 38.0 906 3,645,852 24% 24.6x 19.6x 46.2x 38.5x 3.25
PharmaEngine 4162TT 9.6% 2.8% 18.3% 206.0 791 11,617,152 21% 35.6x 22.5x 36.7x 25.3x 0.24
TaiGen 4157TT 4.1% 12.7% 4.6% 29.5 662 1,825,893 32.6x 1.73
SyneuRx 6575TT 14.2% 60.5% 60.5% 103.0 331 1,548,649
TheVax 6567TT 16.2% 35.4% 35.4% 106.0 297 114,217 3.30
Medigen 3176TT 2.1% 24.8% 26.1% 64.3 280 1,912,190 3.24
TaiwanLiposome 4152TT 3.5% 15.9% 4.6% 124.0 217 261,552 4% 8.33
Koreabiopharma(consensus)
Celltrion 068270KS 4.7% 23.9% 25.3% 104,700 10,378 81,575,900 54% 37.5x 35.3x 100.8x 63.1x 0.84
HanmiPharma 128940KS 5.9% 47.2% 48.1% 384,500 3,411 62,484,847 149% 22.4x 26.2x 524.0x 40.0x 7.49
Yuhan 000100KS 16.8% 21.8% 30.4% 213,000 2,019 9,873,880 1% 17.0x 15.8x 18.6x 18.9x
GreenCross 006280KS 1.3% 14.5% 18.5% 156,500 1,555 8,916,027 10% 15.0x 17.4x 17.0x 31.5x 4.18
ViroMed 084990KS 3.2% 47.5% 48.0% 94,300 1,280 21,935,929 33% 5,388.6x
SKChemical 006120KS 0.5% 13.9% 7.1% 62,400 1,290 8,865,180 35% 21.1x 13.4x 30.0x 12.7x 30.39
LGLifeScience 068870KS 0.2% 0.3% 7.6% 60,800 857 9,533,633 41% 21.0x 15.5x 75.3x 34.9x 2.09
Bukwang 003000KS 4.2% 2.6% 10.2% 26,100 829 10,587,244 1.06
MedyTox 096530KS 4.5% 13.5% 7.7% 32,800 732 6,927,072 32% 57.5x 34.1x 105.6x 114.4x 0.31
ChongKunDang 185750KS 14.4% 11.9% 28.7% 107,500 860 14,110,523 4.89
Genexine 095700KS 3.4% 8.6% 4.3% 42,900 649 4,139,367 0.00 0.72
Binex 053030KS 15.3% 9.3% 12.4% 17,700 471 10,439,523
Medipost 078160KS 13.2% 38.3% 43.8% 59,700 399 7,516,787 1.11
Indiabiopharma(consensus)
Sun SUNPIN 7.4% 17.1% 9.7% 680 24,081 44,941,788 5% 19.8x 18.7x 22.6x 30.2x 1.14 1.00 0.15 2.07
Lupin LPCIN 1.5% 22.4% 20.8% 1,426 9,466 35,079,383 12% 18.3x 19.8x 26.4x 29.2x 1.22 1.06 0.53 9.63
Dr.Reddy's DRRDIN 6.0% 3.3% 6.7% 3,211 7,837 22,243,941 2% 16.4x 14.2x 23.9x 21.6x 2.24 1.47 0.62
Cipla CIPLAIN 7.0% 16.1% 14.2% 546 6,455 15,082,038 16% 21.0x 16.1x 33.5x 24.6x 2.01 1.54 0.37 1.29
Aurobindo ARBPIN 11.6% 18.3% 13.9% 716 6,169 25,548,509 22% 17.4x 14.1x 26.0x 20.8x 0.90 0.75 0.35 0.29
Cadila CDHIN 4.1% 14.2% 9.4% 374 5,641 7,474,073 22% 24.0x 17.7x 35.1x 25.4x 1.35 1.06 0.86 2.71
Piramal PIELIN 23.9% 41.1% 42.1% 1,415 3,597 3,474,265 96% 54.4x 31.0x 119.1x 59.7x 1.24 32.37
Glenmark GNPIN 2.6% 4.0% 9.0% 885 3,678 8,751,675 25% 19.8x 17.3x 32.9x 30.6x 1.03 0.92 0.23 2.89
Biocon BIOSIN 8.4% 67.5% 95.3% 868 2,557 11,333,084 19% 26.9x 22.6x 43.8x 39.3x 2.85 2.46
Wockhardt WPLIN 14.8% 52.0% 54.2% 734 1,195 24,309,975 6% 12.0x 16.5x 17.6x 17.9x 0.00 5.76
Globalpeers(consensus)
Roche ROGVX 0.2% 16.0% 14.7% 232 200,365 347,695,204 7% 11.2x 10.7x 16.6x 15.7x 2.23 2.08 4.97
Novartis NOVNVX 3.1% 16.8% 19.5% 72 189,261 415,611,689 4% 13.9x 14.6x 14.4x 15.2x 4.64 4.44 5.84
Pfizer PFEUS 1.7% 1.0% 2.8% 32 193,945 1,075,530,780 9% 10.7x 10.7x 14.6x 13.2x 2.70 2.50 3.69 6.61
NovoNordisk NVOUS 18.4% 43.4% 39.0% 33 83,895 103,521,025 10% 17.9x 15.2x 1.66 1.58
Gilead GILDUS 4.6% 24.9% 27.3% 76 100,127 920,925,070 5% 4.0x 4.8x 6.2x 6.7x 2.37 16.65
Allegan AGNUS 12.7% 37.4% 34.2% 196 73,343 1,006,576,413 6% 10.0x 11.2x 12.7x 14.5x 1.17 0.97 0.00 3.50
BMS BMYUS 13.9% 18.3% 14.5% 56 93,923 540,286,883 21% 23.1x 16.0x 29.4x 19.7x 1.12 1.07 2.70 1.44
Teva TEVAUS 8.9% 42.0% 36.5% 38 34,799 358,201,595 2% 11.5x 10.1x 7.0x 7.4x 0.80 0.74
Merck MRKGR 3.0% 5.1% 0.2% 94 43,789 46,465,961 12% 14.6x 11.8x 19.2x 15.2x 1.70 1.62 4.34
Mylan MYLUS 4.0% 29.9% 25.2% 38 20,280 271,374,916 10% 11.3x 9.8x 8.7x 8.0x 0.49 0.44 0.00 10.10
MSCIAsiaExJapan MXASJINDEX 4.7% 3.2% 2.0% 516
MSCIAsiaExJapanHealthcare MXASJHCINDE 5.9% 10.4% 9.4% 692.1
S&P500 SPXINDEX 2.4% 6.5% 6.2% 2,177

Source: Bloomberg L.P. and Bernstein analysis.

THE SEARCH FOR QUALITY CONTINUES 113


BERNSTEIN

EXHIBIT 136: Valuation table: Asia-Pacific healthcare services


20161117 Rel.Perf. Price Market 12Mavgtrading EPSCAGR EV/EBITDA P/E PEGRatio Div FCF
ticker 30d YRD LTM Market Value($m) Volume(USD) 1518E 2015A 2016E 2015A 2016E 2015E 2016E Yield(%Yield(%)
BERNSTEINcoverage(ourestimates)
Phoenix 1515HK 7.3% 32.5% 6.0% 12.0 2,006
Bumrungrad BHTB 6.6% 12.3% 9.8% 185.0 3,803
BangkokDusit BDMSTB 1.9% 1.3% 12.8% 22.0 9,614
IHH IHHMK 0.9% 3.6% 4.7% 6.3 11,908

BERNSTEINcoverage(consensus)
IHH IHHMK 0.9% 3.6% 4.7% 6.3 11,908 10,971,481 17% 26.6x 23.7x 55.1x 52.8x 3.29 2.67 #N/AN/ 0.82
BangkokDusit BDMSTB 1.9% 1.3% 12.8% 22.0 9,614 20,550,900 14% 27.6x 25.5x 44.6x 39.7x 3.34 2.97 #N/AN/ 1.46
Bumrungrad BHTB 6.6% 12.3% 9.8% 185.0 3,803 9,081,004 7% 24.6x 23.7x 39.4x 38.7x 6.17 5.63 #N/AN/ 2.12
Phoenix 1515HK 7.3% 32.5% 6.0% 12.0 2,006 5,429,470 19% 42.4x 32.6x 36.8x 33.3x 1.70 1.43 0.00 2.57

China(consensus)
AierEye 300015CH 4.2% 5.5% 2.1% 33.3 4,882 21,326,737 33% 44.6x 35.5x 76.0x 56.8x 0.96
ZhejiangDianDiagnostics 300244CH 1.9% 14.1% 24.7% 33.2 2,661 30,591,429 35% 74.2x 49.6x 86.8x 66.7x 0.97
TigerMed 300347CH 7.3% 2.0% 14.9% 30.1 2,081 20,093,204 16% 60.6x 75.3x 0.58
TopChoiceMedical 600763CH 3.7% 30.4% 38.2% 34.1 1,592 23,304,385 26% 34.8x 38.0x 74.1x 60.0x 0.30
iKang KANGUS 5.5% 15.9% 3.7% 17.2 1,168 8,843,792 0.00
TownHealth 3886HK 0.0% 20.6% 20.1% 1.3 1,271 1,304,039 0.77
ChinaMedical&HealthcareGroup 383HK 4.9% 21.8% 10.4% 0.4 803 423,475 0.00 12.18
Harmonicare 1509HK 28.0% 14.0% 20.7% 6.0 582 876,667 8% 15.8x 16.4x 34.4x 35.6x 3.15 2.65 1.04 1.82
WehzhouKangningPsychiatric 2120HK 2.8% 18.4% 2.5% 37.8 355 754,300 31% 22.8x 21.3x 42.9x 34.8x 1.24 0.93 0.75 6.48
UnionMedical 2138HK 4.8% 20.8% 20.8% 2.4 303 337,482 0.80 2.73
ConcordMedical CCMUP 5.3% 9.3% 11.6% 4.4 195 8,756 4.6x 318.7x 19.1x 0.00
UMP 722HK 3.1% 24.1% 40.3% 1.2 117 299,276 17.9x 32.4x
HumanHealthHoldings 1419HK 8.5% 41.3% 41.3% 2.0 91 1,665,421 16.3x 1.54 3.98

Thailand(consensus)
Ramkhamhaeng RAMTB 17.4% 75.0% 66.7% 3500.0 1,185 15,005 1.05
Vibhavadi VIBHATB 3.6% 47.9% 77.5% 2.8 1,055 3,098,168 14% 28.7x 27.6x 47.3x 35.5x 0.15
BangkokChain BCHTB 9.5% 52.5% 91.7% 13.8 971 3,454,417 28% 28.0x 21.9x 70.8x 47.4x 1.95 1.64 2.98
Chularat CHGTB 11.9% 6.0% 16.5% 2.8 875 3,678,609 17% 38.9x 33.9x 56.4x 49.5x 4.20 3.47 1.28 0.41
ChiangMaiRamMedical CMRTB 2.9% 54.3% 76.5% 4.7 529 464,351 0.69
Ladprao LPHTB 1.7% 42.7% 52.6% 8.9 187 1,851,261 30% 32.3x 24.0x 61.0x 39.2x 2.67

Malaysia(consensus)
KPJ KPJMK 0.2% 0.5% 0.7% 4.2 1,004 751,927 7% 16.0x 15.2x 29.2x 30.2x 3.82 3.36 1.62 5.16

Indonesia(consensus)
MitraKeluarga MIKAIJ 2.5% 18.8% 16.6% 2,850 3,096 1,689,893 18% 53.2x 45.6x 72.8x 61.2x 2.86 2.46 0.88 1.21
Siloam SILOIJ 6.3% 2.0% 11.1% 10,000 863 1,969,089 43% 21.1x 17.4x 132.2x 109.2x 0.38
SaranaMeditanma SAMEIJ 10.9% 7.9% 18.4% 2,860 252 126,697 12% 25.1x 21.5x 59.8x 99.3x 7.13

India(consensus)
Apollo APHSIN 11.3% 18.4% 9.5% 1197 2,452 4,340,566 10% 24.9x 22.7x 46.3x 44.8x 1.71 1.24 0.50 3.29
Fortis FORHIN 9.5% 10.4% 2.1% 161 1,100 3,010,384 236% 86.7x 47.3x 134.8x 0.00 0.13
NaryanaHealth NARHIN 4.3% 30.0% 30.0% 325 978 2,490,827 39.4x 325.0x 0.00 0.88

Australia
Ramsay RHCAU 9.7% 3.9% 7.4% 71 10,678 26,846,520 14% 16.2x 14.0x 35.4x 30.5x 1.65 1.47 1.69 2.83
Sonic SHLAU 2.6% 23.2% 12.4% 22 6,848 21,205,307 9% 15.8x 13.3x 23.7x 21.0x 2.55 2.31 3.36 4.26
PrimaryHealthcare PRYAU 6.6% 56.8% 4.3% 4 1,432 11,008,767 2% 7.0x 7.4x 17.0x 17.8x 3.27 10.00
Healthscope HSOAU 22.4% 15.4% 20.5% 2 2,921 23,669,346 8% 13.6x 12.8x 23.2x 20.5x 2.87 2.63 3.29 6.11

Globalhealthcareservices(consensus)
UniversalHealthServices UHSUS 2.7% 0.5% 2.1% 120.1 11,644 95,720,635 9% 9.3x 9.0x 17.4x 16.4x 1.82 1.66 0.33 6.99
HCA HCAUS 8.5% 8.7% 6.2% 73.5 27,554 234,929,419 14% 7.6x 7.3x 13.6x 10.9x 0.95 0.90 0.00 9.78
TenetHealthcareCorp THCUS 28.7% 45.8% 49.7% 16.4 1,636 60,873,508 5% 8.1x 7.6x 8.1x 13.4x 0.72 0.44 0.00 9.28
CommunityHealthSystems CYHUS 45.4% 74.8% 75.6% 5.5 625 61,333,134 30% 5.7x 7.5x 1.6x 157.1x 0.00 48.78

Chinadistributors(consensus)
Sinopharm 1099HK 8.2% 11.9% 6.6% 34.8 12,414 17,957,803 17% 10.5x 9.4x 23.0x 18.5x 0.92 0.81 1.33 12.42
ShanghaiPharm 2607HK 6.7% 15.4% 9.9% 19.4 7,591 4,327,985 12% 13.0x 11.6x 16.1x 14.4x 1.37 1.23 0.97
Jointown 600998CH 1.3% 8.7% 8.7% 21.3 5,107 19,526,851 23% 33.2x 25.9x 50.4x 41.0x 0.24

Globaldistributors(consensus)
McKesson MCKUS 11.9% 28.3% 23.7% 141.5 31,987 318,081,432 21% 11.8x 11.0x 11.3x 11.3x 1.12 1.12 0.79 14.89
AmerisourceBergen ABCUS 1.1% 24.0% 20.5% 78.9 17,357 212,049,403 18% 11.3x 10.0x 13.8x 12.4x 1.21 1.08 1.72 17.76

MSCIAsiaExJapan MXASJINDEX 4.7% 3.2% 2.0% 515.9


MSCIAsiaExJapanHealthcare MXASJHCIND 5.9% 10.4% 9.4% 692.1
S&P500 SPXINDEX 2.4% 6.5% 6.2% 2,177

Source: Bloomberg L.P. and Bernstein analysis.

