Investment case for “New China” remains intact through recent volatility says William Fong of BAM

by | Aug 26, 2015

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Shanghai, downtown

Here’s the latest view on China from William Fong, Investment Director, Asia Pacific Equities, Baring Asset Management, Hong Kong.

He says that:

  • Recent volatility has been triggered by concerns about the pace of growth in China, the devaluation of the yuan and changing risk appetites as we head into a new interest-rate cycle in the US
  • We believe these concerns are overdone, and point to the changing nature of China’s economy and the emergence of modern companies able to capitalise on new growth drivers, as well as attractive valuations
  • Our bias towards quality companies is an advantage, and industry consolidation could boost profits growth in the next three to five years, but we cannot rule out further volatility short-term

Volatility presents opportunity

Headlines have focused on China in recent weeks, with many investors expressing concern about the pace of economic growth and whether 7% is achievable and the recent decision of the authorities to devaluate the yuan. This comes against the backdrop of general nervousness as we head into a new interest rate cycle in the US, if not in September then soon.

China’s market has sold off quite sharply, following the declines we saw in June and July. Year to date, the MSCI China Index has fallen by 11.8% in US dollar terms, taking it back to levels seen in mid-2014.

To put this in context, while the headlines have focused on China, the reduction in risk appetite has been wider, with the MSCI Asia ex Japan Index and the MSCI Global Emerging Markets Index respectively 15.3% and 17.7% lower in US dollar terms over the same period. To that extent, the China market has not been the worst affected.

In our view, this should be seen as part of a general reduction in risk appetite as we prepare for a new interest-rate cycle.

The proximate cause has been economic growth in China, but that has not been the only reason. It is our belief that the decline is not justified by fundamentals and that the focus on particular economic data points misses the extent of the change in China’s economy in recent years and the emergence of new growth drivers there.

We believe it is possible to identify companies well place to capitalise on these growth drivers over the next three to five years. The recent volatility has created stock picking opportunities for us, increased the potential for strong companies to act as consolidators and emerge stronger, and depressed valuation levels for investors.

Out with the old, in with the new

At the heart of investors’ concern is whether the pace of economic growth in China is slowing from the government’s target level of 7%. Widely tracked measures include indicators such as demand for electricity and steel production.

Not only is economic growth not necessarily a good predictor of equity returns in our experience, as much more depends on company-specific factors, but a focus on such traditional measures also ignores the extent to which China’s economy has rebalanced in recent years.

As can be seen in the chart below, heavy manufacturing and property/ infrastructure construction have been a declining part of China’s economy for a number of years. The new growth driver is the services sector. Measures such as retail sales, telecommunication volumes and passenger traffic have shown steady growth, as have wages, supporting demand for goods and services.

Finding “New China”

Our investment strategy is positioned specifically to benefit from the changing nature of China’s economy and the growing importance of the service sector.

We look for modern, forward-thinking companies with high quality management and strong balance sheets, a clear franchise which it is able to exploit, and the ability to deliver robust long-term profits growth.

We like companies aligned with government policy as the process of urbanisation and improving China’s environment continues. We also like beneficiaries of rising consumption and technological outfitting as companies move along the value chain, as well as “New China” brands, able to compete with the biggest names.

Everyone knows about Tencent and Lenovo, but we think the future is bright for companies such as Geely Automobile, a Chinese car maker able to sell in the EU, and Provence-style body and skincare brand L’Occitane, which has international as well as domestic exposure.

These are only two examples, but we think they are indicative of the well-managed, modern companies it is possible to find in China with thorough research. Although automobile and other consumer stocks have been sold off quite sharply in the recent volatility, the investment case for many of these companies is unchanged, and with valuations lower, they arguably present increased potential and our investment conviction remains high.

Increased upside potential

This goes to a wider point on share price valuations. After the volatility we have seen, the MSCI China Index is trading back at levels below historical means over the last few years. If you accept that the investment case has not fundamentally changed, we think this represents an increased opportunity relative to earlier in the year.

Current valuation levels also do not take account of the various stimulus and reform measures announced and undertaken by the authorities in recent months.  If these are taken into account, we believe share price valuations should be higher. We additionally see potential for increased performance from security selection following the recent volatility as sentiment starts to recover and investors look at investment fundamentals once again.

Le “moat” juste

One of the reasons we look for companies which score well on our “quality” criteria is that they have the potential to ride out market volatility.

In circumstances when investors examine company fundamentals and value the company on its ability to deliver long-term earnings growth, a company with a strong balance sheet, proficient management team and a well-regarded and protected franchise which it can monetise has the potential to generate strong and stable performance.

Warren Buffett describes companies with a strength of franchise like this as companies with an economic moat. We would call them quality companies, but we believe the advantages are clear.

Companies with a strong balance sheet also have the potential to act as consolidators in their industries if conditions are right, increasing market share, removing competitors and potentially increasing profits growth on a three to five-year view.

Yuan way or the other

The decision of the Chinese authorities to allow the currency to depreciate has also concerned investors, who took it as a further sign that the economy was weakening. While we did not anticipate the suddenness of the move, the direction was not a surprise after a long and sustained appreciation

We see this as part of a gradual opening up of China’s markets and currency as the authorities prepare for the possibility of the yuan joining other countries in the International Monetary Fund’s Special Drawing Rights basket, a symbolic boost to the currency’s standing. We do not expect further substantial moves in the short term.

Conclusion

While we cannot rule out the potential for further volatility, we think the outlook for quality “New China” companies is brighter than suggested by recent moves, which have not taken account of positive moves by the authorities. These include the most recent decision of the Chinese authorities to cut short-term rates and inject liquidity into the banking sector, which should provide additional support to the market.”

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