China and the impact on regional equities

By Jayson Forrest - Managing Editor  - IMAP Perspectives

With a population of 1.4 billion and GDP at US$14.72 trillion, China presents an attractive proposition to any investor. But for a country that embraces capitalism so readily, its highly centralised economy and frequent Government policy changes, present a number of challenges to investors.

Putting aside governance issues, China has never been an easy market in which to invest. But nonetheless, it is still a market with strong growth opportunities and domestic companies with solid fundamentals.

However, speaking at the 2022 IMAP Portfolio Management Conference, Rizi Mohanty - Portfolio Manager at FSSA Investment Managers - acknowledges that China carries a broad range of concerns for investors. Some of these include:

• persistent regulatory change impacting a range of sectors, including the Internet (digital technology), education, and property sectors (particularly as a result of debt incurred by Chinese property companies, such as Evergrande);
• ‘common prosperity’ policy, where privately-owned companies and entrepreneurs have come under increasing scrutiny to demonstrate they are sharing their wealth with the greater Chinese population, as well donating and investing in initiatives to help address the inequity balance within China; and
• a slowing economy.

“I believe some of these concerns will persist and have lasting consequences, and not just in China but also in global markets,” says Rizi. “And while some commentators have stated that China is uninvestable, with a Lehman Brothers situation happening with Evergrande, I believe those views are extreme.”

According to Rizi, what is driving these reforms in China are the numerous challenges the country faces, including: the widening wealth gap; high asset prices (particularly in relation to China’s property market); an ageing society; and low birth rates.

“These are structural challenges that require some reforms and fixing, which means there is a cost to these reforms,” he says.

Property remains king in China, with a staggering 80 per cent of China’s household wealth invested in this asset class. This makes the property market in China about double that of the United States. Investment in real estate directly contributes about 15 per cent of GDP, including construction and residential property development, and about 25 per cent of GDP if taking into account upstream and downstream sectors.

“This provides a perspective of how big and unbalanced the property sector is in China. As the Government tries to move policy away from property/infrastructure and more towards consumption, we are seeing some of the fallouts of this through the range of policies the Government is enacting,” says Rizi.

But should investors be concerned about a potential ‘property bubble’?

“It’s an interesting question,” says Rizi. “We’ve all heard stories of under-occupied developments in China, which are commonly referred to as ‘ghost cities’. The Government is working to rein in property development. Private companies like Evergrande, which are highly leveraged, are being brought under state control.

“Some of the state-owned companies are in good shape to takeover projects that are stranded or half finished. So, the Chinese Government’s most recent regulations and policies for the property sector are aimed at avoiding a hard landing, which would destroy the sector.”   

But despite policy developments in China and a slowing economy, Rizi is bullish on China. He believes the key to stock picking is to remain focused on company fundamentals.

When looking at growth opportunities in China, there are four key areas that FSSA Investment Managers focuses on:

• High quality companies. “We seek to identify businesses that are run by a good management team, and where we think profits will be delivered over 5-10 years. And while business governance isn’t as good as other markets, like India, it is improving.”
• A focus on risks. “It’s positive to see the Chinese market more focused on risks. Only 12 months ago, it was hard to find good quality companies with a reasonable valuation, but that’s beginning to change.”
• More accommodative policies. “The Chinese Government doesn’t want to destroy the property sector. Instead, it wants to fix the imbalance that currently exists in a reasonable manner. To do this, policymakers are becoming more accommodative with the easing of monetary supply and property market restrictions.”
• Take advantage of attractive valuations in good companies.
  “Experience has taught us that is you own good quality companies that can compound their earnings, then eventually, the share price follows,” says Rizi.

An example of a quality stock that FSSA Investment Managers likes is China Merchants Bank, which is one of the best performing banks in China. It has continued to grow its earnings through the GFC, property cycles, and the global pandemic.

“What excites us about investing in China is not just because it’s the second largest economy, but it’s also home to a number of competitive, innovative and well-known companies,” says Rizi. “There are also a number of domestic market leaders that are showing strong growth in their respective sectors, like ANTA Sports (sports equipment), Jiangsu Hengrui (pharmaceutical), and Shenzhen Inovance (digital industries).”

It’s a sentiment shared by Dr Joseph Lai - Founder and Chief Investment Officer at Ox Capital Management - who agrees valuations are still cheap in China and Asia emerging markets.

“China is extremely cheap, while India is a little bit more expensive. But the whole of Asia emerging markets is currently very attractively priced, especially after the weakness in share prices over the last couple of months.

“For example, if you look at the Chinese market today, you’ll see some very cheap companies. However, the problem is not finding the cheap companies; the problem is knowing which cheap companies to own. Some well-known companies, like Alibaba, is on 9x earnings, while Tencent is on 17x earnings. These stocks are still cheap, but you need to work out which ones to own.”

The approach Ox Capital Management uses to identify and select stock positions in China is to find companies that do not take unnecessary risks.