114 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 137: Valuation table: Asia-Pacific beverages


Trading Share (In US$ mm) P/E (x) EV/EBITDA (x) ROIC (%) Dividend (%) EPS CAGR
Ticker Currency Price Market cap EV 2016E 2017E 2018E 2016E 2017E 2018E 2015A 2015A 2015-18E
China Beer (H-Share)
China Reso291 HK HKD 16.3 6,819 8,215 37.8x 24.8x 22.6x 11.3x 10.5x 9.8x 3.6% NM NM
Tsingtao H 168 HK HKD 32.0 5,928 4,405 24.9x 24.9x 23.6x 13.8x 13.4x 12.8x 7.2% 1.6% -2.4%
Mean 31.4x 24.8x 23.1x 12.5x 11.9x 11.3x 5.4% 1.6% -2.4%
Median 31.4x 24.8x 23.1x 12.5x 11.9x 11.3x 5.4% 1.6% -2.4%
China Beer (A-share)
Tsingtao A 600600 CH CNY 31.5 5,928 4,405 27.8x 26.8x 25.3x 13.7x 13.5x 12.8x 7.2% 1.4% -0.6%
Yanjing 000729 CH CNY 7.6 3,158 2,953 40.0x 37.6x 32.3x 13.7x 13.1x 12.1x 3.0% 1.0% 13.5%
Chongqing 600132 CH CNY 18.5 1,317 1,264 32.4x 24.6x 21.5x 21.1x 15.4x 15.0x -6.6% 1.3% 27.7%
Mean 33.4x 29.7x 26.4x 16.2x 14.0x 13.3x 1.2% 1.2% 13.5%
Median 32.4x 26.8x 25.3x 13.7x 13.5x 12.8x 3.0% 1.3% 13.5%
China Baijiu
Moutai 600519 CH CNY 320.0 59,264 51,629 23.2x 20.5x 18.0x 13.0x 11.4x 10.1x 26.4% 1.8% 12.9%
Wuliangye 000858 CH CNY 34.9 19,543 14,566 18.7x 16.2x 14.4x 10.1x 8.8x 8.0x 14.3% 2.2% 14.3%
Luzhou Lao000568 CH CNY 34.5 7,126 6,442 27.3x 22.4x 18.7x 18.3x 15.6x 13.7x 12.4% 2.9% 20.6%
Yanghe 002304 CH CNY 68.4 15,186 14,391 17.9x 15.8x 14.1x 12.1x 10.8x 9.6x 19.9% 2.1% 13.3%
Mean 21.8x 18.7x 16.3x 13.4x 11.6x 10.3x 18.3% 2.3% 15.3%
Median 20.9x 18.3x 16.2x 12.6x 11.1x 9.8x 17.1% 2.1% 13.8%
Other APAC Beverage companies
Kirin 2503 JT JPY 1,856.0 16,144 24,728 16.4x 16.4x 15.5x 10.0x 9.6x 9.1x 5.8% 2.3% NM
Asahi 2502 JT JPY 3,655.0 16,821 19,608 17.8x 17.2x 16.1x 9.6x 8.9x 8.6x 6.9% 1.3% 1.8%
ThaiBev THBEV SP SGD 0.9 16,914 17,784 22.8x 20.4x 18.9x 19.5x 17.5x 16.3x 13.9% 3.6% 6.3%
Sapporo 2501 JT JPY 2,874.0 2,155 4,295 19.5x 17.6x 16.4x 9.2x 8.9x 8.7x 1.8% 1.3% 19.3%
United SpirUNSP IN INR 2,040.1 4,468 5,013 79.7x 60.7x 40.8x 38.0x 35.5x 27.8x -3.4% 0.1% NM
United BrewUBBL IN INR 903.5 3,600 3,631 73.8x 65.0x 53.2x 29.8x 27.3x 23.4x 10.0% 0.1% 20.4%
EmperadorEMP PM PHP 7.3 2,418 2,572 16.7x 15.3x 13.9x 13.3x 12.2x 10.7x 9.3% 1.7% 6.7%
Treasury WTWE AU AUD 10.5 6,006 6,015 34.1x 27.2x 22.7x 16.3x 12.9x 11.2x 3.0% 2.6% 37.0%
Coca Cola CCL AU AUD 9.5 5,598 6,659 17.5x 17.0x 16.3x 8.2x 8.0x 7.7x 9.6% 6.0% 3.7%
Mean 33.1x 28.5x 23.8x 17.1x 15.7x 13.7x 6.3% 2.1% 13.6%
Median 19.5x 17.6x 16.4x 13.3x 12.2x 10.7x 6.9% 1.7% 6.7%
International Brewers
ABInBev ABI BB EUR 103.5 230,371 269,329 30.3x 22.7x 20.4x 14.8x 10.7x 10.0x 9.9% 3.1% 2.7%
Carlsberg CARLB DC DKK 612.5 13,863 18,363 21.7x 18.2x 16.4x 9.9x 9.3x 8.9x -1.6% 1.5% 11.4%
Heineken HEIA NA EUR 73.7 46,781 59,231 20.2x 18.6x 16.7x 12.4x 11.8x 11.1x 8.9% 1.5% 10.8%
Molson Co TAP US USD 105.9 22,715 22,642 31.2x 18.0x 18.3x 12.9x 9.1x 8.6x 4.1% 1.7% 15.2%
Efes AEFES TI TRY 18.4 3,449 6,143 26.9x 19.9x 16.6x 10.6x 9.4x 8.3x 3.9% 2.4% NM
AmBev ABEV3 BZ BRL 18.1 89,321 85,417 22.0x 18.8x 16.9x 14.3x 12.5x 11.4x 26.7% 4.0% 9.7%
Mean 25.4x 19.4x 17.6x 12.5x 10.5x 9.7x 8.6% 2.4% 10.0%
Median 24.4x 18.7x 16.8x 12.7x 10.0x 9.4x 6.5% 2.1% 10.8%
International Spirits Companies
Diageo DGE LN GBP 20.9 65,186 77,676 23.8x 20.1x 18.6x 19.7x 17.0x 15.9x 12.8% 2.9% 7.4%
Pernod RI FP EUR 106.1 31,042 40,137 20.5x 19.2x 17.9x 14.1x 13.7x 13.0x 5.6% 1.6% 7.4%
Remy Mart RCO FP EUR 72.8 3,989 4,454 32.7x 28.5x 25.3x 18.7x 16.5x 15.1x 7.0% 1.9% 14.9%
Campari CPR IM EUR 9.0 5,736 6,925 26.2x 21.5x 19.6x 15.7x 13.9x 13.1x 6.4% 1.0% 11.5%
Brown FormBF/B US USD 47.0 18,916 20,698 27.8x 26.6x 24.5x 19.4x 19.1x 17.8x 22.3% 1.3% 5.9%
Mean 26.2x 23.2x 21.2x 17.5x 16.0x 15.0x 10.8% 1.7% 9.4%
Median 26.2x 21.5x 19.6x 18.7x 16.5x 15.1x 7.0% 1.6% 7.4%

Source: Bloomberg L.P. and Bernstein analysis.

THE SEARCH FOR QUALITY CONTINUES 115


BERNSTEIN

APPENDIX: IN-DEPTH REVIEW OF OUR ATTEMPTS


FIRM-WIDE TO CAPTURE QUALITY IN ASIA

In this section, we review in detail the three quantitative approaches developed by the
Bernstein European Equity Strategy team, U.S. Quantitative Research team, and the Asia-
Pacific Equity Strategy team to search for Quality companies that are described earlier
in this chapter. We describe the approaches and their results below.

EUROPEAN EQUITY STRATEGY Our European equity strategy colleagues represent Quality using ROE as the simplest
TEAM'S GLOBAL QUANT proxy. If long-term history is any guide, Quality is bound to disappoint in Asia, having
QUALITY SCREEN ROE AS A
delivered 3% annualized returns over the last 25 years (see Exhibit 138). However, over
PROXY
the last 10 years and also over the last five years, Quality has delivered the best risk-
adjusted returns compared to the other factors (such as Value, Growth, Income, and
Momentum).

Using this ROE-based Quality proxy, we measured the performance of the Quality factor
across the universe of the 300 largest Asian stocks in the MSCI All Country World Index.
Our methodology was to split the group of 300 into quintiles based on their ROEs. The top
quintile contains stocks with the best ROE and the bottom quintile contains stocks with
the lowest ROE. To measure factor performance, we look at the difference in the total
monthly returns (in US$) of the top quintile (equal weighted average for all stocks in the
quintile) and the bottom quintile.

EXHIBIT 138: ROE performance (100 = December 31, 1989)

250
Annualized returns for ROE

1990 - 2015: 3%
200 2005 - 2015: 5.5%
ROE recovered its 1998
levels only in 2010

150

100

50 Between Aug '98 and


Apr '99, ROE collapsed 74%
on an annualized basis

0
Dec-89
Dec-90
Dec-91
Dec-92
Dec-93
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15

Source: MSCI, FactSet, Bloomberg L.P., and Bernstein analysis.

116 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

Quality has underperformed relative to other factors such as Value (P/B and 12-month
forward P/E) and Income (Dividend Yield and FCF Yield) over the last 25 years, both in
terms of annualized returns and on a return-risk ratio basis (see Exhibit 139).

EXHIBIT 139: Factor performance, annualized returns, global versus Asia ex-Japan (1990-2015)

10.0% Annualized Returns (LHS) Return Risk Ratio (RHS) 0.7

9.0%
0.6
8.0%

7.0% 0.5

6.0%
0.4
5.0%
0.3
4.0%

3.0% 0.2

2.0%
0.1
1.0%

0.0% 0.0
12m Fwd PE Div Yield FCF Yield P/B ROE LT Growth 12m price
movement

Source: MSCI, Bloomberg L.P., FactSet, Thomson Reuters, and Bernstein analysis.
However, over the last five years, Quality (by a simple ROE proxy) has performed very well
in Asia (ex-Japan), generating 5.5% annualized returns during this period. On a risk-
adjusted basis, it has been the best-performing factor over the last five years in Asia (ex-
Japan) (see Exhibit 140).

EXHIBIT 140: Annualized return risk ratio across factors, global versus Asia ex-Japan (2011-2015)

7.0% 0.7
Annualized Returns (LHS) Return Risk Ratio (RHS)

5.0% 0.5

3.0% 0.3

1.0% 0.1

-1.0% -0.1

-3.0% -0.3

-5.0% -0.5

-7.0% -0.7
12m price ROE Div Yield FCF Yield LT Growth 12m Fwd PE P/B
movement

Source: MSCI, Bloomberg L.P., FactSet, Thomson Reuters, and Bernstein analysis.

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BERNSTEIN

Almost as a consequence of the strong performance of the Quality factor in Asia (ex-
Japan) over the last five years, the P/B valuations of the high-ROE stocks relative to the
low-ROE stocks are near historical highs (see Exhibit 141).

EXHIBIT 141: ROE factor valuations, Asia (ex-Japan)

6.0
Current valuations are 47%
higher than the long term
average
5.0
P/B valuation

4.0

3.0

2.0

1.0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
ROE Average +1 / -1 std dev

Source: FactSet, MSCI, and Bernstein analysis.

U.S. QUANTITATIVE RESEARCH The Bernstein Quality Model developed by our U.S. Quant team ranks stocks within each
TEAM'S GLOBAL QUANT region based on the following six factors to arrive at a composite quality score:
QUALITY MODEL SIX-FACTOR
COMPOSITE SCORE
Latest ROE

ROE volatility

Year-over-year sales growth

Latest net margins

Sequential trend stability of ROE

Net cash ratio volatility (net cash ratio = [cash & equivalents short-term debt
long-term debt]/market cap)

For China A-shares, due to lack of reliable historical data, only ROE, year-over-year sales
growth, and net margins are used as parameters to construct the composite quality score.
The composite Quality scores are calculated on a region-relative basis. So, it is possible
for a dual-listed stock to have two different composite Quality scores based on its region
of listing.

Based on the composite Quality score, the stocks are ranked into quintiles. Quintile rank 1
indicates the highest-Quality stocks, while quintile rank 5 indicates the lowest Quality
stocks.

