China will become an increasingly important asset class and investors will have difficulty justifying a zero or underweight exposure to Chinese equities. That is the view of Patrick Shum, chief investment officer of Invesco’s Hong Kong-based Asian investment team. When we talk about these markets being too big to ignore, the scale of China’s resurgence as a global economic force is at the very centre of the argument. Shum says, “China’s development is no longer a local phenomenon. China is now a major player in world trade with a market share growing from 2% in the early 1990s to 8.4% in 2006. With the government’s strong support in grooming domestic consumption, China is rapidly building up another pillar for sustained economic growth. China has already emerged as the largest mobile phone market and the fastest growing car market in the world, this is the sort of scale and potential we are talking about.”
Shum sees that global investors are still underinvested in China. “China’s GDP today represents about 4.4% of world GDP in nominal terms or 16% if we take purchasing power parity into consideration, but the China’s equity market accounts for less than 1% of the MSCI AC World Index. We expect to continue to see a significant increase in global investors’ interest in China in the years to come,” says Shum.
A healthy correction
No correction at all would have been far more worrying. As it is, we see the first signs of the market working efficiently. Recently much attention has been focused on concerns over the possibility of a bubble emerging in China’s domestic stock markets, with shares rising so strongly in 2006, up 130.4% in local currency terms. So although China’s domestic ‘A’ share markets had their biggest tumble in 10 years at the end of February, the hysteria died down after a few days when people realised that this was a much-needed release of pressure. After all, why would a move by the State Council to clamp down on illegal share offerings and measures to curb speculation be a bad thing?
Soichi Fuji, an executive managing director for Sumitomo Mitsui Asset Management in Tokyo, is one of a handful of Japanese asset managers with a specialist China team. His view is consistent with others, that a correction is good but it does create a little more volatility: “This correction was within the range of expectations, and I view it as healthy. Going forward, I expect to see some volatility, but over the long term I believe the Chinese stock market will revert to its upward path. Yes, investors should be cautious in the very short run. But I would emphasise they should not be overly cautious. Chinese fundamentals for equity investments do not support suppressed stock prices at low levels over the mid to long term.”
Invesco’s Shum agrees: “Valuations of ‘A’ shares have become a bit stretched and we need to see
earnings/fundamentals catch up with the expanded multiples. The market is likely to remain volatile in the near term; however, we will be
looking to buy on weakness given our confidence in the fundamentals of the market. Besides, we believe the government wants to stabilise the run-away market without causing a major crash, having spent years trying to jump-start the market.”
Far from there being a market meltdown round the corner, Shum says a closer look at the China A share will reveal the other side of the story: “Before the rebound, the China A share market had undergone five years of bear market. The index was halved from its peak in 2001 and it took over five years for the market to return to this level by the end of last year. A lot of excesses and legacies had been wiped out during the bear market, while significant structural improvements had been achieved through economic success and the implementation of reforms by the authorities. There were good fundamental reasons for the market to rebound strongly in 2006.”
Another positive signal for the sustained development of the domestic share market is the greater involvement of sophisticated foreign investors, who are there for the long haul. Yang Liu, managing director of Atlantis Investment Management in Hong Kong, says: “The quality of foreign investors is much higher now.” She also highlights a key to future growth for portfolio investors: “It was the large-cap companies that have been hit hardest in the last few weeks and this supports our belief that small- and mid-cap companies are going to provide the highest returns. As the economy grows so does the number of entrepreneurs, so the quantity and quality of ex-state-owned companies to invest in is increasing.
“There are 200 IPOs of small and medium-sized companies in the pipeline at the moment, which highlights the strength of this sector and the growing investable universe. Corporate governance is also more apparent within Chinese companies and there is a growing understanding of the need to look after minority shareholders. Many companies within China are competing with each other in the absence of big global firms and this is helping them to become stronger and more efficient. The companies that come to lead their sector in China will therefore be in a position to challenge the big global companies outside the country.”
Another China fund manager who firmly believes it is the small and mid caps who provide the growth opportunities is Andy Mantel, founder the China Mantou Fund.
His approach is to be extremely diversified and to set himself apart from investments targeted by other China funds. Mantel says, “We can find much better value within the Greater China universe. We cover the entire universe of China-related stocks, over 5,000 compared with maybe only 500 covered by other funds.”
Daniel Jim, managing director of Hong Kong-based China hedge fund of funds manager Tripod, says, “We see the best opportunity in China now lies within its inefficiencies, and not the more hyped growth prospects. The scale of the change being brought about in China is, by definition, an ideal area for hedge fund managers to operate in. While it is not practical to eliminate 100% the returns to be brought over by beta, we put special emphasis on building a balance, so we can be well positioned for any external shocks affecting China, hopefully balancing-off some of the negative effects and subduing volatility. The performance of our arbitrage manager as well as our opportunistic multi-strategy manager during the recent market turmoil has clearly demonstrated that this process works.”
Tripod runs a relatively concentrated portfolio, with no more than 10 managers, and the intention is to stay with most of them for the long haul instead of trying to get smart by switching in and out of their funds. Jim says, “We view them as our business partners and we strive to build a mutually beneficial relationships with each one of them.”
Better value elsewhere?
Fund managers are not universally bullish about China’s domestic share markets and certainly, on a valuation basis, they are justified in suggesting that the local market may not be the best investment vehicle for the local growth story. For many years, the only way to play China was through Hong Kong and Taiwan. Is it still the case that they offer the best route to China? Fung at Nikko, says: “Both Hong Kong and Taiwan benefit from China’s growth and development. But if you look at the overall GDP and corporate earnings growth rates of Hong Kong and Taiwan, they cannot match up with those on the mainland. It is true that Hong Kong and Taiwan listed companies generally have better corporate management and transparency and they also are trading at lower multiples, but their exposure to the growth in the mainland is not as direct and strong as those mainland companies.
