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Bin Yuan Capital All China Strategy – October 2018

Market Update

Chinese stocks retreated in October. Shanghai Composite Index was down 7.75% in October, Hang

Seng China Enterprise Index was down 7.98% and our benchmark MSCI All China dropped by

10.84%.

China’s economy growth slowed down in October. The Producer Price Index (PPI) rose 3.3% year

on year (YoY) in October 2018, down from 3.6% in September 2018. The Consumer Price Index

(CPI) was 2.5% in October, the same as 2.5% in September. The official manufacturing Purchasing

Managers’ Index (PMI) dropped from 50.8 in September to 50.2 in October, and the official Non-

Manufacturing PMI decreased from 54.9 in September to 53.9 in October. Both manufacturing

and non-manufacturing PMI was still above the expansion/contraction threshold of 50.

Chinese government conducted import tariff cuts to boost trade and consumption. Effective on

November 1, China’s overall tariff reduced from 9.8% to 7.5%, a reduction of nearly RMB60 billion,

mainly from decreased tariffs on machinery, electronic devices, textiles and paper-made

commodities. Meanwhile, China has announced a new round of individual tax cut, which could

reduce annual individual tax of RMB116 billion to alleviate household burdens and drive the

growth of consumption.

Since September, margin calls of pledged shares of many listed companies caused the liquidity

problem. It is common in China to pledge shares for cheaper loan. The selling of those shares due

to margin calls drove the market down, which forced the liquidation of some equity funds as they

hit the minimum Net Asset Value. The Ripple effect caused market dropped further in October.

This disorder went beyond company fundamentals and it is due to less mature financial industry.

In order to support the capital market’s confidence, the government put forward a series of new

measures. For example, the share repurchase system was revised to help eligible listed companies

to buy back shares more easily. In addition, the government also encourages local government to

establish new funds to support the development of listed companies with good quality but

currently trapped with high pledged shares. Banks and brokers are required to review the

company business and financial situations before they liquidate the pledged shares. This will slow

down the selling and stabilize the market negative momentum.

Performance Attribution

The underperformance of this month was due to the weak performance of consumer sectors.

Previously outperformed consumer staples stocks experienced profit-taking. The market is

concerned on the slow-down of domestic consumption growth, which was caused by the reduced

shanty development subsidy and the tightening liquidity since the second quarter. We think these

are cyclical factors and long term secular trend of consumption upgrade still remains intact. The

short term volatilities may stay for one or two quarters due to uncertainties from the trade issue

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with the US. However, as the industries continue to consolidate, industry leaders in our portfolio

will benefit from this trend. The 2019 PE valuation of industry leader stocks are very attractive

with Little Swan (washing machine) at 10x PE, 4.6% dividend yield; Fuanna (Home textile) at 10x

PE, 4% dividend yield. These consumer names are all cash rich and balance sheet strong.

At the stock level, a washing machine manufacturer outperformed in October mainly because

that its controlling shareholder announced a plan to privatize the company to avoid related-party

transactions and streamline its strategy. The company is one of the washing machine duopoly in

the Chinese market and keeps gaining market shares while its controlling shareholder is one of

the leaders among the global household appliance makers. After the merger, we believe that both

companies will benefit from the economies of scale and synergy effect.

A car seller and service provider underperformed in October still due to the trade war concerns

on imported vehicles. Actually, the company has limited exposure on imported car sales and 63%

of its profit is contributed by after-sales services, which has stable and long-term growth. It is

conservative to forecast that the company can achieve 12% CAGR in the next 3 years while trading

at 4.9X PE with 6.2% yield, which is very attractive.

Local Observation and Portfolio Positioning

China's health expenditure in 2017 was RMB5.16 trillion, growing at compound annual growth

rate (CAGR) of 15.7% in the past 17 years. The health expenditure accounted for around 6.2% of

GDP in China in 2017, while the corresponding proportions in the US and Germany are 16.8% and

11.0%, respectively. Driven by the aging population and rising disposable income, we expect the

health expenditure growth to remain robust in the next decades.

Chart 1: Health Expenditure

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Government Pays for the Base, Market Takes Care of Additional Expenditure

A very important achievement for the government in the last 20 years is to have established a

medical security system. China's social primary medical insurance system (see red box in Chart 2)

has three pillars, namely basic medical insurance for the urban employment population, basic

medical insurance for urban non-employed population and new rural cooperative medical care

for rural population. By the end of 2016, the number of people covered by primary medical

insurance exceeded 1.3 billion.