118 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

We screen ~2,900 stocks across 11 regional markets with market capitalizations of


greater than US$1 billion. Due to data sufficiency issues, the Bernstein Quality Model was
only able to generate Quality scores for ~1,600 of these names (see Exhibit 142). Nearly
83% of the stocks in our universe that did not have sufficient data to form a Quality score
were from the China A-shares basket.

EXHIBIT 142: Composition of our Quality screening universe (for the Bernstein Quality Model)

2000 100%
1800 90%
1600 80%
1400 70%
1200 60%
1000 50%
800 40%
600 30%
400 20%
200 10%
0 0%

No. of stocks screened for quality scores (LHS) % of stocks with quality scores (RHS)

Note: China (Shanghai Composite and Shenzhen Composite), Japan (Nikkei 225), India (Nifty CNX500), Korea (KOSPI200), Taiwan (TWSE), Hong Kong (HSCEI
and HSI), Indonesia (JCI Index), Thailand (SET50), Malaysia (FBMKLCI Index), Singapore (STI Index), and Philippines (PCOMP Index).

Source: Bloomberg L.P., MSCI, and Bernstein analysis.

China-listed stocks (Shanghai and Shenzhen listed) formed 51% of stocks for which the
Quality scores were generated by the Bernstein Quality Model (see Exhibit 143).
Industrials formed the largest sector (see Exhibit 144).

EXHIBIT 143: The composition of the Quality screening EXHIBIT 144: The composition of the Quality screening
universe for the Bernstein Quality Model (by region) universe for the Bernstein Quality Model (by sector)
2% China Industrials
2% 2%2% Japan Consumer Discretionary
5% 3%2%
India 4% Materials
6% 22%
Korea Financials
6%
Taiwan 7% Information Technology
7% 51%
Hong Kong
7% Consumer Staples
Indonesia 13% Health Care
8% Thailand Real Estate
12%
Malaysia Utilities
Singapore 12%
13% 12% Energy
Philippines Telecommunication Services

Source: Bloomberg L.P., MSCI, and Bernstein analysis. Source: Bloomberg L.P., MSCI, and Bernstein analysis.

In another quantitative method to identify Quality stocks, we adopted the factor-based


approach developed by our Europe Strategy team. We use ROE as a proxy for Quality. We

THE SEARCH FOR QUALITY CONTINUES 119


BERNSTEIN

identify the largest 300 stocks in Asia ex-Japan that are in the MSCI All Country World ex-
Japan Index. We rank the 300 names from this investment universe, from the highest to
the lowest in terms of ROE values. The top 60 stocks with the highest ROE form the top
quintile and the bottom 60 stocks with the lowest ROE form the bottom quintile. Within
the universe, China forms the dominant country (see Exhibit 145) and financials (see
Exhibit 146) have the highest representation within sectors.

EXHIBIT 145: The composition of the Quality screening EXHIBIT 146: The composition of the Quality screening
universe for the factor-based approach (by geography) universe for the factor-based approach (by sector)
China Financials
3% India 4% Industrials
3%3% 6%
Australia Consumer Discretionary
4% 26% 6% 23%
5% Korea Real Estate
6%
Hong Kong Materials
7%
Taiwan 8% Consumer Staples
Thailand 10% Technology
10%
14% Malaysia 8% Telecom
Indonesia 10% Energy
11% 9%
12% Philippines 9% Utilities
Singapore Health Care

Source: Bloomberg L.P., FactSet, MSCI, and Bernstein analysis. Source: Bloomberg L.P., FactSet, MSCI, and Bernstein analysis.

Exhibit 147 presents the price performance of the top 30 Quality stocks as indicated by
the Bernstein Quality Model. The list is dominated by financials, which form 15 of the top
30 high-Quality names. Exhibit 148 presents the list of the top 30 stocks by market
capitalization. This list is dominated by technology names, while there are only five
financials, in contrast to the top 30 Quality names from the Bernstein Quality Model,
which was dominated by financials.

120 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 147: Price performance of the top 30 stocks by market cap (as indicated by the Bernstein Quality Model)
Quality Percentile Quality Quintile Share Price Performance
Market Cap
Ticker Company Sector (Bernstein Quality (Factor-based
($Bil) 2012 2013 2014 2015 YTD
Model) approach)
700 HK Equity Tencent Holdings Ltd 260 Technology 2 2 60% 99% -77% 36% 39%
941 HK Equity China Mobile Ltd 248 Telecom 35 3 19% -11% 13% -3% 7%
601398 CH Equity ICBC 233 Financials 16 na -2% -14% 36% -6% -4%
1398 HK Equity ICBC 233 Financials 57 2 19% -5% 8% -17% 2%
005930 KS Equity Samsung Electronics Co Ltd 206 Technology 79 3 44% -10% -3% -5% 26%
7203 JT Equity Toyota Motor Corp 190 Consumer Discretionary 9 1 56% 60% 18% -1% -20%
857 HK Equity PetroChina Co Ltd 189 Energy 100 5 14% -23% 1% -41% 6%
601857 CH Equity PetroChina Co Ltd 189 Energy 96 na -7% -15% 40% -23% -12%
601939 CH Equity China Construction Bank Corp 186 Financials 10 na 1% -10% 63% -14% -11%
939 HK Equity China Construction Bank Corp 186 Financials 40 2 15% -6% 9% -17% 8%
2330 TT Equity TSMC 151 Technology 1 1 28% 9% 34% 1% 31%
601288 CH Equity Agricultural Bank of China Ltd 151 Financials 10 na 7% -11% 50% -13% -3%
1288 HK Equity Agricultural Bank of China Ltd 151 Financials 41 2 15% -1% 3% -19% 3%
5 HK Equity HSBC Holdings PLC 147 Financials 39 na 38% 4% -12% -16% -5%
601988 CH Equity Bank of China Ltd 145 Financials 10 na 0% -10% 58% -3% -15%
3988 HK Equity Bank of China Ltd 145 Financials 51 4 21% 3% 22% -21% 1%
9437 JT Equity NTT DOCOMO Inc 100 Telecom 6 2 -12% -99% 2% 40% 3%
9432 JT Equity Nippon Telegraph & Telephone Corp 95 Telecom 33 3 -8% 56% 10% -22% -3%
2318 HK Equity Ping An Insurance Group Co of China 94 Financials 18 2 27% 7% 14% -46% -6%
601318 CH Equity Ping An Insurance Group Co of China 94 Financials 14 na 32% -8% 79% -52% -5%
386 HK Equity China Petroleum & Chemical Corp 88 Energy 98 5 7% -28% -1% -25% 25%
600028 CH Equity China Petroleum & Chemical Corp 88 Energy 82 na -4% -35% 45% -24% 0%
2628 HK Equity China Life Insurance Co Ltd 86 Financials 54 4 32% -4% 26% -18% -17%
601628 CH Equity China Life Insurance Co Ltd 86 Financials 58 na 21% -29% 126% -17% -24%
2914 JT Equity Japan Tobacco Inc 81 Consumer Staples 1 1 -99% 40% -3% 34% -11%
9433 JT Equity KDDI Corp 80 Telecom 3 1 -99% 6% 18% -59% -3%
1299 HK Equity AIA Group Ltd 80 Financials 34 4 25% 29% 11% 8% 13%
9984 JT Equity SoftBank Group Corp 77 Telecom 27 1 39% 193% -22% -15% 8%
TCS IS Equity Tata Consultancy Services Ltd 72 Technology 1 1 8% 73% 18% -5% -2%
8306 JT Equity Mitsubishi UFJ Financial Group Inc 71 Financials 67 4 41% 51% -4% 14% -32%

Source: Bloomberg L.P., FactSet, MSCI, and Bernstein analysis.

THE SEARCH FOR QUALITY CONTINUES 121


BERNSTEIN

EXHIBIT 148: Price performance of the top 30 stocks by market cap (as indicated by the factor-based approach)
Quality Percentile Share Price Performance
Market Cap
Company Sector (Bernstein Quality
($Bil) 2012 2013 2014 2015 YTD
Model)
Alibaba Group Hldg ADR 267 Technology na nm nm nm -22% 27%
Taiwan Semiconductor Mfg 153 Technology 1 28% 9% 34% 1% 31%
Tata Consultancy 71 Technology 1 nm nm nm -5% -2%
Baidu ADR 64 Technology na -14% 77% 28% -17% -7%
Telstra Corp 48 Telecom na 31% 20% 14% -6% -10%
ITC 44 Consumer Staples 7 42% 12% 15% -11% 13%
CSL 37 Healthcare na 68% 28% 26% 21% 0%
Infosys 36 Technology 1 nm nm nm -44% -6%
Sands China 36 Consumer Discretionary 12 55% 87% -40% -30% 29%
Telekomunikasi Indonesia 33 Telecom 3 28% -76% 33% 8% 37%
Housing Dev Finance Corp 34 Financials na 27% -4% 43% 11% 7%
Hongkong Exch & Clearing 33 Financials 36 6% -2% 33% 16% 3%
Netease com ADR 33 Technology na -5% 85% 26% 83% 44%
Coal India 30 Energy 6 18% -18% 32% -14% -5%
Bank Central Asia 30 Financials 9 14% 5% 37% 1% 20%
Formosa Petrochemical 29 Energy 46 -8% -5% -16% 15% 29%
PICC Ppty & Casualty H 25 Financials 29 3% 6% 31% 2% -16%
Bank Rakyat Indonesia 23 Financials 6 3% 4% 61% -2% 7%
Woolworths Ltd 23 Consumer Staples na 17% 15% -9% -20% -1%
Siam Cement 18 Materials na 28% -13% 11% 1% 11%
Siam Cement Fgn 18 Materials na 28% -13% 11% 1% 11%
Wipro 17 Technology 3 -1% 42% -1% 1% -15%
HCL Technologies 17 Technology 1 59% 104% 26% -46% -3%
Largan Precision Co 17 Technology 1 37% 56% 97% -5% 63%
CP All PCL 16 Consumer Staples 31 -11% -9% 1% -8% 55%
Westfield Corp 15 Real Estate na 35% -4% -11% 5% -1%
Brambles 15 Industrials na 5% 22% 16% 9% 4%
Advanced Info Service 14 Telecom 2 49% -5% 26% -39% 2%
SK Holdings 13 Industrials 40 -12% 31% 58% 13% -5%
LG Household & Health 13 Consumer Staples 21 35% -17% 14% 69% -14%

Source: Bloomberg L.P., FactSet, MSCI, and Bernstein analysis.

ASIA-PACIFIC EQUITY STRATEGY What does our Asia-Pacific Equity Strategy team's more recent regional analyses based
TEAM'S REGIONAL QUANT on quantitative proxies say about Quality stocks in Asia? About a year and a half ago, we
QUALITY SCREEN FILTER BY
attempted to identify Quality stocks in Asia based on four characteristics: balance sheet
FOUR QUALITY
CHARACTERISTICS strength, execution ability, management quality, and sustainable competitive advantages
(Asia Strategy: Quality in Asia... What Does It Look Like and Can You Get Paid for It?). We
adopted four quantitative proxies for these characteristics:

Net debt to assets below 30%;

Free cash flow positive;

Non-operating income or loss of less than 20% of operating income; and

ROIC materially higher than the cost of capital.

We used free cash flow as a measure of execution capabilities. We used non-operating


income as a measure of transparency, and therefore, management integrity arguing that a
quality management team will report the basis upon which they make money. We used

122 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

ROIC as a measure to reflect sustainable competitive advantage and low debt to reflect
financial prudence.

We applied this approach to the MSCI Asia ex-Japan universe, the Shanghai Composite,
the Shenzhen Composite, and the Hong Kong Stock Exchange.

EXHIBIT 149: Composition of Quality universe and Quality stocks in Asia ex-Japan

1,600 25

1,400
20
1,200

1,000
15

800

10
600

400
5
200

0 0
MSCI Asia ex- Shanghai Shenzhen HKSE KOSPI 200 Nifty CNX500
Japan Composite Composite

Stock universe for quality screening (LHS) No. of quality stocks (RHS)

Source: Bloomberg L.P., MSCI, and Bernstein analysis.

Of the 682 companies in MSCI Asia ex-Japan with market capitalizations greater than
US$1 billion, 21 stocks satisfied our Quality metrics consistently since 2009. The Quality
list is dominated by names from technology, healthcare, consumer, and telecom (see
Exhibit 150). In addition to MSCI Asia ex-Japan, we selected ~3,500 stocks with market
capitalizations greater than US$1 billion, spread across the Shanghai Composite (944),
the Shenzhen Composite (1431), the Hong Kong Stock Exchange (446), KOSPI 200
(200), and the Nifty CNX500 (500). We applied our Quality filters to arrive at a list of 33
Quality stocks across these markets (see Exhibit 151).

