Less than a year before the Beijing Olympics, China is attracting a lot of attention but underneath the hype there is a compelling investment story.
The reindustrialisation of China over the last two decades has been one of the most remarkable transformations of any economy in recent years. The way that companies have started to move up the value chain from low-value-added assembly work to skilled precision engineering and construction has been nothing short of remarkable.
We expect China to continue to deliver growth in the region of 10 per cent each year, not just in the run up to the Beijing Olympics but well into the medium to long term.
China’s infrastructure explosion has been dramatic. Today, it has 45,000km of expressways compared with less than 7,000km a decade ago. Last year, 3.83 million passenger cars were sold in China, which represents a tenfold increase on a decade ago. The rail network is also expanding rapidly. Under the current five-year plan, Beijing has committed $197bn to new and upgraded rail infrastructure.
Last year, China added the equivalent of the entire power output of the UK to its national grid and the government has committed $184bn to upgrade the grid by the end of the decade. China’s domestic retail oil market is growing rapidly on the back of the country’s transport boom and crude oil imports have risen at a compound annual rate of 18 per cent.
After two decades of strong economic growth, perhaps inevitably we are starting to enter the early stages of a bubble in the mainland China market. Based on the Taiwanese experience in the 1980s, however, we are confident that there will be many more years of strong growth to follow in China.
Our strategy in the portfolios we manage in these markets over the last year has been to favour beneficiaries of rising domestic consumption in China, such as retailers and car companies.
We have also participated in strong economic growth by investing in banks and property companies in Hong Kong and China, and taken selective exposure to commodity-related stocks.
We have been much more cautious on Chinese and Hong Kong exporters, where currency appreciation has already squeezed margins, but are more positive on the prospects for infrastructure-related companies in China, particularly in the run-up to the Olympics.
Unfortunately, there is a problem in getting access to this economy and it is a big one. China’s renminbi-denominated A-share market is not an open one. With a few exceptions, overseas investors cannot participate.
Foreign investors are invited to participate in the hard currency B-share market but, as demand is much more limited, it has never risen to the same premium as the A-share market. Nor have the H shares listed on the Hong Kong exchange, despite all share classes representing equal ownership in the issuing company.
For investors new to investing in China, a brief explanation is probably in order here. Both A shares and B shares are issued by companies listed on the exchanges in mainland China. A shares can be bought by Chinese individuals and B shares by overseas investors. H shares, on the other hand, are in companies listed on the Hong Kong stock exchange.
With artificial constraints on who can invest in the A-share market in China, the laws of economics cannot apply and the arbitrageurs have not been able to iron out these wrinkles. As a result, there has been a sharp divergence in performance between the different share classes in recent months, with remarkable inflows from domestic investors driving A shares to a premium over H shares.
The artificial premium attached to many A shares over the equivalent Hong Kong-listed H shares is one reason we believe that H shares offer a much more attractive and more fairly valued way for investors to gain exposure to China’s growth story than the volatile and highly valued A-share market.
Another reason is the impact of a recent change in Chinese legislation relaxing the restriction on Chinese citizens investing overseas.
The qualified domestic institutional investor programme, or QDII, was established in June last year and 19 financial institutions have been qualified under the scheme, 18 of them commercial banks. Until now, little of the $14.5bn raised by these banks has been invested overseas, as they were required to invest in foreign money markets and fixed-income products which generated little interest from their retail clients. However, changes introduced last month permit QDIIs to invest up to half their investment quota in overseas stocks.
In the near term, we are expecting Hong Kong-listed companies to be the primary beneficiaries of this wave of liquidity, with China-related markets across Asia likely to benefit later.
With the help of this additional investment from mainland Chinese investors, it is our contention that the valuation of Hong Kong-listed H shares will converge gradually with A shares, with those at the most significant discounts to mainland valuations likely to benefit most.
The positioning of the portfolios we manage in the region reflects this thinking, with a strong preference for H shares over A shares in the current environment overlaying the investments we have chosen on the basis of earnings surprise and likely outperformance of the broader market.
We believe the valuation premium attached to many of the companies listed on the domestic A-share market is an anomaly and we are positioned in anticipation of benefiting from the inexorable laws of economics as China continues to open up to the world.
We remain confident that the broader China story is a long-term, one, set to run through next year’s Olympics and well beyond.