Great \road \to china
Investors undaunted by the prospect \of some risk are viewing the Chinese \market as an exceptional opportunity \\\
The dog \will have \its day
As China’s Year of the Dog gets under \way, investors are hoping for a repeat \performance of the growth that was \the dominant narrative of last year \\\
February 16 marked the beginning of a new year in China. But while 2018 is the Year of the Dog, associated with honesty, faithfulness and a strong sense of responsibility in the Chinese zodiac, investors will be hoping for a repeat of 2017 – the Year of the Rooster – during which the MSCI Index returned almost 55%.
Much like the returns in the American markets last year, a large part of this performance was driven by the share price gains of internet giants Tencent and Alibaba. As a result, those investors willing to take some risk in their portfolios and add some China exposure were very well rewarded.
With an average fund return of 36.51%, the IA China sector was the best performer of all peer groups, and it has started 2018 in similar fashion. For the month of January, China was again the best-performing sector for retail investors as the average fund was up by 4.2%.
So as the firecrackers die down, the question on most investors’ lips is that after such a good run can these returns continue, and just what is the best way of accessing the Chinese growth story?
The right angle
In this guide we look at what is happening in China from a multiple of angles. Square Mile’s investment research analyst provides an overview, examining the factors that drove performance last year, an outlook for 2018 and one of the best ways investors can get involved in the region.
In our viewpoint section we speak to three fund buyers to find out how they are accessing the region and whether in their view a slowdown is imminent. Also, just what is the best way of investing in China, is it through an Asia-Pacific fund, a global emerging markets fund, or a single country offering?
Lastly, Matthews Asia’s Tiffany Hsiao, manager of the Matthews China Small Companies Fund, explains why Chinese small caps are less volatile than investors may think and how 2018 could be the year that innovative companies come into their own.
Adam Lewis, contributing editor
‘As the firecrackers die down, the question on most investors’ lips is that after such a good run can these returns continue?’
The keys \to the city
With the once closely guarded Chinese equity market now more open to foreign investors, and government financial reforms taking effect, the country could be on the brink of making great strides during 2018
China was the second best-performing emerging market country during 2017, as defined by MSCI, delivering a return of about 41%. It was only pipped to the post by Poland, which returned close to 42%.
It has been well documented there has been a synchronised upsurge in growth over 2017 in sterling terms, and few would deny that China has played a central role in this.
Chinese growth has been driven by a number of domestic factors, including increasing wealth, innovation and entrepreneurship, all of which was supported by financial reform at the highest level.
This has created an environment in which technology has thrived. Tech-centric firms, such as Tencent and Alibaba, have overtaken the once dominant state-owned enterprises to become the largest corporations in China, bolstering performance during 2017.
‘Tech-centric firms have overtaken the once dominant state-owned enterprises to become the largest corporations in China’
Lynn Hunter, investment research analyst, Square Mile Investment Consulting & Research
Last year, there were another couple of key events in the Chinese market. While supply-side structural reform was first mapped out in 2015, its effect was evident during 2017.
The reduction of surplus production capacity, such as within the steel and coal industries, helped China to maintain a manufacturing PMI above 50 and avoid the cyclical slowdown that many had had predicted. The progression and impact of this is expected to continue for a number of years.
In December 2016, China’s vast equity market was opened up to foreign investors through the Hong Kong and Shenzhen ‘Connect’ initiatives, and this has had its first full year of influence. Previously, A-shares had been unavailable to most overseas investors.
This year could see further liberalisation of Chinese financial markets as the decision by the MSCI to include Chinese A-shares in its indices will come into effect. Although this will have a minimal impact initially, over time it could be expected to lead a new investor base in the region.
Given that 2017 was such a strong year for Chinese stock market performance, what does this year hold in store?
There remain a number of potential headwinds that could surface, including the impact of faster than expected hikes in US rates, the rise of protectionism following Trump’s withdrawal from the trans-Pacific partnership, higher credit expansion and increasing levels of debt. Investors will also question whether the recent corporate profit rally can continue.
Despite valuations now being closer to fair value, earnings trends look positive and if companies continue to beat expectations, this will support further share price expansion.
‘The decision by the MSCI
to include Chinese A-shares
in its indices could, over time, lead to a new investor base
in the region’
Other factors that led to earnings improvements in 2017, such as increased construction activity, will remain in place and are conducive for healthy, ongoing corporate earnings growth.
Political stability remains a good backdrop for continued economic reform, in both the supply side and within state-owned enterprises. With inflation only increasing slightly, and real disposable income up by 8%, consumers will have a choice of saving – historically into property – or spending.
