Darius McDermott, managing director, Fund Calibre looks at whether the dislike of China as an investment region makes now an attractive entry point?
As we are now in the new Premier League season the old football saying “it’s the hope that kills you” comes to mind, particularly when I think of just how bad my beloved Chelsea were last season. I have no idea what to expect this season!
After two years of constant pain, investors in China could be forgiven for believing 2023 would yield better returns from the world’s second largest economy. Regulatory crackdowns from China’s ruling party saw both the technology and education sectors quickly come under fire in February 2021 – but no one could’ve imagined this would be a catalyst for such a challenging period. Their zero-Covid policy, a clampdown on the property development sector and geopolitical uncertainty all resulted in a fall of over 50 per cent for Chinese equities over the next 20 months.
However, there was optimism towards the back end of last year that an abrupt end to lockdowns – coupled with measures to reinvigorate the residential property market – would act as a catalyst to promote an economic recovery. With regards to ending Covid lockdowns, there were positives as service sectors, such as travel and hospitality, did start to recover, but ultimately the uneven nature of the reopening – coupled with concerns around stimulus and weak external demand – have brought that recovery to a grinding halt, with the MSCI China down 12 per cent in the past six months alone**.
But the updates from many of the managers we speak to are more measured, citing attractive valuations and improving fundamentals at a company level, while the strength of the consumer must not be overlooked. This opens up the question of whether the malaise/dislike of the region makes this an attractive entry point?
Challenges to overcome take time, but the tailwinds behind China remain strong
Matthews Asia investment strategist Andy Rothman says one of the main reasons why China is not doing as well as many predicted is that the region has only started to get over the challenges of Covid in January 2023, compared to more than two years ago for most Western economies. He points to the fact it took other countries 15 months to get back to pre-Covid growth levels after the last wave of cases – China is only halfway through this.
Rothman says there are green shoots in the services sector, which is the largest part of the economy and the biggest employer. In the first half of 2023, per capita spending on services rose almost 13 per cent year-over-year (YoY). Domestic tourism revenue during the first six months of the year, for example, increased 96 per cent YoY***.
He says: “One of the brightest data points is that in each of the last two quarters, household consumption increased at a faster pace than the growth rate of income, signalling an initial recovery in consumer confidence.”https://professionalparaplanner.co.uk/wp-admin/media-upload.php?post_id=15140&type=image&TB_iframe=1
This matters because many believe the consumer will be an important element in the recovery. For example, Fidelity China Special Situations manager Dale Nicholls says his portfolio has been focused on the rise of the consumer – particularly the consumer discretionary sector. He says: “We believe consumption to be the main driver of the recovery, although it will be bumpy and vary across different areas. There is a confidence issue amongst the Chinese consumers but as we know, the consumer is “cashed-up” with record household savings, so I am still positive and see a path to recovery.”****
The second concern is the ongoing recovery from those crackdowns back in February 2021. Rothman says this crackdown on entrepreneurs has hit businesses and consumer confidence hard, citing that around 90 per cent of companies and 90 per cent of urban employment is with small, privately owned companies.
We have started to see attempts by the government to boost confidence among entrepreneurs. Last month, CCP Central Committee and the State Council issued a joint statement on “promoting the development and growth of the private economy.” This was supported by a further CCP meeting which reiterated this attitude towards entrepreneurs and platform companies a few days later.
I also want to touch on the improving quality of companies in China – the number of companies with a market cap in excess of $500m has doubled in the past decade (2,089 in 2012 compared with 4,047 in 2022). FSSA Greater China Growth fund manager Martin Lau says although its authoritarian nature draws controversy, in the context of emerging markets, China has a stable government and political order – with its stock market both highly regulated and deeply liquid^.
Nicholls says China’s 5 per cent GDP target still looks achievable in 2023, making it one of the few regions that will see accelerated growth – adding that corporate earnings should follow suit****. I would also point to the long-term picture, and this is that over the past decade China has accounted for about one-third of global growth – a greater contribution than the US, Europe and Japan combined***.
The challenges are still prominent – youth unemployment passed 20 per cent, the property sector continues to struggle, and private fixed asset investment turned negative, the first time since the start of the Covid-19 pandemic, indicative of a dearth of investment from businesses. This is without going into the ongoing geopolitical wrangling. But there is an argument a lot of the downside is priced in while the upside is being ignored.
Ultimately a lot of this will come down to how much you trust the government to back entrepreneurs in China. Big swings in sentiment and attitude are nothing new in the region, but recent moves by the government – coupled with many of the long-term tailwinds – make this an attraction entry point at these valuations. But patience will be the key.
Funds to consider:
The stalwart
The FSSA Greater China Growth fund is a good starting point, having consistently performed over a long period. The fund focuses on individual company research, with manager Martin Lau investing in quality companies with barriers to entry, pricing power and sustainable growth. Governance is a very important element of the fund, although Lau does look at state owned enterprises where this is improving. The fund also has a strict valuation discipline
Double whammy investment trust opportunity
Managed by Dale Nicholls, the Fidelity China Special Situations trust invests predominantly in companies listed both domestically in China and on the Hong Kong Stock Exchange. The trust has a bias towards mid and small-sized companies. In addition to cheap valuations, this trust is operating at a 7 per cent discount^^^.
The Asia Pac option
Those wanting a wider Asia portfolio with some exposure to China might consider the Ninety One Asia Pacific Franchise fund, which currently invests almost 40 per cent in China^^^. More than 60 per cent of its value is in its top ten holdings and the total portfolio only comprises around 30 stocks^^^. Most of these are larger companies.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
*Source: FE Analytics, total returns in pounds sterling for MSCI China, figures from 12 February 2021 to 31 October 2022
**Source: FE Analytics, total returns in pounds sterling for MSCI China, figures from 7 February 2023 to 4 August 2023
***Source: Matthews Asia Sinology – July 2023
****Source: Fidelity China Special Situations – Measuring China’s recovery
^Source: FSSA China Equities: Back in the Doldrums
^^Source: FE Analytics – figures to August 3
^^^Source: Provider factsheet, figures at 30 June 2023