THE SEARCH FOR QUALITY CONTINUES 123


BERNSTEIN

EXHIBIT 150: Price performance of Quality stocks from MSCI Asia ex-Japan
Quality Percentile Quality Quintile Share Price Performance
Market Cap
Company Sector (Bernstein Quality (Factor-based
($Bil) 2012 2013 2014 2015 YTD
Model) approach)
TSMC 153 Technology 1 1 28% 9% 34% 1% 30%
Tata Consultancy 71 Technology 1 1 8% 73% 18% -5% -3%
ITC 44 Consumer Staples 7 1 42% 12% 15% -11% 11%
CSL 37 Healthcare na 1 68% 28% 26% 21% -1%
PT Telkom 33 Telecom 3 1 28% -76% 33% 8% 37%
NAVER 26 Technology na 2 8% 219% -2% -8% 29%
Unilever Indonesia 26 Consumer Staples 5 2 11% 25% 24% 15% 21%
Woolworths 23 Consumer Staples na 1 17% 15% -9% -20% -1%
Asian Paints 17 Materials 3 2 71% -89% 54% 17% 34%
HCL Tech 17 Technology 1 1 59% 104% 26% -46% -5%
Haier 5 Consumer Discretionary na na 63% 98% -18% -15% -17%
Largan 17 Technology 1 1 37% 56% 97% -5% 63%
Advanced Info 14 Telecom 2 1 49% -5% 26% -39% 3%
Shenzhou Intl 10 Consumer Discretionary na 2 66% 66% -12% 74% 14%
DiGi.com 9 Telecom 5 1 36% -6% 24% -12% -8%
Singapore Exchange 6 Financials 6 na 14% 4% 8% -1% -6%
Divi's Lab 5 Healthcare 2 na 42% 11% 41% -33% 6%
China Medical System 4 Healthcare na na 16% 38% 55% -11% 11%
BEC W orld 1 Consumer Discretionary 1 na 58% -29% 1% -40% -35%
Berjaya Sports 1 Consumer Discretionary na na 1% -9% -13% -13% 4%
FIH 1 Consumer Discretionary na na -1% -13% -1% -33% -22%

Note: For percentiles, 1 = high Quality, 100 = low Quality. For Quintiles, 1 = high Quality, 5 = low Quality.

Source: Bloomberg L.P. and Bernstein analysis.

EXHIBIT 151: Price performance of Quality stocks from Mainland China, Hong Kong, Korea, and India
Quality Percentile Quality Quintile Share Price Performance
Market Cap
Company Sector (Bernstein Quality (Factor-based
($Bil) 2012 2013 2014 2015 YTD
Model) approach)
Samsung Electronics 213 Information Technology 79 3 44% -10% -3% -5% 26%
Tata Consultancy 71 Information Technology 1 1 8% 73% 18% -5% -2%
Kweichow Moutai 57 Consumer Staples 16 na 8% -39% 48% 15% 41%
ITC 44 Consumer Staples 7 1 42% 12% 15% -11% 13%
Infosys 36 Information Technology 1 1 -16% 50% -43% -44% -6%
NAVER 26 Information Technology 20 2 8% 219% -2% -8% 29%
Amorepacific Corp 19 Consumer Staples 2 2 15% -18% 122% -81% -10%
Asian Paints 17 Materials 3 2 71% -89% 54% 17% 33%
HCL Tech 17 Information Technology 1 1 59% 104% 26% -46% -3%
Jiangsu Yanghe Brewery 15 Consumer Staples 10 na -28% -56% 94% -13% 0%
LG Household 13 Consumer Staples 21 1 35% -17% 14% 69% -14%
Hero Moto 10 Consumer Discretionary 6 1 0% 9% 50% -13% 27%
Shenzhou Intl. 10 Consumer Discretionary na 2 66% 66% -12% 74% 17%
NMDC 7 Materials 0 na 3% -14% 2% -38% 30%
Fuyao Glass 7 Consumer Discretionary 10 na 9% -5% 46% 25% 18%
Aisino 6 Information Technology 35 na -25% 36% 51% 83% -19%
Halla Visteon 6 Consumer Discretionary 59 na 9% 64% 25% 7% 10%
Dong-E-E-Jiao 6 Healthcare 2 na -6% -2% -6% 40% 12%
Divi's Lab 5 Healthcare 2 na 42% 11% 41% -33% 11%
Haier 5 Consumer Discretionary na na 63% 98% -18% -15% -14%
China Medical System 4 Healthcare na na 16% 38% 55% -11% 12%
Colgate 4 Consumer Staples 38 na 58% -14% 32% -46% -6%
P&G 3 Consumer Staples 0 na 46% 10% 91% -3% 24%
VTech 3 Information Technology na na 12% 16% 10% -28% 13%
Shandong Denghai Seeds 2 Consumer Staples 10 na -18% 47% -8% -47% 4%
Kehua Bio-Engineering 2 Healthcare 28 na 2% 60% 26% 37% -21%
Biostime 2 Consumer Staples na na 77% 186% -77% 0% 24%
Hebei Chengde Lolo 2 Consumer Staples 16 na -3% 78% -10% -25% -13%
Grand Korea Leisure 1 Consumer Discretionary 0 na 57% 41% -20% -25% -5%
Shandong Shanda WIT 1 Healthcare 0 na 33% 95% -15% 35% 38%
Sa Sa 1 Consumer Discretionary na na 48% 43% -40% -52% 33%
Huabao 1 Materials na na -3% 12% 48% -55% 7%
Shandong Luoxin 1 Healthcare na na 56% -20% 127% -17% -25%

Note: For percentiles, 1 = high Quality, 100 = low Quality. For Quintiles, 1 = high Quality, 5 = low Quality.

Source: Bloomberg L.P. and Bernstein analysis.

124 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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Clearly, quantitative approaches have their limitations. For one, the Quality screening
universe generally tends to be restricted to the large-cap stocks present in MSCI indices.
This is particularly true for the factor-based approach. The factor-based approach also
relies on mean reversion (the valuation of factors tends to revert to the long-term average)
to assign stocks within the factor to a long-short portfolio, which, in turn, determines the
top and bottom quintiles. This clearly does not take into account the risk of disruption. In
the event of disruption, the mean reversion may not happen at all. This is especially true
for healthcare where the success of a new, untested drug or the strength of the new drug
pipeline may result in a higher risk of disruption.

The Bernstein Quality Model developed by our U.S. Quant team calculates quality scores
for the stocks relative to the region they are listed in. Therefore, the function of a stock
being in a high-Quality or a low-Quality quintile is as much a function of its inherent
Quality as it is about the Quality of other stocks in the region. In addition, given the
quintile-based rankings of Quality stocks, we end up with 300 top quintile Quality names
in a universe of 1,500 stocks. To imagine that there are 300 top Quality names in Asia
tends to be a little hard to digest from a fundamental, non-quant perspective.

In Exhibit 152, we summarize the quantitative approaches discussed in this section. One
of the key differences that emerge is that financials dominate the top-Quality names in the
Bernstein Quality Model. However, in our analysis using quantitative proxies, we have
excluded financials on the basis that cash flow and debt metrics, for example, aren't
particularly useful measures and that we believe that banks are rarely able to achieve
sustainable competitive advantages.

EXHIBIT 152: A summary of quantitative approaches


Quantitative Approach Screening criteria Screening universe Dominant top quality sectors
Bernstein Quality Model Latest ROE Financials (19%)
China Mainland (A - shares)
ROE volatility Industrials (16%)
1-year sales growth
Latest net margins Financials (18%)
Emerging Asia
Sequential trend stability of ROE Technology (14%)
Net cash ratio volatility
Industrials (34%)
Developed Asia (Japan, Singapore, Hong Kong)
Financials (13%)
Factor-based approach ROE Consumer Staples (17%)
MSCI All Country World Asia ex-Japan Index Technology (13%)
Healthcare (5%)
Quantitative proxies Net debt to assets below 30% Technology (24%)
MSCI Asia ex-Japan
Positive free cash flow Consumer Discretionary (24%)
Non-operating income / (loss) as
% of operating income
ROIC materially higher than cost
of capital China Mainland (A - shares), India (Nifty Consumer Staples (30%)
CNX500), Korea (KOSPI 200) Technology (21%)
Consumer Discretionary (21%)

Source: Bloomberg L.P., MSCI, FactSet, and Bernstein analysis.

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BERNSTEIN

126 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

IS IT INDIA'S TURN? PART I


What can we learn from China's rise?

OVERVIEW

By a number of economic indicators, India today is similar to China in 2000-05. Over this
period, China pursued an aggressive policy of infrastructure development, urbanization,
and export growth, which have made it the world's largest economy on a PPP basis.
China's GDP has expanded at a 10% CAGR, contributing a net increase of 30% of global
GDP, and China's share of total global GDP expanded from 4.5% in 2004 to 15% in
2015.

With the rate of growth in China now inevitably slowing, the world is starting to turn its
attention to India, which will soon pass China to become the world's most populous
country. Can the China miracle be repeated?

In this chapter, we compare and contrast the differences in India today with those of
China of the early 2000s. We also review the policies that helped propel China forward in
growth and the resulting implications for investors.

This chapter is divided into three sections:

India today is similar to China in 2000-2005but with some important differences

Key lessons from the last 15 years of Chinese development

Investment implications from Chinese returns over the last 15 years

INDIA TODAY IS AT A SIMILAR LEVEL OF DEVELOPMENT TO


CHINA IN 2000-05

GDP per capita in China reached US$7,925 per annum at the end of 2015, growing at a
remarkable 10.7% CAGR since 1978 when Deng Xiaoping first started to reform and
open up the economy (see Exhibit 153). In comparison, GDP per capita in India today is at
c.US$1,600 per annum. While the gap seems incredibly large, India today is basically
equivalent to where China was in 2004.

Over the last 11 years since China was at current Indian levels of GDP per capita, GDP for
China has expanded at a 10% CAGR contributing a net increase of 30% of global GDP,
and China's share of total global GDP has expanded from 4.5% to 15% over this period
(see Exhibit 154).

IS IT INDIA'S TURN? PART I 127


BERNSTEIN

Other comparisons between China and India all point to India's current level of
development similar to where China was between 2000 and 2005. With China's rate of
growth now slowing, many investors are questioning whether India can repeat the miracle
and propel global growth forward similar to how China has over the past 10-15 years.

In this chapter, we hope to illuminate the stark differences in the structure of the
economies of these two giants at a similar stage of growth, and review:

The difference in composition of GDP and drivers of growth

The role of Foreign Direct Investment (FDI) and the ease of doing business

Demographic trends and implications

We expect these differences will lead to a different path for India, but we also believe
there is much that India can learn from China.

EXHIBIT 153: China GDP per capita is 5x that of India


9,000
0.8X 1.1X 1.3X 1.7X 2.0X 2.1X 2.4X 2.3X 2.5X 3.4X 3.3X 4.3X 4.8X 5.0X
8,000
GDP per capita, current prices US$
7,000

6,000

5,000

4,000

3,000

2,000

1,000

-
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2015
India China

Note: GDP per capita is in nominal terms. There is an additional impact of current movements against the USD.

Source: World Bank and Bernstein analysis.

128 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 154: Share of world GDP by country (%)

15 14.8
India
China
10

5 4.5
2.8
1.4 1.6 1.7

0
1990 2004 2015

Source: World Bank and Bernstein analysis.

Until the late 1980s, both the economies were at a similar scale. China's pace of growth
only lifted to 10% levels post the Chinese economic reforms of 1978-84 (see Exhibit
155). India has experienced a slower rate of growth (6-7%) since the beginning of its
reforms in the early 1990s.

EXHIBIT 155: Real GDP CAGR (%): China's GDP growth rate has outperformed India's since the 1970s

11 10 11
China
10 9 India
9
8 8
7
7 7
6
6 6 6
5
4 4
4
3
3
2
1
0 Years
196070 197080 198090 199000 200010 201015

Note: Real GDP is in USD, not PPP.

Source: World Bank and Bernstein analysis.

IS IT INDIA'S TURN? PART I 129


BERNSTEIN

COMPONENTS OF GROSS The composition of the GDP of India today is very different from that of China in 2000-05.
DOMESTIC PRODUCT While on a per capita basis India is now at a similar size to that of China of 2004,
DIFFERENT DRIVERS
manufacturing (including mining) comprises only 20% for India today versus 41% for
China in 2004 India instead has larger agricultural and service sectors (see Exhibit
156). On a consumption basis, India has been driven by households, whereas China has
had relatively high gross capital formation and higher government expenditures (see
Exhibit 157).

EXHIBIT 156: Manufacturing has historically accounted for a large share of the GDP for China

2004 2015
100

90

80 41
47
70 56 55
Share in GDP (%)

60

50

40 41
17 36 20
30

20
27 24
10 19 16
0
China India China India

Agriculture Manufacturing Services

Note: Manufacturing includes mining.

Source: World Bank, RBI, China's National Bureau of Statistics (China NBS), and Bernstein analysis.

130 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

EXHIBIT 157: India is a consumption-driven economy but China is an investment-driven economy

2004 2015
100

32 34
80
43 46
Share in GDP (%)

60

40 58 58
41 37

20

14 11 14 11
0

-20
China India China India

Government Consumption Capital Formation Net Exports

Source: World Bank, RBI, China NBS, and Bernstein analysis.

The higher level of capital formation in the Chinese economy has resulted in significantly
different levels of infrastructure development between the two countries. To anyone
visiting Shanghai and Mumbai, the differences are very stark even in the business
capitals of the two countries.

Whether we look at highway density, goods transported per capita by rail or air, power
consumption per capita, or air passengers per capita, it is clear that the level of activity in
India is in many cases well below the 15-year "GDP per capita gap" and closer to a 20-25-
year gap (see Exhibit 158 to Exhibit 162). The only infrastructure metric where India is
comparable to China is on access to improved water facilities (see Exhibit 163).

The gap is also wide in consumer durables, including the ownership of cars, televisions,
refrigerators, and air conditioners (see Exhibit 164 to Exhibit 167). However, the gap is
less severe in IT-related fields closer to around five years in smartphone and the
Internet penetration (see Exhibit 168 and Exhibit 169). Other consumer metrics such as
credit card penetration also show India trailing considerably.

IS IT INDIA'S TURN? PART I 131


BERNSTEIN

EXHIBIT 158: India is far behind China in EXHIBIT 159: railroads. EXHIBIT 160: air travel
infrastructure build and usage like
highways

Length of Highway per Sq. Railway Goods Transported Air Freight Transported per
0.50 Km of Land Area per Capita Capita
15
0.40 2000
0.30 10
1500
km

ton-km

ton-km
0.20 1000
5
0.10 500

0.00 0 0

1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014

1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
2013
China India China India China India

Source: Government websites and Bernstein Source: Government websites and Bernstein Source: Government websites and Bernstein
analysis. analysis. analysis.