There have been growing restrictions on mortgages as the government aims to avoid the bursting of any property bubble, so private investment uptake is growing. This has not been to the detriment of consumption, which is likely to continue its growth trajectory into 2018, benefiting current hot-topic areas of the market such as health and exercise.
Chinese stocks represented about 30% of the MSCI Emerging Markets index at the end of 2017. With the inclusion of A-shares, this is only going to increase over coming years.
Although many emerging market strategies might struggle to go overweight, owing to mandated country limits, the region does bring diversification benefits. The broadness of the market and share type (across A-shares, B-shares, H-shares, red chips, etc) means a different form of diversification is possible.
As the Chinese market has matured, this has created opportunities in various sectors. Depending on the outcome an investor is seeking, strategies focusing on dividend-paying companies or high-growth smaller companies may better meet their needs.
It is worth noting that, with a focus on more targeted areas of the market, the overall level of investment risk or volatility may increase. This is something investors must consider with regard to their portfolio as a whole.
Tiffany Hsiao, manager of the Matthews China \Small Companies Fund, explains how innovation and technology is the key to Chinese small-cap success
Why should investors consider Chinese smaller companies?
Small-cap companies are at the forefront of China’s economic shift away from fixed asset investments (such as manufacturing, infrastructure and real estate) and towards innovation, consumption and services.
The amount of innovation in the more entrepreneurial regions is promising and smaller Chinese companies are tapping into it. They tend to thrive mostly in productivity and value-enhancing industries such as automation, healthcare, e-commerce and education, which are all areas that tend to be under-represented in large-cap orientated benchmarks and portfolios.
Are Chinese smaller companies a risky investment?
There are misconceptions about the level of volatility in China’s small-cap market. In fact, China’s small-cap stocks tend to be less volatile than the large-cap stocks because they are more macro-agnostic and carry less debt. More surprisingly, compared with US small-caps, as represented by the Russell 2000 Index, Chinese small-caps were less volatile, had higher return on equity and lower leverage ratios.
‘There are misconceptions about the level of volatility
in China’s small-cap market.
In fact, China’s small-cap stocks tend to be less
volatile than the
Tiffany Hsiao, manager,
Matthews China Small Companies Fund
What returns should investors expect?
2017 was undoubtedly the year of Chinese technology stocks, thanks to the performance of several large internet companies. There could be many opportunities further down the cap scale in 2018 if investors are willing to look. 2018 might be the year that innovative Chinese small companies come into their own.
Small companies typically do not have much capital to compete with their larger peers. A way to win against bigger companies, therefore, is through sustainable innovation. This could be a technology innovation that results in an intellectual-property moat or a business-model innovation where the small company has figured out a better way to do business.
In 2016, according to data from the International Monetary Fund, China accounted for 28% of global GDP growth – a rising trend we think is likely to continue. We believe a portion of this growth can be captured by investing in smaller Chinese companies.
‘Demand for consumer-
driven applications in technology devices
continues to grow among millennnials’
How many companies do you have to choose from?
China provides a broad investment universe for stockpickers: approximately 4,500 companies with a market cap of less than US$3bn, which we define to be small cap, are domiciled in China.
These companies provide opportunities for higher growth at lower valuations because they are less well known.
This allows active managers like us to uncover high-quality companies that have good corporate governance at lower valuations.
What drove performance in 2017?
Our holdings in small-cap technology, healthcare and industrial companies were significant contributors to fund performance.
As demand for consumer-driven apps in technology devices continues to grow among millennials, we see opportunity in Chinese small-cap companies that manufacture modules for smartphones, as well as those that innovate to make handsets thinner and lighter and with a longer battery life.
In which sectors are you expecting to find the best hunting grounds for holdings?
I expect China’s ongoing reforms to create healthy prospects for several sectors. Consider the government’s stricter stance towards cleaning up the environment. The country is still powered by dirty coal, so the government has been stringent on the use of coal lately in order to clean up the air and water. Supply-side reform is happening in certain sectors, such as materials and energy. I think these changes will ultimately create opportunities for companies that have better cost disciplines and can gain regional market share.
We also believe China will be a powerhouse in global healthcare, whether it is in pharmaceuticals, drug discovery or diagnostics. This is interesting because, in the past, the Chinese have been famous copy cats, but it’s moved away from that image and mentality, and the government has put in place new initiatives to help the country’s entrepreneurs become global innovators.
To learn more about how we invest in China, visit global.matthewsasia.com
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Sky high and rising?