“For the more conservative and shorter-term investors, Hong Kong and Taiwan can be their alternatives. However, the risk-return trade-off of the good mainland companies still offers better value in the long term.”
Sumitomo Mitsui’s Fuji says: “As I look at the current data, using the ‘Shanghai-Shenzhen 300 index’ for China, on the surface, and from a static point of view, yes there could be better value offered in Hong Kong and Taiwan. But having said that, this statement is highly arguable.
“Just for the readers’ reference, I would like to depict the market PER [price/earnings ratio] in the respective markets from a static point of view. The current PERs based on actual results of China, Hong Kong and Taiwan are respectively about 20 times, a little below 20 times, and somewhat shy of 18 times. Likewise, the one-year forward estimated PERs are about 16 times for China, slightly below 19 times for Hong Kong, and about 13.5 times in Taiwan. However, earnings estimates in China have been constantly revised upwards. In other words the E in the PER multiple seems to be weaving, in the outlook that the ‘E’ would be revised upwards. The long-term outlook for EPS growth for China is north of 19%, just around 14% in Hong Kong, and approximately 18% in Taiwan. When I consider the dynamic earnings outlook of China, ‘value’ could be a tricky concept to be compared among these three markets.”
The idea that foreign capital is suddenly going to lose interest in the China story, however familiar it has become, loses sight of the bigger picture. Today, with China the world’s fourth largest economy, GDP in excess of $2trn and the holder of the largest foreign reserves, reportedly now exceeding $1.5trn, it looks simply too big for any global players to ignore.
And as Fuji-san points out, “Looking out over the next three years, we have the Beijing Olympics in 2008 and the Shanghai Expo in 2010. There is no doubt that these are economically stimulating events, and like any economy around the globe, the Chinese economy is not totally immune to economic cycles. Yes, the macro economic volatility of fluctuations in China have became smaller, but in the short run there is a potential risk for the economy to overheat, and go through a slowdown phase afterwards. Parallel to this phenomenon, there is a possibility for the market to surge and a ‘sense of completion/contentment’ to prevail. If we see a stock market correction linked to this, I would rather interpret this as a ‘healthy event’. Having said that, I would like to emphasise that my mid-to-long-term view is quite positive on the Chinese economy and Chinese equity market.”
Nikko’s Kwok-On Fung says: “Internally, the risk comes from a slowdown of the pace of structural reform (both the real economy and the stock market) to allow China to smoothly transit to a market economy, as well as whether the Chinese bureaucrats can implement the change without causing chaos. Externally, the risks of trade protectionism, military conflict (especially over the Taiwan Strait), energy prices or a US dollar crisis are the major factors that could have significant impact on China’s economic growth and development.”
On a five- to 10-year macro view, Fung suggests the outlook for China should be brighter than the rest of Asia, assuming it can maintain the 8-10% GDP growth. “There is still huge room for economic growth in China as the central and interior regions still lag far behind the coastal China regions. Politically, China has the motivation and determination to grow and develop; and it has a greater ability to maintain a politically and socially stable environment for growth and development than many south-east Asian countries. China has high savings and strong financial resources for investment and growth.”
Invesco’s Shum quotes several examples of the progress witnessd in China. “GDP and national income has increased at a compound per annum rate of over 10%. Resident savings have more than doubled to over $2trn in bank deposit accounts, because of limited investment opportunities. The perception of the Reminbi has shifted from an unwanted currency into the darling of every international investor. Corporate revenue growth and profitability continues to rise rapidly.
All these positive developments were seemingly ignored by the domestic mainland Chinese investors until after the government announced the tradable/non-tradable A-share market reform program (April 2005) and in July 2005 when the Renminbi exchange rate system was changed from a fixed peg against the US dollar to a crawling peg against a basket of currencies. At today’s level, valuation is no longer as compelling as it was a year ago but a PER of 22x is still far from excessive when compound earnings growth of at least 20% pa is expected this year
What sets China apart as a growth story in the region is its sheer scale. Fuji observes: “There are Asian countries that are well equipped with the potential to grow, but the decisive difference would be in the size, the strength and the speed of domestic demand growth that China has. In addition to this, China is not only equipped with the extra available capacity, but it also has plenty of room to boost productivity. Our long-term macro outlook for China, relative to the rest of Asia, is quite strong. As a country, China has strong potential, not only from the ‘supply side’ for production, but also from the ‘demand side’ for consumption. Put another way, the Chinese economy is positioned to be an extremely strong ‘net exporter’.”
China’s funds market is maturing but it still has a lot of growing up to do. Nikko’s Fung reckons the pace of this maturing may surprise the market. “Also, the current overhang for A shares will be resolved or justified by fundamental improvements. The momentum of growth and structural change of the Chinese stock market still makes the risk-return trade-off of the China A shares market attractive.”
Sumitomo Mitsui’s Fuji says: “The long-term expected annualised returns from Chinese equity portfolios should be in the approximate range from 10% to 15%. This ‘approximate range’ is based on our current outlook that the Chinese economy has the potential to grow around 10% per annum in nominal terms. I also believe that China is equipped with the fundamentals to sustain a level to exceed 8% for long-term growth in real terms. Our analysis on their corporate earnings growth also supports this view on annualised returns to be in the approximate range from 10% to 15% for Chinese equity portfolios.
“In contrast, I see the expected rate of return for equity investments in developed countries to be in the range of mid-to-high single digits. To put things into perspective, the volatility of returns could be naturally higher for Chinese equity investments when compared to those of developed countries. But if the investor has the required level of risk tolerance and the investment time horizon, they should be well compensated for investing in Chinese equities.”