EXHIBIT 161: shipping EXHIBIT 162: and electricity EXHIBIT 163: India is comparable to
China in clean water access

Container Port Traffic per Electric Power Consumption Access to Improved Water
0.15
Capita per Capita Source (% of Population)
20-Foot Equivalent Units (TEUs)

4,000 100%
KWh per Capita

0.10 3,000 90%

2,000 80%
0.05
1,000 70%

0 60%
0.00 1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

China India China India China India

Source: Government websites and Bernstein Source: Government websites and Bernstein Source: Government websites and Bernstein
analysis. analysis. analysis.

EXHIBIT 164: India is also far behind EXHIBIT 165: televisions EXHIBIT 166: refrigerators.
China in durables ownership, including
cars

Passenger Vehicle TV Household Peneration Refrigerator Household


Ownership Penetration
140%
8.0% 120% 100%
100% 80%
6.0%
80%
60%
4.0% 60%
40% 40%
2.0% 20% 20%
0%
0%
0.0%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

China India
China India China India

Source: Organisation Internationale des Source: Government websites and Bernstein Source: Government websites, Ernst & Young (EY),
Constructeurs d'Automobiles (OICA) and Bernstein analysis. and Bernstein analysis.
analysis.

132 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 167: and air conditioners EXHIBIT 168: However, India's gap to EXHIBIT 169: and Internet penetration
China is narrower in smartphone
penetration

Air Conditioner Household Smartphone Penetration Internet Penetration


Penetration
60% 60%
100% 50%
50%
80% 40%
40%
60% 30%
30%
40% 20%
20%
20% 10%
10%
0% 0%
0%

1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2007 2008 2009 2010 2011 2012 2013 2014

China India China India China India

Source: Government websites, EY, and Bernstein Source: Gartner and Bernstein analysis. Source: World Bank and Bernstein analysis.
analysis.

THE ROLE OF INTERNATIONAL The huge local market, business supportive policies, the availability of lower wages, and
TRADE IN DRIVING GROWTH less stringent labor laws made China an attractive destination for Western investment.
Over time, ecosystems and supply chains developed, helping China to become the export
hub of the world. In India, a lack of government focus, skilled labor, stringent labor laws,
and bureaucratic approval processes created barriers to investment.

While China's exports have grown 10x in the last 12-13 years, achieving an overall net
export balance of over US$550 billion, India remains a net importer, with an export scale
comparable to what China had in 2002-03 (see Exhibit 170 and Exhibit 171). The
composition of exports for China is almost entirely manufactured goods (95%), while for
India, the pie is much smaller, and manufactured goods account for only ~70% of total
exports (see Exhibit 172 and Exhibit 173).

EXHIBIT 170: China's net goods exports are US$560 billion EXHIBIT 171: whereas India is a net importer with export
against gross exports of US$2.1 trillion volumes similar to China in 2002/03

2,500 2,500
China Trade of goods (US$ bn) India Trade of goods (US$ bn)

2,000 2,000

1,500 1,500

1,000 1,000

500 500

- -
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014

Net exports (US$bn) Imports (US$bn) Net imports (US$bn) Imports (US$bn)
Exports (US$bn) Exports (US$ bn)

Source: IMF and Bernstein analysis. Source: IMF and Bernstein analysis.

IS IT INDIA'S TURN? PART I 133


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EXHIBIT 172: Since the early 2000s, over 90% of China's exports have been manufactured goods

100% 5%
6% 10% 7%
13% 12%
15%
80% 7%

29% 8%
60%
91% 92% 94% 94% 94%
85% 88%
40% 26% 82%
76%
63%

20%
26%

0%
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Metals Agriculture Food Others Fuel Manufacturedproducts

Source: World Bank and Bernstein analysis.

EXHIBIT 173: Manufactured goods only represent ~70% of India's exports; fuel and food rank much higher than in China

100%
8% 8% 6%
12%
16% 18% 13% 11% 15% 19%
13%
80% 17% 17%
12%
25% 9% 8% 11%

60%

40% 72% 72% 76% 74% 78% 77%


66% 67% 71%
65%
58%
20%

0%
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015

Manufactured Metals Agriculture Fuel Food Others

Source: World Bank and Bernstein analysis.

AUTO MANUFACTURING HAS While India's manufacturing sector has failed to gain a significant share in international
BEEN AN OUTLIER IN INDIA markets, automobiles have been an outlier. Most of India's current auto/auto parts market
is domestically manufactured, and India fares well in exports of two-wheel vehicles.

The genesis of this was the government's automobile policy adopted in 1993. This
allowed for automatic approvals for foreign holdings up to 51%, a reduction in excise and
import duties (for components, etc.), as well as indigenization schedules for foreign
vendors. The large domestic base with low levels of existing ownership and increasing
incomes made India an attractive market for foreign producers. Not surprising, a large

134 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


BERNSTEIN

number of international companies formed partnerships with Indian vendors. The


establishment of manufacturing facilities by international companies led to the
development of a large number of auto ancillary providers, a few of which have expanded
to become large exporters for global manufacturers. On the finished vehicle side, exports
are largely for two-wheelers for which Africa and other developing countries are key
markets. Moreover, a number of international producers are exporting to other
geographies, capitalizing on the lower labor costs as well as spare domestic capacity.

While manufacturing units in India started as pure assembly operations (major


components were imported), the growing scale of local demand and local customization
requirements enabled a large number of auto parts manufacturers to establish domestic
operations. With growing domestic scale and a focus on quality, as well as lower labor
costs, India is now exporting components to leading global manufacturers. Today, India is
a net exporter in the auto sector, with passenger vehicle exports at a similar level to China
(see Exhibit 174 and Exhibit 175).

EXHIBIT 174: India is a net exporter of both vehicles and auto EXHIBIT 175: and has a similar level of exports of
components passenger vehicles as China

7,000 Auto exports (US$ mn)


India auto trade (US$ mn)
30,000 28,281
6,000 5,654

25,000
5,000

3,885 3,795 20,000


4,000

3,000 15,000

2,000 10,000
6,449
5,654
1,000 780 5,000 3,885 3,677
235 780
31
- -
Auto parts Passenger Goods vehicles Auto parts Passenger Goods vehicles
vehicles vehicles

Exports (US$ mn) Imports (US$ mn) India China

Source: UN Comtrade and Bernstein analysis. Source: UN Comtrade and Bernstein analysis.

SERVICES: INDIA IS VERY Another key difference between the two countries is in service exports. On an aggregate
STRONG IN IT SERVICES LIKE basis, China's service exports at US$211 billion appear to be well ahead of India, which is
CHINA IS IN TRADE-RELATED
at US$155 billion. However, in China, exports are largely led by travel (tourism) and
SERVICES
services related to construction and trade which, in turn, depend on goods exported
from China. India, on the other hand, is highly skewed to pure services with a large
dependence on computer and IT-related services (see Exhibit 176 and Exhibit 177). This
is clearly another area where India should continue to invest and grow.

IS IT INDIA'S TURN? PART I 135


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EXHIBIT 176: Growth in service exports over 15 years EXHIBIT 177: The value of service exports by segment
yoy growth in services revenue from exports 100%
70%
90%
60% 29%
80%
50% 45%
70%
40%
60%
30%
50% 10%
20% 47%
40%
10%
30% 27%
0%
20% 13%
-10%
10% 18%
-20% 12%
0%
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
India China

India China Transportation Travel Computer & IS Others

Source: UN Comtrade and Bernstein analysis. Source: UN Comtrade and Bernstein analysis.

THE ROLE OF FOREIGN DIRECT Both India and China are attractive for international companies looking to access cheaper
INVESTMENT (FDI) labor as well as a large domestic market. However, while China has been one of the most
favored FDI destinations, India failed to scale up (see Exhibit 178). The current FDI run
rate in India is less than one-fifth that of China.

We believe that the differences are largely explained by: 1) the earlier opening up of
China's economy (from 1978) than that of India (1990s); 2) China's superior
infrastructure; 3) an easier business climate with regard to approvals; and 4) China's
vertical structure with a single regulatory body as opposed to the federal structure in India
with multiple government bodies (RBI, the Foreign Investment Promotion Board, the
Ministry of Commerce, etc.), which make approvals in India significantly slower and more
cumbersome.

While for China the bulk of the FDI is concentrated in manufacturing and real estate (over
60%), in India the highest share has gone into the services sector, led by computer
services (see Exhibit 179 and Exhibit 180).

136 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 178: FDI in India is less than one-fifth that of China


300
FDI inflow comparison (US$ bn)
250
250 241

200

150 133 131

100
58
44 42 44
50 34 36
20 24
0 3 0 4 1 4 4 4
-
1988

1991

1994

1997

2000

2003

2006

2009

2012

2015
India China

Source: World Bank and Bernstein analysis.

EXHIBIT 179: Breakdown of FDI in China by sector (2014) EXHIBIT 180: Breakdown of equity FDI in India by sector
(FY2016)
Tech IT & Utility, Others, Power, Pharma,
Telecom,
Serv., Computing, 2% 5% 2% 2% Construc
3% 3% tion,
2%
0%
Tourism,
Financials,
3%
3%

Transport & Chemicals,


Manu-
Logistics, 4%
facturing,
4% Auto,
33%
Wholesale 6%
Others,
& Retail, 37%
8%
Trading,
Leasing & 10%
Comm.
Serv.,
10% Computer
Software,
Services,
Property, 15% 17%
29%

Source: China NBS and Bernstein analysis. Source: Department of Industrial Policy and Promotion, and Bernstein analysis.

EASE OF DOING BUSINESS Neither India nor China score highly on the "ease of doing business" metric; however, here
again, China is significantly ahead. China has traditionally scored in the 80-90 range as
compared to India, which is nearer to 130 (note, in this case, the lower the better). These
rankings are significantly lower than other leading manufacturing and service companies
globally the United States ranks at 8, the United Kingdom at 7, and Korea at 5 (see
Exhibit 181).

IS IT INDIA'S TURN? PART I 137


BERNSTEIN

India significantly lags China in three areas: registering property, insolvency laws, and
enforcing contracts the only area where India appears to score more favorably is in
obtaining credit. These rankings have remained relatively constant over the last decade
(see Exhibit 182 and 183).

EXHIBIT 181: Rankings for key/large manufacturing- and services-focused countries globally

Spain, 32

UK, 7 France, 29

Canada, 22
Korea, 5 Mexico, 47

Germany, 17 Philippines, 99 India, 130

Russia, 40
Australia, 15 Indonesia, 91 Brazil, 123
Italy, 50
Japan, 34 China, 78 Argentina, 116
United States, 8

0 20 40 60 80 100 120 140


Rankings for ease of doing business

Source: World Bank Group and Bernstein analysis.

EXHIBIT 182: Rankings for both countries have largely remained similar across years
160
Rankings for ease of doing business
142
140 133 134 132 132 134 131 130
120 122
120

96
100 89 91 91 90
83 83 84
79 78
80

60

40

20

0
2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

China India

Source: World Bank Group and Bernstein analysis.

138 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 183: Major reforms undertaken by China and India


Areas China India
Eliminated minimum capital and certification requirement to
2015
commence operations
Eliminated the requirements of minimum capital and a capital Reduced registration fees, but introduced a requirement to file
2014
Starting a verification report from an auditing firm declaration before starting a business
Business Exempted micro and small companies from paying several
2012
administrative fees from January 2012 to December 2014
Established an online VAT registration system and replaced
2010
physical stamps with online versions
2012 Streamlined and centralized preconstruction approvals Established strict time limits for preconstruction approvals
Dealing with
Construction Electronic processing for building permit applications and
permits 2007 allowed online application of safety certificates for construction
companies
Eliminated internal wiring inspections (in Delhi) and improved
2015
Getting working processes of utilities (in Mumbai)
electricity Reduced the security deposit for getting a connection (in
2014
Mumbai)
Introducing credit information on industry regulations, which
2013
guaranteed borrowers right to check their data
New property law expanded range of assets that can be used as
Getting credit 2008
collateral (Included receivables)
Introduced a new law that gave secured creditors a priority in Launched unified and centralized collateral registry; credit
2007
payment information made available at the private credit bureau

Protecting Enhanced disclosure requirements by board members; more


minority 2014 remedies for prejudicial related-party transactions; additional
investors safeguards for shareholders
Social security contribution rate reduced for Shanghai
2015
companies
Enhanced electronic system for filing/paying taxes; adopted new
2014
communication channels in its taxpayer service

Paying taxes 2011 Introduced mandatory electronic filing and payment for VAT

Unified the tax regimes for domestic and foreign enterprises;


2010 Abolished the FBT and improved electronic payment system
clarification on calculation of taxable income for corporates

Reduced corporate income tax rate and unified the criteria and
2008
accounting methods for tax deductions
2009 Relaxed trade credit restrictions

Implemented an electronic data interchange system, thereby


2008
Trading across reducing time taken for exports
borders
ICEGATE system for online lodging of customs declarations,
2007 risk management, and electronic payments; system also allows
shipping lines to submit cargo manifest in advance

Amended its civil procedure code to streamline and speed up all


2013
Enforcing court proceedings
contracts Tightened the rules on enforcement of judgments, limiting ways
2008
to hide assets and escape enforcement
New enterprise bankruptcy law containing reorganization
Resolving procedures allowed the formation of creditors committees,
2007
insolvency granted rights to secured creditors, and established a role for
professional bankruptcy administrators

Source: World Bank and Bernstein analysis.

DEMOGRAPHICS: INDIA IS A Both India and China had similar population demographics in the 1970s a population
YOUNGER COUNTRY, WITH AN growth rate of ~2% and an age pyramid highly skewed toward a younger population, with
AGE DEMOGRAPHY SIMILAR TO
~40% of the population below the age of 14. It was at this stage that China enacted the
THAT OF CHINA OF 1995
one-child policy (1979), slowing population growth and shifting the median age upward.
India, on the other hand, continued to grow at a much faster pace supported by improved
healthcare and higher income levels (see Exhibit 184).

