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China, Today

Inclusion and transformation in 2019

11 January 2019
Authors: Greg KuhnertCo-Head of 4Factor, Wenchang MaPortfolio Manager

At a glance

  • 2018, the Year of the Dog, has been volatile so far, but we believe the long-term investment case remains sound, with opportunities emerging at individual stock level.
  • China’s transformation, based on reform and technical innovation, continues unabated.
  • International investors remain underweight, and increasing levels of index inclusion should support markets over the long term.
  • The correction is generating stock-picking opportunities on a valuation basis.

 

2018: volatility bites in the Year of the Dog

Volatility in the Chinese equities market in 2018 has been driven by tightening domestic liquidity as well as escalating trade tensions with the US.

However, the long-term investment case for China remains clear and opportunities are emerging in this environment. If we look beyond short-term headwinds, active investors with a disciplined investment process should be able to find quality Chinese companies with good long-term growth potential and decent management.

China’s transformation continues

Concerns about China abound, including a build-up of debt, negative demographic trends, state-owned enterprise inefficiency and general corporate governance risk. We recognise the challenges in all these areas. Yet, we should not ignore China’s ongoing transformation, which is being driven by government reform and innovation in the economy. This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term.

Reform

Government reform efforts are happening on multiple fronts. Supply-side reform has nearly completed its third year, with capacity reduction targets well on track and even exceeding expectations in certain industries such as steel. Environmental control remains stringent, driving significant decreases in air and water pollution. State-owned enterprise reform is helping to align the interests of the state, management teams and public shareholders. Financial reforms continue to foster better risk control in financial institutions and a further opening of the domestic capital market to global investors.

Innovation

With a large consumer base and growing wealth, China has seen increasing demand for higher quality products and services. Large numbers of Chinese go on shopping sprees abroad, which is driving domestic companies to innovate so that they can capture more market share. Good infrastructure and efficient supply chains provide the backbone for a more innovative China. An abundant and inexpensive talent pool, significant social capital and supportive government policy also play crucial roles.

An example of this is the World Intellectual Property Organisation’s Seven Pillars of Innovation, where China has generally performed in line or even better than the average high-income country, and is well ahead of what might be a more obvious comparator, the average for upper middle-income countries.

Figure 1: The seven pillars of innovation

Figure 1

Scale 0 to 100, higher score means greater capacity.
Source: World Intellectual Property Organisation, HSBC, Dec 2017.

Global investors remain underweight

Although more and more investors, both institutional and retail, are considering strategic allocations to China, they remain underweight despite moves to open capital markets and make investing in China easier.

MSCI is looking to quadruple China A-share weighting in its major benchmark indices from 2019, only one year after its initial inclusion, which is faster than the market expected. FTSE Russell will also start phased inclusion from June 2019, which will see China A-shares representing 5.5% of its emerging market index. If fully included, China A-shares should account for more than 16% of the MSCI Emerging Markets Index and more than 20% of the Russell Emerging Markets Index. China’s onshore and offshore markets together will account for over 40% and 50% of the two indices, respectively.

Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, we think global investors’ allocation to the world’s second-largest equity market will grow over time. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market.

Drawdown offers potential entry point

We believe the market drawdown provides entry opportunities for fundamental investors and will reward them in the long term.

Following a significant pullback in 2018, the Chinese equity market currently trades below its 10-year historical average valuation level from both the forward price-earnings and the price-to-book perspective. The valuation discount versus developed markets has widened despite the more positive growth outlook.

Stock selection opportunities and risks

Although we do not attempt to call the bottom without seeing evidence of positive surprises on corporate earnings, an increasing number of opportunities are emerging on the back of the market pullback. As more value emerges, we are finding opportunities in a number of sectors. The evidence suggests that companies with good quality, attractive valuations, improving operating momentum and increasing investor attention tend to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently sees most opportunities in the materials, energy, financial, utility, and communication services sectors.

Clearly, the Chinese equity market faces short- to medium-term, most significantly policy execution and growing trade tensions between China and its trade partners, particularly the US. Over the long term, we believe a consistent investment strategy focusing on identifying high conviction ideas, using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors. We remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment such as China.

Our bottom-up stock-picking generates ideas from a broad range of sectors, covering both new and old economy segments. Fundamental analysis, combined with objective screening, will continue to drive new investment ideas for our portfolio.

 

Important Information

The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date shown and are subject to change without notice. The value of investments, and any income generated from them, can go down as well as up and will be affected by changes in interest rates, exchange rates, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets invested in. Although we believe the information obtained from public and third party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec’s internal data may not be audited.

Greg Kuhnert
Greg Kuhnert Co-Head of 4Factor
Wenchang Ma
Wenchang Ma Portfolio Manager

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