To complement our 'Chasing the Dragon' October feature, Philip Ehrmann explains why he is confident that improving productivity and efficiency among Chinese companies will counterbalance these costs and allow the country to retain its position as a manufacturing powerhouse. 

Suddenly, a growing number of investors are becoming increasingly fretful about China’s rising labour costs. However, Ehrmann, an investor with 20 years’ experience in emerging markets, is not one of them.

Ehrmann has an acquaintance who, year in and year out, has been negotiating decreases of some 5 to 7 per cent a year in the price of components that finish up in global products made in the US. However, rising labour costs in China could put a stop to this. ‘It is catch-up time for the Chinese,’ he says.

With the authorities now rebalancing the economy toward the internal market rather than the export market and introducing a belated dose of social justice for poorly paid workers, Ehrmann makes an obvious point: ‘You can’t have a consumer-led growth economy unless you have rising wages. The average income in urban areas has been rising at between 13 and 14 per cent a year. That is the background to the last decade. Only during the global financial crisis did this trend level off.

‘China’s unique selling point used to be low-cost widgets, but the reality now, with greater emphasis on capital equipment, is gains in productivity and efficiency. These serve to keep costs down,’ he says

To emphasise his point he cites the example of Lenovo, the computer giant that bought the personal computer division of IBM. Less than 2 per cent of Lenovo costs are labour costs, he says, so staff costs have a minor impact on the cost of Lenovo’s products compared with other production costs.

Ehrmann looks beyond companies reliant on low-cost labour. He says: ‘I’m much more interested in industries that are leap-frogging.’ One such company is China Mobile, which has a mind-boggling 500 million subscribers.

One of the peculiarities of China’s equity market is its system of A shares for domestic investors and H shares, quoted in Hong Kong, for foreigners. Ehrmann predicts this system will end when the Chinese authorities feel the time has come to take capital markets to the next level. He suggests this will happen more quickly than many believe.

China Mobile, he points out, is not listed on mainland markets, but in the US. The authorities prevented the company from raising equity capital in China and the country’s equity landscape is still not particularly clear.

This is partly down to circumstance. To avoid the voracious asset grab seen in Russia by its oligarchs, China sought breathing space to work out who owns what in the business sphere. This is an ongoing process with no end yet in sight. But at some stage the way will be clearer for China’s markets to progress to the next stage in the growing process. China has just made its first export loan in renminbis to Indonesia, and this march toward the mainstream will be emulated in the corporate sector. ‘It is just a question of timing,’ says Ehrmann. ‘We’ll see a repeat of what we saw in Korea and Taiwan.’

Ehrmann makes the point that, in emerging markets, politics is an overwhelming consideration for investors. He says: ‘There is very little to suggest [the Chinese Communist Party] is backsliding on its stated aims.’ Ehrmann points to the action being taken by China on the environment and its commitments at the Copenhagen climate summit as evidence of this.

Ehrmann is certain there is still value to be found in Chinese equities. ‘But you need to be focused to find it,’ he says. He looks for the usual value indicators: good cash flows, balance sheet strength, barriers to market entry and so on. But he adds: ‘You have to ensure management has the same commercial interests as shareholders. It is not always the case. Their priority might be sales or employment.’

Chinese companies that concentrate on return on capital employed (ROCE) are still in a minority, but their numbers are growing, Ehrmann says. Opportunities exist to buy companies at less than 12 times earnings – businesses that will grow by 25 per cent over the next 12 months.

However, Ehrmann warns that in his 20-year career in emerging markets the one constant has been the certainty that a crisis will eventually follow a period of prosperity. ‘In emerging markets, you can never assume that things will proceed in the way they have,’ he says.