IS IT INDIA'S TURN? PART I 139


BERNSTEIN

Today, only 18% of the population is below the age of 14 in China versus 29% in India
(see Exhibit 185 and Exhibit 186). In fact, the age demography of India today is similar to
that of China in 1995. Moreover, both countries have made incredible progress in the
elimination of poverty. While in the early 1990s over 50% of Chinese and nearly 50% of
Indians were living below the poverty line (on a PPP adjusted basis), by 2013, this had
fallen to 2% for China and 18% for India (see Exhibit 187). In just under two decades, over
890 million people were alleviated from poverty in these two countries.

EXHIBIT 184: Population growth in India has outpaced China

2.5 2.3
2.2 China
2.1 2.1
India
2.0 1.9
1.8
Populationgrowth(%)

1.6
1.5
1.5
1.3
1.1
1.0

0.6 0.5
0.5

0.0
196070 197080 198090 199000 200010 201015

Source: World Bank and Bernstein analysis.

EXHIBIT 185: China age profile: The population of young EXHIBIT 186: India is a relatively young country 30% of the
people has declined sharply population is below 14 years

100% 100%

90% 90%

80% 80%

70% 70% 55 53 54
54 53 53 54 54 55 56 57
57 58 59
61 61 63
60% 63 63 60% 63
65
69 70 68 50%
50%

40% 40%

30% 30%

20% 40 42 41 40 39
20% 40 41 40 40
36
39 38 36 34
31 32 30 29
30 29 26
10% 21 18 18
10%

0% 0%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015

0-14 15-59 60-64 65+ 0-14 15-59 60-64 65+

Source: United Nations Age and Development database, and Bernstein Source: United Nations Age and Development database, and Bernstein
analysis. analysis.

140 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 187: There has been a significant decline in poverty levels in the two countries

70 67
%ofpopulationbelowpovertyline

China
60 India
50 45
41
40 38

30
21 18
20
10 8
2
0
1990 2000 2011 2013

Note: Data interpolated only for selective years.

Source: World Bank and Bernstein analysis.

CHINA'S DEMOGRAPHY WAS In the late 1990s and early 2000s, the bulk of the population of China was in the 25-35-
WELL-PLACED FOR STRONG year old range. This provided China with a large and cheap workforce, which helped
GROWTH IN THE LATE 2000S
enable growth over the next 15 years. However, the one-child policy dramatically dropped
NOW IT IS AGEING
the birth rate, leading to a gradual increase in the median age. Today, 8% of the
population is over 65 years old, and that is expected to climb to 16% over the next 20
years (see Exhibit 188). This will have a negative impact on the growth outlook as the
population of workers starts to shrink, and will put strains on government finances as
healthcare costs rise. In January 2016, the one-child policy was officially dropped as
China tries to boost the size of the younger generation.

In contrast, India fares well in age demography. Twenty-nine percent of the population is
currently under 14, and the size of the workforce is expected to grow by 165 million over
the next 10 years (ages 15-60) (see Exhibit 189).

Basic education remains a big gap between the two countries. India significantly lags
China, with 27% of the population classified as illiterate and two-thirds still living in rural
areas (see Exhibit 190). Only 15% of Indians have progressed to a senior secondary level
or above, compared to 23% in China (see Exhibit 191).

HOWEVER, THE NUMBER OF While the number of people taking up research positions is lower in India, the number of
UNDERGRADUATES IS HIGHER undergraduates is higher with a large share of them specializing in engineering. Most of
IN INDIA FOCUS IS MORE
these engineering graduates are heading for IT services the IT industry has been
TOWARD SERVICES
generating c.0.2 million new jobs annually for the last few years (see Exhibit 192 and
Exhibit 193).

IS IT INDIA'S TURN? PART I 141


BERNSTEIN

EXHIBIT 188: China: The share of people above the age of 65 EXHIBIT 189: India: Age pyramid
will increase

100 100
90 18 18 18 18 18 90 24 24
29 26 24
80 80
70 70
60 60
50 64 61 59 50
68 67
40 40 66 68 66 66
63
30 30
20 7 7 20
5 7
10 6 16 10 4
8 10 11 14 3 3 4 5
0 0 5 4 4 5 6
2015 2020 2025 2030 2035 2015 2020 2025 2030 2035
114 1559 6064 65+ 114 1559 6064 65+

Source: World Bank, and Bernstein estimates (2016 and beyond) and analysis. Source: World Bank, and Bernstein estimates (2016 and beyond) and
analysis.

EXHIBIT 190: China is now mostly urban, while India remains EXHIBIT 191: India still has a large illiterate population
mostly rural

100 100
100% 100% JuniorCollege
9% 7%
Diploma 0% 1%
90% 7%
SeniorSecondary 14%
33% Urban
80%
23%
70% 56%
60% JuniorSecondary 39%
50%
32%
40%
67% Rural
30% 3%
44% Primary,belowPrimary 27%
20%
10% Others
27%
6%
Illiterate
0% 5%
China India China India

Source: World Bank, Census India, and Bernstein analysis. Source: Census India, World Bank, and Bernstein analysis.

142 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 192: India has a higher number of university EXHIBIT 193: India also has a greater focus on engineering
graduates and students with Master's degrees, but a smaller and science
number of PhDs

25 23.5 Agri 4% 1% 4% 1%
Education 5%
China 9% 15%
Economics
20 India 18.2 Law 8% 3% 1%
Numberofpeople(inmn)

Medicine

15
Eng./Science 22% 33%

10

Admin/Art/SS 52%
5 44%
3.4
1.5
0.3 0.1
0
PHDs Masters Undergraduates China India

Note: For China, short-term courses are not included. Note: For China, the breakdown is for students with normal courses in higher
education institutes (HEIs).
Source: National Bureau of Statistics (India), Ministry of HRD (India), and
Bernstein analysis. Source: National Bureau of Statistics (India), Ministry of HRD (India), and
Bernstein analysis.

R&D INDIA SIGNIFICANTLY Globally, developed countries spend 2-3% of their GDP on R&D, with the bulk of it coming
LAGS CHINA IN THE NUMBER OF from the private sector. China has scaled up its R&D expenditure over the last two
STUDENTS WITH PHDS, AND
decades, increasing from c.1% in 2000 to over 2% now. On the output side, the number
R&D SPENDING
of patents filed has seen a sevenfold increase over the last 10 years (see Exhibit 194 and
Exhibit 195). India, in contrast, has failed to scale up its R&D expenditure. On the
services/tech side, a large part of the growth has been in IT services where the level of
R&D is relatively low. In the manufacturing sector, tech hardware is largely imported.
Many large engineering vendors have entered into partnerships with international vendors
rather than develop their own technology.

Investment in research and development in India as a percentage of GDP has remained


flattish at 0.8% of GDP over the last decade, with only one-third of it coming from the
private sector (as opposed to the bulk of expenditure coming from the private sector
globally). Accordingly, the number of patents filed in India has seen very slow growth and
has been flattish over the last five years.

IS IT INDIA'S TURN? PART I 143


BERNSTEIN

EXHIBIT 194: R&D expenditure as a percentage of GDP in China has increased over time, while that it has been flat in India
2.5%
R&D Expense (% of GDP)
2.0%
1.9%
2.0%
1.8%
1.7% 1.7%

1.5%
1.5% 1.3%
1.4% 1.4%
1.2%
1.1%
1.1%
1.0% 0.9% 0.9%
0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8%
0.6%
0.7% 0.7%
0.7% 0.7% 0.7% 0.7% 0.7% 0.7%
0.6% 0.6%
0.6%
0.5%

0.0%
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013
China India

Source: World Bank and Bernstein analysis.

EXHIBIT 195: China has had exponential growth in patent filing in the last two decades
1,000 928
No. of Patents Filed
900 825
Thousands

800
700 653

600 526
500
391
400
315
290
300 245
211
173
200 130
105
80
100 47 50 52 63 29 35 37 34 40 42 44 43 43
10 4 11 4 14 3 20 4 19 5 19 7 23 9 2510 9 5 9 11 11 13 17 24
0
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

China India

Source: World Bank and Bernstein analysis.

INDIA HAS A LOWER The lower focus on R&D in India can also been seen in the number of researchers involved
PERCENTAGE OF THE in R&D in India. Even in the mid-1990s, the number of researchers in China was ahead of
POPULATION FOCUSING ON R&D
India's current number (see Exhibit 196); today, it is almost 6x higher.

In 2014, China had 2.5x more PhD students enrolled than in India (see Exhibit 197).
Within this group, China has more science, engineering, and medical students (see Exhibit
198), whereas India has a greater share of students studying agriculture and "other"
courses (which comprises social science, Indian languages, and commerce).

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EXHIBIT 196: Number of researchers in R&D (per million people) is significantly lower in India

1,000
857 903
China
800 India

600 547
443
400

200 152 135 157


110
0
1996 2000 2005 2010

Source: World Bank and Bernstein analysis.

EXHIBIT 197: Number of PhDs enrolled in India in 2014 was EXHIBIT 198: China has a higher share of PhDs in
less than half the number in China engineering, science, and medical science

55,989 23 45
1% 100%
Law 5%
5% 14%
NumberofPHDs Agriculture
10%
Engineering 36%
18%
6%
23,067
Science 19%

MedicalScience 13% 50%

Other 22%

China India China India

Source: National Bureau of Statistics (India), Ministry of HRD (India), and Source: National Bureau of Statistics (India), Ministry of HRD (India), and
Bernstein analysis. Bernstein analysis.

IS IT INDIA'S TURN? PART I 145


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WHAT CAN INDIA LEARN FROM THE LAST 15 YEARS OF


CHINESE DEVELOPMENT?

After 35 years of rapid growth, China is often seen as an economic miracle. In this section,
we discuss in detail at how China's policies have driven this miracle. Among the various
policy documents, we believe the series of five-year plans are the most useful to provide a
continuous frame-by-frame picture of what the central government tried to do. We focus
on the policies and progress made over the last 15 years the period is likely to be most
similar to the next 15 years in India. However, given the continuity of China's reforms and
economic progress since 1978, we will also refer to earlier periods.

We have identified five key lessons from China's economic miracle that we believe could
benefit India: (1) Broad-based industrialization; (2) Focus on human capital and
technology; (3) Installation of world-leading infrastructure; (4) Global integration; and (5)
Broad and pragmatic market liberalization. Of these, we believe the "secret sauce" is
found in the last two.

Market liberalization and global integration have been the twin bedrocks of China's reform
since 1978, and correspond to the often quoted "Reform and Open Up" directive (
). For the Indian government to replicate this will not be easy. It took a special mix of
historical endowments and burden for the Chinese government to be able to pursue
market liberalization and global integration for so long and so successfully. India has a
different mix of historical influences.

Nevertheless, learning these lessons will be useful for India's economic development, and
for investors to understand where India may be heading. We review all five key policies
here.

1. HIGHER VALUE, BROAD- The rise of China's economy is well-documented. Rapid industrialization is often cited as a
BASED INDUSTRIALIZATION primary driver. However, we believe the true picture is more complicated than this.

The industrial sector was already the largest portion of Chinese GDP in 1980,
contributing to 44% of total GDP (see Exhibit 199). Its share has not increased over the
past 35 years. However, given its size, it has been the largest contributor of GDP growth
(see Exhibit 200). The contribution from agriculture has steadily declined, while all other
sectors (especially the "Others" segment) have expanded.

China's economic miracle is not just about an increasing portion of the economy moving
into production of manufactured goods. It was about moving up the manufacturing ladder,
producing more value-added and sophisticated products, and about the industrialization
of every part of the economy, from farming to construction, logistics, and to services.

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EXHIBIT 199: Contrary to popular misconception, China did not see a greater share of the economy move into the industrial
sector over the last 35 years; the industrial segment has always been the largest contributor to the economy (at 36-44%)

China's GDP Contribution by Sector


100%
9% 10% 10% 11% Others
90% 16% 19% 18% 20%
5% 5% 6%
2% 2% 5%
4% 4% 4% Transport & Logistics
80% 2% 5% 6% 5%
3% 5% 6% 6% 4%
4% 6%
6% 5% 5% 6%
70% 6% Property
6% 7% 7%
5%
30% 28% 4% 6%
60% 20% 7% Construction
27% 15% 12% 10%
50% 9%
4% 8% 8% 7% 9% Finance
9% 10%
40% 7%
Agriculture
30%

20% 44% 41% 40% 42% 40% Wholesale & Retail


38% 37% 36%
10% Industrial
0%
1980 1985 1990 1995 2000 2005 2010 2014

Source: China NBS and Bernstein analysis.

EXHIBIT 200: The industrial segment has also constantly been the largest contributor to GDP growth over the last 35 years;
its share increased until 2005, peaking at 43%

China's Incremental GDP Contribution by Sector


100%
11% 9% 12%
90% 18% Others
5% 8% 24% 23% 23%
5%
3% 4%
80% 5% 5% 4%
5% 7% Transport & Logistics
5% 5% 7% 4%
70% 5% 7%
9% 5% 7% 6%
5% 6% Property
5% 8%
60% 26% 17% 3% 8%
4%
26% 9% 8% 9% Construction
50% 7%
8% 7% 9%
9% 10% Finance
40% 13% 5% 11%
30% Agriculture

20% 43% 39% 43%


35% 39%
32% 30% Wholesale & Retail
10%
Industrial
0%
1980-1985 1985-1990 1990-1995 1995-2000 2000-2005 2005-2010 2010-2014

Source: China NBS and Bernstein analysis.

