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Backing China in the Year of the Dog

Backing China in the Year of the Dog

Greg Kuhert

The Chinese domestic A-share market is the second largest in the world, but only 2 per cent of its stocks are in the hands of foreign shareholders, write Investec’s Greg Kuhnert and Truman Du.

Greg Kuhnert

It was only last summer that MSCI announced the inclusion of A-shares in its Emerging Markets Index, the first 222 to be incorporated from June 2018.

If the index were to embrace all Chinese stocks, China would account for nearly 40 per cent of the MSCI Emerging Markets Index.

According to research by EPFR and Morgan Stanley analysing China’s weighting in global emerging markets funds in aggregate relative to its weighting in the MSCI EM index, the international investment community still remains extremely underweight Chinese equities. We think this trend will reverse over time.

China’s capital market has been reformed. The Shenzhen Stock Exchange has followed the example of Shanghai and joined the Stock Connect program, which gives investors broad stock market access throughout the whole of China – a prerequisite for the decision to include Chinese A-shares in the MSCI Emerging Markets Index.

From an active management perspective, Chinese A-shares have the ability to provide enrichment to a portfolio by adding quality and growth factors and diversification benefits thanks to their low level of correlation with broader global markets.

This, combined with the perception that the Chinese stock market is inadequately studied, means that the Chinese market may be ripe for active stock selection based on rigorous analysis.

China still trades at a large discount to developed markets, despite a rapidly modernising ‘old’ economy (capital goods, energy, chemicals, real estate) and the emergence of a dynamic ‘new’ economy (consumer, technology, internet and healthcare).

After the 2013 change of direction away from the growth-driven economic policy carried out under former president Hu Jintao, Xi Jinping is more focused on a moderate course of growth.

This is based on sustainable company growth that is having a positive impact on key figures such as profitability and cash flow. In addition, significant state reforms have taken place over recent years that have led to greater efficiency within large-scale companies.

While ‘old’ economy growth rates began declining after 2011, these have started to recover more recently, especially within the real estate and infrastructure sectors.

The Chinese government’s strategic focus to improve the environment has also created several interesting new investment opportunities within the ‘old’ economy, including gas and hydro power companies in the utilities sector, the electric vehicle supply chain and industrial automation in the industrials sector.

In the ‘new’ economy, China has one of the highest global growth rates in e-commerce, technology, consumer discretionary and healthcare.

The service sector alone accounted for more than 50 per cent of China’s GDP in 2016, up from approximately 40 per cent a decade ago.

To us, this points to China’s growth becoming less capital intensive and cyclical and therefore more sustainable and shareholder friendly – a transition we would like to see continue.

It is here that we believe the most attractive growth potential could be found because the superior growth rate and cash flow generation in these sectors should reward equity holders over the long term.

While a pause or correction in share prices may be due in the short term, we would view this as a buying opportunity.

The bottom-up fundamentals of Chinese companies are improving and valuations still look attractive relative to history and other global markets, given indicators such as rising corporate profitability due to a broad-based improvement in the economy spanning exports, infrastructure investment, domestic consumption and a pick-up in private investment by corporates, and stronger corporate cash flows with companies paying down debt.

Where are we seeing opportunity?

The most valuable Chinese companies still include the two flagship internet competitors Alibaba and Tencent, which also hold important positions in our portfolio as well.

The two technology giants have long since grown out of their development phases and are now seen as innovative and highly profitable. In addition, financial stocks, such as the Bank of China or the China Construction Bank, are also top positions in our portfolio.

Our A-share holdings range across a diverse set of sectors from consumers and technology to financials and commodities in order to capture our best ideas and conviction across the economy.

Two of our largest holdings in A-shares are dairy company Inner Mongolia Yili, and Ping An, a financial conglomerate with primary focus in insurance, banking and financial technology.

Yili is benefiting from increasing consumer popularity through its strong brand, superior food safety control and constant product innovation in liquid milk and yoghurt. It has seen consistently strong earnings growth and cash flow generation.

Ping An is a beneficiary from increasing life insurance penetration in China. More importantly, we believe that its strong position after multi-year investments in financial technology has enabled Ping An to provide superior customer experience and manage its business units more efficiently going forward.

It is a good example of where a traditional sector in China is transforming itself to be more return-focused and shareholder-aware.

Greg Kuhnert is a portfolio manager on the Investec All China Equity Strategy.

 

Backing China in the Year of the Dog
Greg Kuhnert
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