“There are a lot of cheap companies in China, so buy the best businesses with reduced idiosyncratic risk. By doing so, as earnings grow, you should make money,” Joseph says. “China remains a market that offers rich opportunities for investors.”

And what about the governance risks in China, with its ‘one-party’ communist regime? How does an investor manage governance risk in a portfolio?

“It’s definitely not easy managing governance risk in China,” says Rizi. “You need to be very selective with the companies you invest in. We tend to stay away from businesses that benefit from the Chinese Communist Party, because when this favourable treatment stops, it ends very quickly.

“Instead, we look for businesses with a solid track record that have done well, irrespective of the Government. These businesses tend to be more resilient. But even then, we still get it wrong, when these companies are affected by changes to Government policy and regulation, like companies in the education sector.

“So, when investing in China, you need to very selective with your stock picks, run a diversified portfolio, and be mindful of where the risks are.”

Joseph agrees: “When it comes to selecting stocks, most active managers would prefer privately run businesses as opposed to state-owned companies, simply because they are better run and more accountable to shareholders.

“When we pick private enterprises, we ensure we understand who is behind the company, what they have done before, what is their experience and track record, and do they have integrity.

“In a country like China, the big companies have not been able to extract monopoly profits. That’s because when they try to do that, the Government will immediately stop them. And that’s what the recent crackdown has been about with some of these massive companies, like Tencent and Alibaba, working in an anti-competitive way.

“So, on the one hand, China is a free market but on the other hand, there is Government interference to protect consumers from monopolies and to ensue consumers are not paying too much for services.”   

Another thing Joseph believes investors need to be mindful of is, that when it comes to investing, what has worked in markets over the last 10-20 years, may not work now.

According to Joseph, the last 10 years have been characterised by low inflation, reasonably fast global growth, and geopolitical stability. But looking ahead to the next five or 10 years, and it becomes a different picture, with slower economic growth, higher inflation, and greater geopolitical instability.

It’s because of these factors that Joseph believes we are beginning to see a new era of deglobalisation - a movement towards a less connected world, characterised by powerful nation states, local solutions, and tighter border controls, rather than global institutions, treaties, and free movement.

“Globalisation has been a fantastic catalyst for low inflation over the last 20 years. But as deglobalisation continues, it’s likely we’ll see a higher inflationary environment,” he says.

So, given this new environment, what sort of stocks are likely to perform well?

“In the next 5-10 years, you want to be holding stocks that the world absolutely needs. These stocks are resources and commodities. The good thing for emerging markets, including Asia, is these regions have quite a few countries with good population growth and resource endowments.”

Joseph remains excited about the opportunities available in Asia, with many of these emerging countries able to deal with high inflation and high interest rates because they are already used to them. “So, they won’t be as impacted by a novel high inflation/interest rate environment, compared to developed economies.” 

And while Ox Capital Management remains bullish on China, what really excites the manager are the opportunities in other Asia emerging markets, particularly Indonesia.

“Indonesia is a country that is well endowed with resources,” says Joseph. “It’s also a country with a young and growing population. And while its terms of trade haven’t been good over the last 10 years, that has changed considerably over the last 18 months due to the rise in energy prices.

“Consumption is picking up rapidly, and businesses are starting to invest again. There is a nascent cyclical recovery occurring in Indonesia. We find this exciting and subsequently own a lot of exposure to companies involved in the domestic consumption and telecommunications sectors in Indonesia.”

Another reason why Ox Capital Management is excited about Indonesia is its supply of battery grade nickel to the world. Nickel is particularly important for the burgeoning electric vehicle sector, and demand for nickel for electric vehicle batteries will only grow, as energy requirements increase in coming years.

“Class 1 grade nickel demand for batteries is growing at a rate of over 50 per cent and supply is limited. The lack of alternatives for nickel means that the bulk of incremental supply will come from Indonesia,” Joseph says. “Indonesia is creating a whole new industry of battery manufacturing - from mining and processing, through to battery assembly. Global companies, like LG and CATL, have invested significantly to set up manufacturing plants in Indonesia.”

Ox Capital Management’s portfolio includes ANTM, an Indonesian Government owned gold and nickel miner that is a key player in the Indonesian Government’s strategy to domesticate electric vehicle battery production. Another stock the manager likes is Vale Indonesia, which is a pure play on nickel.

And what about India as an emerging market?

“What we find interesting about India is while you might not have the same number of sizeable companies or get the level of growth as you do in China, you do get good quality companies,” says Rizi. He adds that established companies - like private banks, IT services, and consumer-related businesses - are generating higher than average long-term returns.

“China and India are quite different markets in terms of opportunities, but from a regional perspective, we still like Indian companies. The challenge with India is valuation. Good companies tend to be fairly expensive,” he says.

Dr Joseph Lai is Founder and Chief Investment Officer at Ox Capital Management; and

Rizi Mohanty is Portfolio Manager at FSSA Investment Managers.

The session was moderated by Dr Isaac Poole CIMA^® - the Chief Investment Officer at Oreana Financial Services.