When talking about industrialization in China, many people instinctively think of labor-
intensive sweatshops, manufacturing of low value-added merchandise. This included the
export-oriented manufacturing plants established by global MNCs such as Nike in China's
free trade zones, as well as domestic factories that supplied the world with cheap

IS IT INDIA'S TURN? PART I 147


BERNSTEIN

production capacity. China became the world's factory. Global consumers benefited from
the flood of cheap apparel, shoes, toys, and other similarly simple manufactured
merchandise.

What is often overlooked is the dramatic growth in China's manufacturing of more


complicated machines, transport equipment, electrical appliances, and electronics. Since
1990, the textile, rubber, and metal merchandise share has declined from 27% of total
industrial exports to just 18%. In contrast, machinery and transportation equipment has
increased its contribution from 12% to 48% (see Exhibit 201). Machinery includes
electric motors, transformers, circuit breakers, compressors, and related parts.
Transportation includes finished automobiles, ships, rail locomotives, and related parts.
Over the last 15 years, China has also began producing its own finished goods in home
appliances, televisions, computers, mobile phones, cameras, meters and precision
measurement devices, medical equipment, bullet train systems, and even nuclear power
stations. By 2014, ~30% of its exports were from these high-technology products (see
Exhibit 202). The same development also happened in the domestic market what was
historically imported became locally produced.

EXHIBIT 201: The share of light manufacturing products commonly associated with China's development like textiles,
rubber, plastic, and metal merchandise declined over the 1990-2000 period, and but has been steady since then; in
contrast, more advanced products like machinery and transport equipment have gained share significantly

China's Industrial Production Export Share by Product Segment


100% 5% 5%
8% 7% 6% 6%
90%
12%
80% 25%
37%
70% 49% 52% 48%
60%
53%
50%
43%
40% 39%
30% 27% 25% 28%
20%
27% 25%
10% 19% 18% 17% 18%
0%
1990 1995 2000 2005 2010 2014

Textile, Rubber, Metals Miscellaneous Machinery and Transport Equipment Petrochemical

Source: China NBS, China Customs, and Bernstein analysis.

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EXHIBIT 202: In particular, an increasing proportion of exports came from machinery, electrical equipment, and electronic
products; the high-tech segment accounted for a significant portion

Share of Total China Export


70%
59%
60% 56% 56%

50%
42%
40%
32% 31%
29% 28%
30%

20%

10%
N/A N/A
0%
1996 2000 2005 2010 2014

Machinery, Electric and Electronic Products High-Tech Products

Source: China NBS, China Customs, and Bernstein analysis.

Home appliances were an early example. Global branded air conditioners initially
dominated the Chinese market in the 1980s and the early 1990s. In the late 1990s,
manufacturing started to switch to China, and local brands also began to flourish. By the
late 2000, China became the largest manufacturer of air conditioners, and local brands
grew to dominate the domestic market. By 2015, China manufactured ~80% of the
world's air conditioners, producing 156 million units (see Exhibit 203). Local brands made
up ~90% of total units sold in the domestic market (see Exhibit 204); brands like Gree,
Haier, and Midea are gradually going global. A similar pattern is seen in other consumer
electric and electronic products such as washing machines (see Exhibit 205),
refrigerators (see Exhibit 206), laptops (see Exhibit 207), and now mobile phones (see
Exhibit 208).

IS IT INDIA'S TURN? PART I 149


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EXHIBIT 203: China air conditioner production volume grew EXHIBIT 204: China's domestic air conditioner market is
12x between 1998 and 2015 dominated by local brands

China Air Conditioner Production 2015 China Air Conditioner Sales


Volume (Million Units) Volume Brand Share
180 Internation
al Brands,
156
160 11%
145
139
140 131
124
120 109
Gree, 28%
100 Other
80 81 81 Local
80
64 68 68 Brands,
60 25%
48
40 31
23
18
20 12 13 Midea,
Haier,
25%
12%
-
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Source: China NBS and Bernstein analysis. Source: China Air Conditioner Yearbook (2015) and Bernstein analysis.

EXHIBIT 205: China's washing machine production followed EXHIBIT 206: as has its refrigerator production
a similar pattern

China Washing Machine Production China Refrigerator Production


(Million Units) (Million Units)
80.0 100.0
88.0
70.0 90.0

60.0 80.0
70.0
50.0
60.0
40.0
50.0
30.0 40.0
20.0 30.0
10.0 20.0 10.6
0.0 10.0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

0.0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

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EXHIBIT 207: In electronic products, China's laptop EXHIBIT 208: Meanwhile, China's production of mobile
production grew ~6x between 2004 and 2012, before phones has continued to grow unabated, increasing ~75x
declining with the rest of the PC market between 1998 and 2014

China Laptop Production (Million China Mobile Handset Production


Units) (Million Units)
300 1,800 1,682
253 1,600
250 227
1,400
200 1,200
1,000
150
800
100 600
400
50 32
200 22
0 0

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

Rapid industrialization took place with a homegrown capital goods sector. Between 2000
and 2014, China's production of power generators and motor engines increased 11x and
10x, respectively (see Exhibit 209 and Exhibit 210); China's bullet trains are all locally
produced, with the manufacturing of most components also localized (see Exhibit 211); in
advanced nuclear power stations, the localization ratio steadily increased to reach >80%
(see Exhibit 212); in industrial automation, Chinese companies' share increased from 25%
in 2009 to 33% in 2015 (see Exhibit 213).

Today, as China continues to develop, its industrial sector exhibits a wide spectrum of
technological capabilities, ranging from "technology absorbers" to true innovators and
original technology owners (see Exhibit 214).

IS IT INDIA'S TURN? PART I 151


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EXHIBIT 209: In heavy industries, China's production of EXHIBIT 210: and its output of motor engines surged by a
power generators grew ~11x between 2000 and 2014, as similar multiple
measured in KWh

Power Generators (Million KWh) China Motor Engines Produced


(Million KWh)
160
2,500
140
120
2,000
100
80 1,500
60
40 1,000

20
500
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014 -

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Power Generators (Million KWh)

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

EXHIBIT 211: High-speed train locomotives: China has localized most of the components going into bullet trains; most of the
suppliers are also Chinese

Source: Bernstein Asian Capital Goods team.

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EXHIBIT 212: Nuclear power plants: Chinese companies now produce almost all of the components for their nuclear power
plants with AP1000 technology; they compete for contracts to build them overseas

Designated Components Supplier


Key components Technology Adopter Sanmen 1 Haiyang 1 Sanmen 2 Haiyang 2
Pressure vessel SEG, First Heavy Doosan Heavy Doosan Heavy First Heavy SEG
Control rods SEG NCMD NCMD SEG SEG
Reactor internals SEG NCMD NCMD SEG SEG
Steam generator SEG, HEC Doosan Heavy Doosan Heavy HEC SEG
Pressurizer SEG DEC SEG DEC
Main pump HEC CW-EMD CW-EMD HEC HEC
Reactor coolant piping First Heavy, Erzhong First Heavy First Heavy SEG SEG
Safety injection tank SEG SEG SEG SEG
Fuel handling equip. SEG SEG SEG
Valves Westinghouse
Steam turbine generator MHI/HEC MHI/HEC MHI/HEC MHI/HEC

Localcontentlevelincreases

Note: Shaded boxes are Chinese companies (SEG is Shanghai Electric, HEC is Harbin Electric, and DEC is Dongfeng Electric).

Source: Bernstein Asian Capital Goods team.

EXHIBIT 213: Local substitution is an ongoing trend in the Chinese industrial automation space

Market Share of Domestic Players


35%
32.8% 33.0%
32.3% 32.6%

30.0%
30%

27.1%

24.8%
25%

20%
2009 2010 2011 2012 2013 2014 2015

Source: China Automation Market Research Seminar (CAMRS), company filings, and Bernstein estimates and analysis.

IS IT INDIA'S TURN? PART I 153


BERNSTEIN

EXHIBIT 214: Chinese companies exhibit a wide range of technology capabilities in the industrial and automation space

Originative

Adaptive Railwayequipment
DCS (processautomation)
Nuclear/coalfiredpower
Constr.equip. Laserprocessing
T&D Videosurveillance
Absorptive Windturbine
Motioncontrol
Chinese company
Hydraulicvalve Agri.equip.
technology level
Robot/Vision
Gasturbine
Factorydiscretecontrol

Source: Bernstein analysis.

CHINA'S DEVELOPMENT IS All three countries began industrialization by producing low-end products, while also
SIMILAR TO THAT OF JAPAN, developing capabilities for more sophisticated products. Today, each is a leader in a
SOUTH KOREA, AND TAIWAN
different array of high-tech industries: Taiwan in semiconductor production, South Korea
in shipbuilding and consumer electronics, and Japan in many sectors ranging from
industrial robots to pharmaceuticals.

Developing the heavy and high-tech industrial sector was an explicit policy of the Chinese
government. As early as the 8th Five-Year Plan (1990-95), the State Council identified the
"need to use modern equipment and production methods to rebuild our companies" In
the 10th Five-Year Plan (2000-05), the heavy industrial segment was devoted an entire
paragraph; the government targeted to increase the share of machinery, electric, and
electronic equipment exports to 50% by 2005.

Even within agriculture, government policy has been to industrialize. The 10th Five-Year
Plan targets the scaling-up of farming and husbandry operations, utilizing larger and
better equipment, and harnessing modern agricultural science and technologies. To build
scale, it also promoted the trading of rural land usage rights an especially difficult and
sensitive issue. Improving the efficiency of the agriculture sector was expected to free up
greater excess labor, so the plan also called for an orderly flow of 40 million rural workers
into urban areas between 2000 and 2005 and the generation of a similar number of
urban employment opportunities to cater to them. This led to accelerated urbanization,
and the development of a large pool of human capital to build and support more advanced
industries there.

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We can also see this in the numbers. Between 1995 and 2012, total workers in
agriculture, husbandry, fishery, and forestry declined by 16% (see Exhibit 215).
Meanwhile, the installed base of combine harvesters increased 20x from just 75k units in
1995 to 1.6 million in 2014 (see Exhibit 216). Total output of various produce grew
dramatically during that period (see Exhibit 217).

While the service industry had its own section in each of the various five-year plans, it was
clearly lower in importance than the industrial and agricultural sectors for the
government. Within services, the government also prioritized those that are more relevant
for manufacturing than consumption. In the 8th Five-Year Plan, the prioritized order of
importance of the service sector was: commercial or professional services, finance,
insurance, and tourism. The objective was to reduce employment pressures, increase
capital accumulation, and promote economic restructuring.

By 2000, the 10th Five-Year Plan considered consumer and business services separately.
Within consumer services, the priority was on residential property development and
related industries (e.g., furnishing and property management); tourism was seen as the
next biggest thing. Other consumption-driven industries like retail, restaurant, and
entertainment (among others) were put into one category. In contrast, business services
were more diversified, ranging from franchising, distribution, logistics, banking, insurance,
to various professional services or intermediaries (e.g., accounting, legal, consulting, and
IT).

EXHIBIT 215: Total labor in agriculture, husbandry, forestry, EXHIBIT 216: while the level of industrialization increased;
and fishery dropped by 16% between 1995 and 2012 the total installed base of combine harvesters grew 20x
between 1995 and 2014

China Agriculture / Husbandry / China Installed Base of Combines


Forestry / Fishery Workers (Million) (KUnits)
350 323 1,800
1,585
300 1,600
270
1,400
250
1,200
200 1,000
150 800
600
100
400
50 200 75
0 -
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

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EXHIBIT 217: Growth in agricultural, husbandry, forestry, and fishery products grew rapidly from 1995 to 2014

China Agricultural Output Growth (1995-2014)


500%
462%
450%

400%

350%

300%

250%
195%
200%
157%
150%

100%
66%
50% 30%

0%
Crops Vegetables Fruits Meat Seafood (1996-2014)

Source: China NBS and Bernstein analysis.

THE NEW THEME IS "Made in China 2025" is the latest national policy supporting industrial transformation. It
TRANSFORMATION AND has four pillars (see Exhibit 218): smart manufacturing, encouraging much higher levels of
UPGRADE
automation in manufacturing; supply chain debottlenecking, aiming to promote local
substitution and further removing the dependence on imported core components; green
development, taking the environment and energy efficiency much more seriously; and
high-end equipment exports with a focus on overseas infrastructure development ("one
belt, one road"). All four pillars reinforce the overarching theme of upgrading the
manufacturing sector to make it smarter, environmentally friendlier, more self-sufficient,
and more competitive globally.

The Chinese government, wary of the overcapacity built during the booming years, is also
actively driving a transformation within China's industrial sector further shifting the
growth engine from low-end manufacturing (the production of steel, coal, and shoes) to
advanced equipment manufacturing (nuclear power, high-speed rail, automation, and
others), with the aim to continue to move up the value chain. According to the "strategic
emerging industries" policy plan, China aims to grow seven identified sectors from 8% of
GDP in 2015 to 15% by 2020, indicating a CAGR of 20% (see Exhibit 219). Recent data
points suggest that the transformation and upgrading of these sectors is progressing
well; financial indicators for equipment and high-tech industries are generally healthier
than the broad industrial sector (see Exhibit 220 to Exhibit 222).

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EXHIBIT 218: Four modules of the "Made in China 2025" blueprint

Smart
manufacturing
Local
(industrial
substitution
automation)

Green Incubating
development global champions

Source: Bernstein analysis.

EXHIBIT 219: China's ongoing transformation: An upgrade in the manufacturing sector

Strategic Emerging Industries Output as % of GDP


20%
Energy saving
Information technology
Bio-tech
15% Alternative energy
High-end equipment mfg
Advanced materials
10% New engergy vehicle
15%
5%
8%

0%
2015 2020

Source: State Council, China NBS, and Bernstein analysis.

