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Why advisers and clients can’t ignore China

China’s significance is hard to overlook as a main drive and global growth the evolution of its middle class

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China is very much a region that has historically divided opinion from an investment standpoint. On one hand, there are questionable business practices; a huge debt problem and patchy human rights records, On the other, China’s significance as a primary source of global growth and evolution of its emerging middle class is hard to overlook. It could prove unwise to ignore the opportunities it may offer investors going forwards.

China continues to transition from being a manufacturing powerhouse to service led economy, with the tertiary (services) industry accounting for 52 per cent of Chinese GDP, as at September 2016.

Growth has been driven by increased domestic wealth, technological innovation and entrepreneurship, supported by financial reform at the highest level. The Chinese stockmarket has long been renowned for the dominance of state-owned enterprises (SOEs) but, more recently, tech companies Tencent and Alibaba have overtaken these, even the banks, to become the current largest corporations in China.

A noteworthy reform is the opening up of China’s vast equity market to foreign investors. A-shares have historically been unavailable to most overseas investors but through the Hong Kong – Shanghai and Hong Kong – Shenzhen ‘Connect’ initiatives this is no longer the case.

Investment managers can still access Chinese companies through B-shares (stocks traded in foreign currency) and H-shares (mainland China companies listed on the more user- friendly Hong Kong exchange but incorporated in mainland China).

However, relative to more established marketplaces, it is still early days for the H-share market. They have only been trading since 1993, initially consisting of nine SOEs and this has since grown to over 200, with a total market cap of over US$700bn.

To give a sense of the potential opportunity set, this still significantly lags the 3,000 plus strong complement of companies listed in the A-share market that will soon be available.

Another clear sign of market advancement is MSCI’s recent decision to include Chinese A-shares in its indices. This has acknowledged the progress that China has made in addressing concerns raised, such as reducing the number of voluntary trading suspensions.

However this is a slow process and will occur in two stages in 2018    firstly on a 5 per cent partial inclusion basis. This will have minimal impact on benchmarks initially but as the inclusion basis is increased over time, China’s weighting in both Asia and emerging market indices will grow and ultimately become even more significant.

Upon full inclusion, China (onshore and offshore listings) is estimated to comprise over 37per cent of the MSCI Emerging Markets index, 10per cent higher than its current weighting.

The ‘One Belt One Road’ initiative is a mega infrastructure project to establish a transnational network connecting Asia, Europe and Africa. The three major pillars of this, infrastructure, trade & investment, and industrial capacity cooperation could, if successful, massively boost trade volume and ultimately improve returns on investment in the long term. This could additionally bolster China’s position in the global economy at a valuable time as it experiences well-documented slowing economic growth.

It would be reckless to ignore the fact that China is still an emerging market, with a level and number of risks that reflect this. Chinese credit was recently downgraded by Moodys from Aa3 to A1, indicating specific risks, including a high level of leverage within SOEs. However, this is not a new concern to investors in China, and is indeed one that the region is working towards rectifying.

Diverse ethnicities and cultures means China has diverse and distinct tastes, in which local companies may be best placed to profit. Investment via an active approach, where the manager has access and connections could be an advantageous way to access the region.

The following funds provide entry to the Chinese market through differing strategies:

First State Greater China:  The fund is invested in quality mid and large cap growth companies that are based in, or have significant operations in, China, Hong Kong or Taiwan. The team undertake rigorous research to assess sustainability of growth, strength of franchise, financials and management, with only select companies meeting their high standards, and where there is a clear alignment with investors’ best interests. This strategy offers investors with relatively more conservative access to what can be a volatile region.

Matthews China Dividend: Chinese dividend policies have been steadily improving and the average pay-out ratio has grown dramatically over recent years. This fund is invested in companies providing an attractive current yield while also being well positioned to grow future dividends, both of which can positively impact total return. Additionally, consistent payment of dividends can help to reduce volatility of long-term total returns.

Matthews China Small Companies:  Small and medium sized companies now account for around.60 per cent of China’s GDP and have grown at a faster rate than the Chinese economy as a whole. This fund invests in well-managed companies in China, Hong Kong and Taiwan in their initial stages of growth, with a market capitalisation of around US$3bn and under. This is an expansive market made up of a wide array of companies, therefore requires thorough due diligence. Even then, investment in smaller companies can be more unpredictable and therefore potentially more volatile than their larger cap peers.

Passive investment: This is another option to access the region. This can provide inexpensive, broad access across China and offer a level of diversification that one might not always receive through more concentrated portfolios. However, in a market currently dominated by a number of large players and SOEs, investors must be aware that the actual benefits of diversification may be less than anticipated, and there are a number of sizable listed companies that are not currently run for the benefit of stakeholders.

Emerging markets, as they are defined, are constantly changing and progressing, and China is absolutely no different.

Lynn Hunter is investment research analyst at Square Mile Investment Consulting and Research 

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