Chart 2: China's Multi-level Medical Security System

The total health expenditure is shared by three parties – the government, employers and

individuals. As the result of basic medical insurance system establishment, the CAGR of health

expenditures borne by individuals over the past few years was 10.5%, far below the growth rate

of the overall health expenditures (15.7%). Thus, the proportion of individual part reduced to 28.8%

in 2017 from 60% in 2001.

Chart 3: Health Expenditure Structure

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However, the aging population is putting pressure on social insurance system. From 2009 to 2013,

the growth of medical expenditure was higher than that of urban residents' medical income

(42.3%). Therefore, it is unrealistic for the government and employers to further cover the

individual part of the health expenditures.

Chart 4: Imbalance of Urban Medical Income & Expenditure

China's commercial health insurance plays an important complementary role in the medical

security system, covering the part that is not covered by basic medical insurance. The penetration

rate is still quite low, and the commercial health insurance market grew rapidly. The market size

increased from RMB6.55 billion in 2000 to RMB439 billion in 2017, representing a CAGR of 28%.

From 2010 to 2017, the proportion of health insurance premiums to personal insurance premiums

increased significantly from 6.6% to 16.4%, and the proportion to total premium in the industry

increased from 4.1% to 12%. Based on our estimation, it is conservatively to estimate that the

premium scale of health insurance will increase to RMB1.2 trillion in 2022, with a compound

annual growth rate of 22.3%. The profitability of healthcare insurance is also significantly higher

than other kinds of insurance.

Who will Benefit

With the increase of people’s awareness, commercial health insurance became more and more

popular. In the past few years, taking the three major insurance companies as an example, the

growth of premium income of health insurance was considerably higher than that of other

insurance categories.

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Chart 5: Health Insurance Growth Vs Life Insurance Growth Chart 6: Proportion of Health

Insurance in Life Insurance

Unlike consumption and universal insurance, consumers buying health insurance target to pursue

a long-term protection. That’s why consumers of health insurance are usually less price sensitive

to long-duration health insurances than other types of insurances, but consumers are more

concerned about the claims-paying ability. Therefore, big insurance groups have obvious

advantages due to brand awareness and strong capital support. We believe that insurance

companies like Ping An will leverage their strong brand endorsement and excellent service to

benefit from China's fast commercial health insurance development. Due to lower price sensitivity,

these big insurance companies will have better product structure and higher profitability in long-

term.

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Bin Yuan on the Road

Oct 25, 2018

Fuanna, the second largest home textile manufacturer in China

• Benefiting from the consumption upgrade trend, Fuanna’s

overall sales, especially sales of its high-end series,

recorded strong growth in the first three quarters of 2018.

Oct 17, 2018

Daxing District, Beijing City.

• While attending a battery forum in Daxing District, Beijing

City, our analyst passed a Tesla electric car and a NIO

electric car parked on a street. Chinese consumers are

willing to buy electric vehicles (BEV) partly due to the

government’s supporting policies.

• The battery industry is transitioning from high energy

density products to high safety, high price-performance

ratio, so that requirement for a high quality industrial

chain is increasing fast.

“In 2018, total sales volume of electric vehicles exceeded 1 million units, and the sales

target for 2020 will reach 2 million units.” – State Ministry of Industry and Information

Technology, Mr. Xie Sanming.

Oct 24, 2018

C&S Paper, a household tissue manufacturer in China

• C&S Paper celebrated its 40th anniversary in October.

Regional leaders from all over China were invited to

present their achievements. The company emphasizes the

importance of delegating power to regional level, and that

brings incentive to employees.

"Combination of beauty and quality is Fuanna’s lifelong

pursuit." – Fuanna CEO, Mr. Lin Guofang.

"We have an open culture and delegation is really important, this will inspire those

talented people to do their jobs well." – C&S Paper CEO, Mr. Deng Guanbiao.

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Sincerely,

Bin Yuan Capital

Specialized

China Manager

• Shanghai/Hong Kong-based, value focused China manager

• Long only absolute return mindset • $600M+ AUM invested in All China and China A share

strategies

• Founders with 35+ years combined investment experience

• Core team formerly with GE Asset Management (“GEAM”) managing $5B across 3 funds; EM, Greater China & China A Shares

Experienced

Team

• Class A – Management Fee 1.5% • Class B – Management Fee 1%, Performance Fee 10% • Class C – Management Fee 2%, Performance Fee 20%

Fund Fee

Structure

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