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EXHIBIT 220: The high-tech manufacturing PMI is consistently above the manufacturing PMI and stayed well above 50%
despite a dip in February 2016

High-Tech Mfg PMI vs. General Mfg Industry PMI


60%

55.6%
54.8% 54.6%
55% 53.2%
53.1% 53.0%
52.2% 52.4% 52.6% 52.4%
51.3%
50.8%

50% 48.9%
50.0% 49.7% 49.8% 49.8% 49.6% 49.7% 50.2% 50.1% 50.1% 50.0% 49.9% 50.4% 50.4%
49.4% 49.0%

45%
Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16

High-Tech Mfg PMI Mfg PMI

Source: China NBS and Bernstein analysis.

EXHIBIT 221: High-tech manufacturing value-add growth is consistently above general manufacturing growth; equipment
manufacturing has shown a sign of recovery since July 2016

Value-add Growth of High Tech Mfg, Equipment Mfg and General Mfg
14% 12.20%
11.50% 11.60% 11.80%
12% 10.5% 10.4% 10.8% 10.3%
9.2% 9.6% 9.60% 9.70%
10%
8%
6% 7.70%
6.80% 6.70% 6.70% 7.20% 7.00% 7.20% 6.90% 7.20% 7.20% 7.00% 6.80%
6.60% 6.50%
4% 6.00%

2%
0%

High Tech Mfg Growth Mfg Growth Equipment Mfg

Source: China NBS and Bernstein analysis.

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EXHIBIT 222: China's ongoing transformation: An upgrade in the manufacturing sector

Profit Growth by Sector (Jan-Aug 2016, y/y)


25%

20%

15%

10% 19.8%
8.4% 14.1%
5%

0%
Industrial Manufacturing Electronics

Source: State Council, China NBS, and Bernstein analysis.

2. HUMAN CAPITAL AND Transforming itself from being the factory of the world's cheap merchandise, to building
TECHNOLOGY HAS BEEN KEY TO the machinery and electronic equipment to run these factories, requires a deep bench of
DEVELOPMENT
talent that can learn, adapt, and advance the latest technologies and sciences. The
Chinese government's five-year plans have always had a chapter on education, talent
development, and R&D.

Education initiatives span across all levels. The 10th Five-Year Plan, for instance, set a
target to increase junior secondary level enrollment rates to 90%, senior secondary level
enrollment rates to 60%, and higher education enrollment rates to 15% by 2005. In
addition, the government also promoted other forms of professional training. The
government also supported various ways to improve education quality and increase
capacity encouraging the establishment of private and community schools and allowing
higher learning institutions greater autonomy in setting their own syllabuses.

Results of these initiatives have been good. By 2014, the average years of education had
risen to 9.3 years from 7.9 in 2000 (see Exhibit 223); almost 90% of adults in China have
completed at least nine years of schooling, and the senior secondary level enrollment rate
has reached 82.5%. The number of people with higher education qualifications (diploma
and above) has increased from 3% of the total population in 1990 to 21% in 2010 (see
Exhibit 224).

Apart from building talent organically, the government targeted talent from abroad,
especially in the form of returnees (or the well-known "sea-turtles"). The 10th Five-Year
Plan sought to attract international talent, especially those who are leaders in their
respective fields. It also encouraged Chinese students to study abroad, to make
reasonable use of international education resources, and sought to attract them back by
guaranteeing their freedom of movement. As a result, the number of new overseas
students has grown from 39k in 2000 to 460k, while the number of overseas students
returning to China has increased from less than 10k in 2000 to 365k in 2014 (see

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BERNSTEIN

Exhibit 225). As China becomes wealthier, overseas students are becoming more willing
to return, and the virtuous cycle spins faster. In 2000, total returnees were about 40% of
students that had gone abroad three years ago; by 2015, that ratio has gone beyond
100%.

The government is also progressively increasing research and development intensity. The
10th Five-Year Plan aimed to increase R&D spending to 1.5% of GDP by 2005; the 11th
Five-Year Plan targeted 2% by 2010. While actual spending levels fell short of the
targets, the trajectory remained firmly positive. R&D spending increased from just 0.6% of
GDP in 1995 to 1.3% in 2005 and to 2% in 2014 (see Exhibit 226). Total annual patents
filed has also increased from 41k to 1.2 million domestically and 3.8k to 93.3k
internationally (see Exhibit 227 and 228). China already produces 18% of the patents
granted around the world (see Exhibit 229). In some fields, like telecommunications
equipment, Chinese companies (e.g., Huawei and ZTE) have already been leading the
industry. R&D spending in China is also sustainable, as it is driven by corporations instead
of the government: in 2002, ~64% of total R&D was spent by corporations; this increased
to 79% by 2014 (see Exhibit 230). A full 80% of incremental R&D dollars between those
12 years were funded by the corporate sector.

The Chinese government has always recognized the strong link between education and
R&D on the one hand, and industries and the economy on the other. As early as the 8th
Five-Year Plan, the government had set this guiding principal: "economic development
must rely on technology and science; technology and science must also be for economic
development." Part of its approach is to recognize "up-and-coming" and/or "economically
critical" fields of research and guide resources in that direction. As early as 1990, the 8th
Five-Year Plan recognized biological engineering, digital IT, telecommunications, and
th
automation as some of the more promising areas. In 2000, the 10 Five-Year Plan added
high-speed broadband, bio-semiconductors, vaccines, among others, to the mix.

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EXHIBIT 223: Average years of education for the Chinese EXHIBIT 224: The number of people with advanced degrees
population have increased steadily over the last ~15 years (diploma and above) has increased from 2% in 1990 to 8%
in 2000 and 21% in 2010

China Average Years of Education for China Population by Education Level


Population Aged 15 and Over
100% 1%
2% 1%
7% 6%
9.5 7% Bachelor or
9.3 90%
9% 15% above
9.1 80%
9 31% Diploma
70% 16%
8.5 60% 42%
8.5 Senior High
50%
36%
7.9 40%
8 Junior High
30% 59%
7.5 20% 41%
27% Primary or
10% below
7 0%
2000 2005 2010 2014 1990 2000 2010

Source: State Council, China Census, Sun Yat-Sen University, and Bernstein Source: China Census and Bernstein analysis.
analysis.

EXHIBIT 225: The number of Chinese students going overseas has increased 22x from 1995 to 2014; the number of overseas
students returning to China has expanded 60x; almost all overseas students now decide to return to China

China Students Going Overseas and Returning


900 124% 140%
119%
800
104% 107% 120%
700 94%
100%
600 81%
76%
500 69% 460 80%
400 414 58%
400 52% 340 354 365
60%
285
300 36% 37% 41% 36% 38% 229
273
29% 28% 180 186 40%
200 125 117 115 119 134 144 108 135
84
44 69 20%
100 206 217 227 187 248 399 12 18 20 25 35 42
0 0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Students Going Overseas (K) Overseas Students Returning (K) % of Overseas Students Returning*

* Overseas students returning this year as a percentage of students going overseas three years ago.

Source: China NBS and Bernstein analysis.

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BERNSTEIN

EXHIBIT 226: China's R&D expenditure increased from 0.6% of GDP in 1995 to 2% in 2014

China R&D Expenditure as % of GDP


2.5%

1.99%2.02%
1.91%
2.0% 1.78%
1.66%1.71%
1.44%
1.5% 1.31%1.37%1.37%
1.21%
1.06%1.12%
0.89%0.94%
1.0%
0.64%0.65%0.75%
0.57%
0.56%
0.5%

0.0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: China NBS and Bernstein analysis.

EXHIBIT 227: Patents granted to Chinese EXHIBIT 228: while outside of China, it increased 24x
companies/institutions within China increased 28x between
1995 and 2014

Patents Originating from China Patents Originating From China


Granted in China (K) Granted Outside of China (K)
1,400 100 93.3
1,209
90
1,200
80
1,000 70

800 60
50
600 40
400 30
20
200
41 10 3.8
0 0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

162 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 229: Patents granted to Chinese companies/institutions now make up 18% of global patents, although they are
still predominantly granted within China

Global Patents Granted by Country of Origin and Patent Authority


100%

90%

80%

70%

60%

50%

40%
70%
30%

20%

10% 18%
0% 2% 1% 1% 2%
EPO (Europe) JPO (Japan) KIPO (Korea) SIPO (China) USPTO (US) Global

China Other

Source: China NBS and Bernstein analysis.

EXHIBIT 230: China's R&D is also sustainable, with corporations funding ~79% of the expenditure, up from 64% in 2002

China R&D Spending Share by Funding Source


100%
90% 24.7% 24.6% 25.1% 22.7% 22.6% 22.1% 21.2%
28.9% 28.2% 26.4% 25.9%
80% 36.0% 33.2%
70%
60%
50%
40% 74.1% 75.3% 75.4% 74.9% 77.3% 77.4% 77.9% 78.8%
71.1% 71.8% 73.6%
30% 64.0% 66.8%
20%
10%
0%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Corporate Government

Source: China NBS and Bernstein analysis.

3. WORLD-LEADING China is often criticized, by those who only read about the country in newspapers, for
INFRASTRUCTURE overbuilding and leaving behind empty highways, which lead to nowhere. The claim is
false. China does not yet have overcapacity in infrastructure. As Exhibit 237 shows, there
is a strong correlation between per capita GDP and per capita fixed assets formation, and
China is right in line. It is often easy to overlook the importance of building world-class
infrastructure ahead of demand to propel growth. Much of the incremental infrastructure
capacity has been utilized quickly.

IS IT INDIA'S TURN? PART I 163


BERNSTEIN

The 8th Five-Year Plan discusses this point: "As infrastructure building requires a high
level of investment and lead-time, with relatively low prices and fees, we need to plan
early, implement policies that promote investment, and raise finance through multiple
channels."

An example of this is the highway system. In the 10th Five-Year Plan, the government set a
target of 25k km of highways by 2005. Between 2000 and 2014, the length of total roads
in China doubled and highways grew 6x (see Exhibit 231 and Exhibit 232). During the
same period, total civilian vehicles on the road grew even faster, increasing over 8x (see
Exhibit 233). In addition, road cargo traffic volumes exploded due to the rise of
e-commerce, with total tonnage moved by road growing ~230% between 2000 and
2014. Total parcels delivered increased 126-fold, from just 110 million packages in 2000
to ~14 billion in 2014.

The same pattern of rapid expansion of infrastructure capacity being quickly utilized by
faster-growing demand is seen across many areas. In electricity, generation capacity
grew from 135 billion KWh in 2000 to 563 billion KWh in 2014, increasing 3.2-fold;
usage has grown from 125 billion KWh to 533 billion, or 3.3-fold, over the same time
period (see Exhibit 234). Growth in residential power consumption has grown faster than
industrial. For seaports, the total length of piers increased 2.8x between 2000 and 2014
and the total number of berths increased 2.3x; meanwhile, total port throughput has
increased 5.1-fold (see Exhibit 235). For railways, the total track length increased 63%
from 2000 to 2014, mostly driven by the construction of tracks for bullet trains (i.e.,
multiple unit locomotives); meanwhile, passenger traffic grew 124% and cargo traffic
grew 114% (see Exhibit 236).

EXHIBIT 231: Total length of roads in EXHIBIT 232: highways increased EXHIBIT 233: but both were
China increased 200% between 2000 590%... outstripped by the accelerating growth
and 2014, while of on-road civilian vehicles, which grew
810%

Road (Thousand Km) Highway (Thousand Km) Civilian Vehicles On-road


(Million)
450 120
400 160
100
350 140
300 +200% 80 +590% 120 +810%
250 100
60
200 390 112 80
146
150 330 40 60
74
100 40 78
132 159 20 41
50 16 20 16 32
0 0 0
2000 2005 2010 2014 2000 2005 2010 2014 2000 2005 2010 2014

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

164 ASIA 2017: THE NEW ECONOMY WON. WHAT NOW?


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EXHIBIT 234: China: Electricity capacity EXHIBIT 235: China: Seaport capacity EXHIBIT 236: China: Railway capacity
versus usage versus usage versus usage

Electricity (2000-2014 Growth) Seaports (2000-2014 Growth) Railway (2000-2014 growth)


450% 394% 600% 140% 124%
513%
400% 114%
500% 120%
318% 325%
350%
100%
300% 400%
250% 280% 80% 63%
300% 234%
200% 60%
150% 200%
40%
100%
100% 20%
50%
0% 0% 0%
Capacity Total Usage Residential Seaport Pier Seaport Seaport Track Length Passenger Cargo Traffic
Usage Length Berths Throughput Traffic

Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis. Source: China NBS and Bernstein analysis.

China has also aimed to build world-leading infrastructure that can have a strong
multiplier effect for the industries and consumption. Some have stalled, such as the 3.2km
Maglev track between Shanghai Pudong Airport and an arbitrary station slightly closer to
the city center (but still quite far away). But many others have flourished, for example: 1)
China's various deep water ports carrying its international trade are now competing with
Hong Kong and its world-leading 4G, and 2) fiber network now drives vigorous growth in
e-commerce, the Internet content, and applications. China is now embarking on the
construction of large datacenters to support the future growth of digital media, including
HD and 4K content.

Infrastructure building requires strong centralized political power. It is needed to


coordinate projects that span and affect multiple administrative regions to push
through vested interests and raise sufficient finances. For example, the Southern Water
for North () project aims to divert water from the more humid South to the more
arid North. The project is expected to cost RMB120 billion. Construction began in 2002;
two of the diversion waterways were completed in 2013 and 2014, respectively, while
another is still being appraised. Construction passes through five populous provinces
where 330k residents had to be relocated. Other examples include the Three Gorges
Dam that took 12 years to build and had cost RMB180 billion, including ~RMB80 billion to
relocate the 1.2 million residents affected. Another is the bullet train system in China,
which has cost over RMB1 trillion so far, and each line has