China is making huge strides towards becoming a global champion in technology, as the IA China sector generated one of the strongest returns of last year, but will the growth continue through 2018?\\
Investors in China enjoyed a fruitful 2017, demonstrated by the fact the IA China sector generated the strongest sector return of the year, up 36.51% in sterling terms. After such a good year, the question on most investors’ lips is can this growth continue into 2018, or is a slowdown imminent?
If January’s numbers are anything to go by, 2018 is off to a good start. With a sector average fund return of 4.2%, China was again the best-performing sector for retail investors, so can this continue?
Coming of age
Adrian Lowcock, senior investment director at Architas, believes China is primed to lead emerging markets again this year, as the underlying economic data is supportive of strong single-digit growth and valuations remain attractive.
“Growth is expected to continue, but may fall from around 6.8%, as seen in 2017, to 6.4% over the next year,” he says. “This is generally owing to improved regulation and oversight of the financial system, with more focus on quality growth.
‘There has been a shift from ‘made in China’ to ‘innovated in China’ as the country has emerged as a global leader in technology’
Adrian Lowcock, senior investment director, Architas
“China is continuing to progress from a global exporter to domestic consumer, and there has been a shift from ‘made in China’ to ‘innovated in China’ as the country has emerged as a global leader in technology.
“Instead of western companies benefiting outright, we have seen Chinese equivalents of Facebook, Amazon, Ebay and the like dominate their home market, so investors now need to access these businesses.
“There are also risks, of course. Chinese debt is huge but is no longer growing as quickly. It is a command economy and there has been a significant misallocation of resources, resulting in industries with oversupply and little, if any, profits.
“However, there are many state-owned enterprises that are heavily indebted and inefficient, often referred to as zombie companies. These should be allowed to fail to reduce capacity and let surviving companies run more efficiently and profitably.
“We believe those emerging markets closest to China will benefit from a halo effect, so we prefer Asian EM.
“It is a mistake to think the urbanisation of China is complete and that the region is a developed economy. It is not.
Beyond the cities, it is still very agricultural and rural. Only around 7% of people have a mortgage, for example, which also means the housing market is not necessarily in a bubble, as many investors believe.”
Stick or twist?
While Iboss does not have holdings in China specifically, Chris Rush, senior investment analyst at the company, explains that it gains exposure to the region through relative overweight positions in global emerging markets and Asia.
‘Asian corporate governance has markedly improved and political turmoil in developed markets has, at least partially, narrowed the gap’
Chris Rush, senior investment analyst, Iboss
“The favourable demographics and valuations relative to the west remain well-reported tailwinds,” he says. “However, it is the narrowing of political disruption that is perhaps underestimated.
“Traditionally, investors would expect to receive a risk premium for the political risk involved in investing in Asian equities. However, not only has corporate governance markedly improved but the increasing political turmoil in developed markets has, at least partially, narrowed the gap.
“We do, however, have some concerns. A large part – 41% – of the Chinese index (MSCI China) is technology based, with 30% of the index comprising of just two technology stocks: Tencent and Alibaba.
“The domination of these technology stocks has had a marked effect on the characteristics of the market. For example, the correlation between the index and the Nasdaq hit an eight-year high in 2017 (0.7).
“We do not plan on making any changes to our overall GEM/Asia allocation, although we have ensured we are not overexposed to technology stocks in the coming 12 months.”
‘An increasing number of Asian funds have large Chinese exposure, either directly or through Hong Kong and, arguably, Taiwan’
Ben Yearsley, director, Shore Financial Planning
How to invest
When it comes to investing in China, investors have a number of different options. They can go for a single country fund, a global emerging offering or an Asia-Pacific portfolio.
Ben Yearsley, a director at Shore Financial Planning, believes that for the majority of investors, an Asian fund is probably the simplest route.
“Not only will you get broad exposure to China, you get the knock-on impact on other countries,” he says. “If you went down the EM route, you would end up with eastern Europe and LatAm as well as Asian emerging.
“An increasing number of Asian funds have large Chinese exposure, either directly or through Hong Kong and, arguably, Taiwan.
“Two of my favourite funds, First State Asia Focus and Schroder Asian Alpha Plus, both have large weights in China.
“First State has 17% in China, as well as further holdings in Hong Kong and Taiwan. Information technology and software feature strongly, and as you would expect the average market cap is quite high.
“The Schroder fund has more than First State in China, and is more exposed to the names that have driven the market last year, Alibaba and Tencent to name two. In my view, these two funds give you good broad exposure to the market and the key themes.
“However, what neither the First State or Schroder funds really give you is direct exposure to small cap, so I would probably balance out these with either an Asian or Chinese smaller companies fund to give you that domestic kicker.”