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Reasons to keep faith in China’s fundamentals

By Nicholas Yeo
 — 1 minute read

China’s forceful economic rebound bodes well for company earnings in 2021, incentivising active investors to refocus on fundamentals and seize on volatility amid potential headwinds.

Nicholas Yeo

China set a new tourism record during its Labour Day holiday in May after authorities sped up COVID-19 vaccinations. It points to a drastically improved outlook for consumer spending.

Even if year-on-year comparisons create a flattering picture of growth – given the depths of the 2020 shutdown – A-share companies are still forecasting 38 per cent growth in earnings per share on average for 2021 – with high-quality companies even better placed.

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Although policymakers have tightened credit conditions, the People’s Bank of China has committed to keeping interest rates accommodative. That should ease concerns that inflation will lead to policy tightening after increased industrial activity drove commodity prices.

Aside from geopolitical tensions – which are hard to quantify at a company level – the key risk for investors to watch will be regulatory overhang. With the COVID-19 pandemic under control in China, policymakers are focused on fostering more sustainable economic growth. That includes regulating industries that had grown rapidly without adequate oversight.

Most prominently, authorities have moved to curb monopolistic practices by platform businesses in areas such as financial technology. These firms seek to cross-sell tech-based services to the network of users on their platforms.

Of course, regulatory clampdowns typically lead to share-price volatility and create opportunities to buy quality companies at lower valuations. This year could be a productive one for active stock picking.

There’s every reason for investors to be positive about prospects for China’s A-shares market. Our Research Institute forecasts that China’s economy will expand around 9.5 per cent in 2021.

The nation’s post-pandemic rebound should spur wage increases, which would support continued structural growth in domestic consumption. Firms in the consumer staples, consumer discretionary and healthcare sectors would be in line to benefit.

Consumer staples led share-price performance in 2020 and were first to face the sell-off when the market corrected after Chinese New Year as investors rotated out of growth-oriented names over fears of monetary tightening.

While companies have clawed back lost ground, a number of quality consumer and healthcare stocks remain 10-20 per cent cheaper than before Chinese New Year – with fundamentals that are largely unchanged.

Overall, Chinese exports are rising and economic data – including from the Labour Day holiday – are encouraging. Not only do company earnings prospects appear healthy, but their earnings are of higher quality than for peers in other markets.

For example, share buy-backs have become common among S&P 500 stocks, typically funded by cheap credit. In contrast, China is striving to deleverage and lower financial risk.

At the same time, compared to the S&P 500, Chinese A-shares are almost 50 per cent cheaper on a price-to-book basis and almost 30 per cent cheaper on a price-to-earnings metric.

Looking ahead, the structural drivers of Chinese consumption remain intact; the nation’s generation of aspirational Millennials will continue to buy high-quality goods and services. 

There are opportunities across a variety of names and sectors, from condiments producers and auto-parts makers to new energy firms and battery suppliers. Investors might focus on industry leaders with strong market shares and defendable competitive advantages. They can absorb higher input costs – which will be key in an environment of rising commodity prices.

In general, such quality companies are quickest to recover from external shocks and better placed to deliver sustainable earnings growth. Their management teams also tend to be more prudent and receptive to engagement on environmental, social and governance (ESG) issues.

Selecting firms with strong ESG standards improves investors’ chances of avoiding loss-making corporate failures and scandals. It’s also a way to generate potential alpha by investing in positive change at companies. Ultimately, progressive ESG policies can help drive a company’s returns and share price over the long run.

At a sector level, rising disposable incomes and increasingly health-conscious citizens boost the prospects for healthcare services. Authorities have increased tax breaks for research and development spending to drive innovation and reduce dependence on Western technology. 

This could be a key factor among China’s growing array of pharmaceutical firms. My team has taken stakes in clinical research organisations that service pharma firms, for instance.

I’m also positive on the outlook for China’s wealth management industry, which should benefit from continued capital market liberalisations. We recently invested in an IT solutions provider for portfolio management and trading platforms used by financial institutions.

Separately, growth is anticipated in renewable energy amid supportive government policies to meet environmental targets. The outlook appears bright for electric vehicles, with adoption low in second and third-tier cities. The government may introduce incentives to boost rural sales and invest in charging infrastructure – which would support long-term industry growth.

Nicholas Yeo, head of China equities, Aberdeen Standard Investments

 

 

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Reasons to keep faith in China’s fundamentals
Nicholas Yeo
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