Top China Fund Manager Sees Fiery Spirit as Toast of Town

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(Bloomberg) -- The grain liquor that is China’s national spirit is known for its potency. To investors, the companies that distill the alcohol known as baijiu also pack quite the punch.

E Fund Management Co.’s Xiao Nan, a top fund manager in China, describes the sector’s business model as “stand still and collect money.” His E Fund Consumption Industry Equity Fund has returned 52 percent over three years through May 4, the best performance among 161 A-share funds with at least three years of history and more than 1 billion yuan ($157 million) of assets, according to data compiled by Bloomberg. About a third of his portfolio are baijiu stocks like Kweichow Moutai Co. and Wuliangye Yibin Co., which have both been on bull runs over the last three years.

“It is a very unique sector in China with a very attractive business model,” he said in an interview. “In or outside China, it’s hard to find a similar sector to invest in.”

Despite the optimism, some analysts have warned that Chinese distillers might find it increasingly hard to adapt to the changing tastes of a younger generation of drinkers. Government bans on consumption of the liquor by state officials, and controls set on bottle prices, also add to uncertainty over the future of baijiu stocks.

More attractive

Notwithstanding their strong returns and high cash flow, Chinese distillers are trading at a substantial discount to domestic brewers. The shares of China Resources Beer Holdings Co. and Tsingtao Brewery Co. trade at about 39 times blended forward 12-month earnings, compared with about 22 times for Moutai as well as Wuliangye.

This is despite a beer market that’s shrinking in volume and fierce competition from foreign companies like Anheuser-Busch InBev NV, said Euan McLeish, an analyst at Hong Kong-based Sanford C. Bernstein.

“The fundamentals for high-end baijiu is so much more attractive than the brewers at way cheaper prices,” he said. “There’s a real contradiction there between what the same pool of investors are willing to pay.”

China’s baijiu stocks also trade at a discount to global liquor distilling peers like Brown-Forman Corp. and Remy Cointreau SA. Even though the shares of the two Chinese ultra-premium distillers, Moutai and Wuliangye, have both risen about 200 percent in the last three years, their price-to-earnings multiple has lagged the top 20 biggest distillers and vintners in the world.

Shares of Baijiu producers climbed Monday. Moutai gained 5.3 percent, the biggest jump of the year, while Wuliangye rose 4.3 percent.

Investors’ caution, reflected in valuation discount carried by baijiu stocks, may have to do with the sector’s rocky recent history.

Bottles of Moutai and Wuliangye were popular indulgences among government officials up until Chinese president Xi Jinping’s crackdown on corruption in 2012, which triggered a plunge in shares of baijiu producers. Even after revenue recovered, investors remained sensitive to any hint of regulatory risk. Last year, Moutai stocks briefly lost $6 billion of value after state media Xinhua said that analysts’ valuations were “overly high”.

But demand from government officials for baijiu, which is traditionally served together with big meals and imbibed pure, has been replaced by sales to an emerging middle class that can now afford premium liquor for celebrations.

“In China, baijiu is not just a luxury good but an important social tool,” said Xiao. “Opening a bottle of premium baijiu is the highest sign of respect given to a guest.”

Moutai and Wuliangye enjoy pricing power. After Moutai boosted bottle prices by a fifth this year, first quarter profit jumped 39 percent and revenue climbed 32 percent. Their strong free cash flow is generally distributed in dividends rather than tied up in investments -- another plus point, said Xiao.

Changing Taste

Moutai’s earnings have grown 64 percent in the last 12 months, beating 81 percent of its peers globally, as its operating margin reaches 75 percent -- higher than 99 percent of its peers, according to data compiled by Bloomberg.

In the long run, baijiu’s tradition-steeped ways could prevent distillers from easily adapting to the changing palates of globalized young Chinese, said Capital Securities analyst Gu Xiangjun.

Several Chinese distillers may also face supply-side constrains. Moutai, for example, uses only grain grown in Maotai town, and can only produce 60,000 metric tons of liquor at the maximum based on the land it controls. It’s still 53 percent away from that limit and is going into new business areas.

For now, many analysts see more upside in the stock price of Moutai, which overtook Diageo Plc as the world’s most valuable distiller. Analysts have a 12-month price target of 831.21 yuan, implying a return of 25 percent from current levels. Moutai boasts 28 buys, two holds and no sells, according to analyst recommendations compiled by Bloomberg.

Moutai’s upward climb is a bellwether for the sector, said Capital Securities’ Gu. “Moutai acts as a ceiling for baijiu stocks. The higher it goes, the more space there is for the rest.”

©2018 Bloomberg L.P.

With assistance from Rachel Chang, Cindy Wang

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