It’s the three year anniversary of Stock Connect today, 17 November. Stock Connect, a collaboration between the Hong Kong, Shanghai and Shenzhen Stock Exchanges, allows international and Mainland Chinese investors to trade securities in each other's markets through the trading and clearing facilities of their home exchange. First launched in November 2014, the scheme now covers a total of over 2,400 eligible equities, including 900 in Shanghai, 1,000 in Shenzhen and 500 in Hong Kong.
Wenchang Ma, Assistant Portfolio Manager, Investec All China Equity Strategy, answers questions about the relevance of Stock Connect for international investors into China and the broader investment case for China.
Wenchang Ma, Assistant Portfolio Manager, Investec All China Equity Strategy
Harnessing our experience gained first from QFII and RQFII, we started investing in China through the Stock Connect programme in January 2015, with Investec Asset Management being the first global investment manager to do so with a UCITS Fund. We have access to Stock Connect across a wide range of our investment strategies, and our 4FactorTM team in particular have been pioneers investing in the region.
Chinese companies offer high earnings and cash flow growth opportunities, and the Chinese equity market is the second largest in the world. However, valuation is still at a discount compared to the global equity market, and China is still under-represented in global investor’s portfolios. The domestic market is dominated by retail investors who are quite often short-term trading oriented. There is a variety of investment opportunities for disciplined institutional investors to generate returns from. We continue to find new exciting ideas to invest in and aim to continue to seek alpha for our investors.
The Stock Connect programme marks an important step towards capital market opening. It offers foreign investors easier access to the attractive growth opportunities on China’s domestic equity market. Despite being the second largest equity market globally, China’s equity market remains under-explored by global investors. This is set to change gradually in the future as we see more investors now making use of the Stock Connect programme to add quality and growth to their existing portfolios and to take advantage of the diversification benefits. As China continues to improve the access facilities and market regulation, investors will find their existing concerns addressed gradually, as we have seen with the development of the Stock Connect programme.
We have been investing into China’s A-share market since before the Connect programme was launched. We believe in the opportunities China has to offer and have been advocating that consistently. China’s economic growth is shifting from heavy investment-driven to more sustainable and consumer-driven. An increasing number of companies are demonstrating sustainable competitive advantage based on innovation, and are adopting share-holder friendly corporate governance. All of these are enhancing our confidence in this market.
The 2015 A-share market crisis most certainly reminded investors of the challenges investing in an emerging market, even one as rapidly moving forward as China. The last year in particular we have begun to see greater investor confidence investing into the market. A catalyst to this was the announcement that MSCI will be including China A shares within their Emerging Markets index from June 2018, now that a number of the early challenges associated with investing in China have been incrementally addressed.Wenchang Ma discusses more in this podcast, available here
Electric cars are currently too expensive and inconvenient relative to internal combustion engine cars for mass adoption to occur. Industry analysts currently predict that the comparative cost of ownership will occur by 2023 in China, although this is accelerating and may happen sooner. While that may seem far away the implications of that cost of ownership crossover date are pertinent now.
For investors, this means beginning to look for opportunities today that will add long-term value to portfolios. We think these opportunities can actually be found in non-traditional areas of the supply chain that are perhaps overlooked by the market.
For the mass adoption of pure electric vehicles (EVs) to take root and consumer demand to grow, the economics need to make sense. Driving internal-combustion engine (ICE) cars is becoming more expensive due to regulatory and compliance costs. Meanwhile, the cost of electric batteries and powertrains continue to fall, contributing to an accelerating fall in the total cost of ownership of EVs.
UBS recently dismantled and analysed a Chevy Bolt – the first electric vehicle available at a mass-market price point of $37,000. They found that the cost to produce an EV powertrain was less than expected. As a result, they revised down the expected date when the cost over ownership between ICE cars and EVs would cross over from 2025 to 2023. This perhaps indicates an acceleration in the cost reduction.
China, the largest passenger vehicle market in the world, is perhaps set for the fastest and most significant change. For example, Geely Automotive recently announce that its Volvo brand will no longer launch pure ICE models from 2019. BAIC Motor also plans to accelerate its investment in EVs, which includes the development of battery production facilities.
Before consumers will be willing to adopt EVs on a mass scale:
The first two requirements are linked. Only an EV-specific platform provides sufficient space to lay the required batteries in order for the vehicle to have a range of +200 miles, based on current densities. Retrofitting an ICE car has not proven successful at this. The best adopted EVs to date have been those with the best range profile.
Likewise, consumers will remain wary of running out of charge before completing a journey, so will shy away from electric cars on a mass basis until a charging network is in place.
To date, Tesla’s dedicated electric vehicles has best delivered both consumer requirements. It has singularly proven that the previously believed high barriers to entry to the auto industry are really not that high at all, and to an incredible reception.
Indeed, more than 400,000 people have pre-ordered a vehicle that until this month has never been manufactured before, let alone test driven. That is unprecedented.
This shows that consumers’ perception of EVs is changing at a time when the total cost of ownership is coming down.
For traditional auto manufacturers, it will be a case of investing in facilities, R&D and margin in order to gain brand, positioning and share. In the medium term, that means margin and return dilution, all things being equal. Longer-term implications include impairment and write down risk to legacy ICE assets and investment.
For the traditional auto suppliers, the size and ownership of existing profit pools will change. For example, in time the suppliers of ICE powertrains and related component parts will experience volume falls.
What is perhaps most surprising, though, is that the real winners will come from outside the traditional auto supply chain.
In terms of new components, UBS found the volume of semi-conductor content to be 6 times greater in an EV powertrain compared to an ICE powertrain. And lithium and cobalt, the most critical raw material for battery chemistry, will be supplied by miners.
The incumbent suppliers will not only face competition for content per vehicle dollars from non-traditional component suppliers of new components; those non-traditional suppliers plan to take share using their bargaining power and position of strength. LG, for example, is a non-traditional supplier to the auto industry, which used its position as battery supplier to take share, supplying other components, too. In fact 56% of content in the Chevy Bolt was supplied by LG according to UBS.
For investors wishing for exposure to EV adoption in China, one company placed to tread a similar path to LG is Shenzhen Inovance Technology. Originally a manufacturer in the industrial robot value chain, Inovance has forged an adjacent position in commercial EVs, supplying integrated controllers. The development of a recent plant in partnership with Brusa, a Swiss EV powertrain supplier, looks set to further secure its arrival as a non-traditional supplier in the EV market.
The date 2023 may seem far away but what is clear is that the implications of that cost of ownership crossover date are pertinent now. Investing in Chinese auto-related equities must, therefore, take account of all the key changes currently being wrought by the take-up of EVs in China:
On 20 June 2017, MSCI announced that with effect from June 2018, 222 China A-share large cap stocks will be included in the MSCI Emerging Markets and All Country World (ACWI) indices through a two stage process. This represents a milestone in the evolution of China’s domestic equity capital markets, the second largest in the world by market capitalisation.
It gives recognition to the significant progress by the Chinese authorities in the opening of their markets to foreign investors, especially through the Hong Kong and Shanghai/Shenzhen Connect schemes.
This event may be easily dismissed in the short term. The initial impact on indices is likely to be small due to MSCI’s phased approach to inclusion. For example, China A-shares will represent just 0.73% of the MSCI Emerging Markets Index in 2018, due to MSCI’s partial inclusion factor of 5%.
But based on over 15 years’ experience investing in Chinese and broader Asian markets, including the China A-share market, we believe dismissing the importance of this event would ignore a number of important features and benefits of the market that A-shares can bring to global and regional portfolios.
MSCI is a leading global index provider. Approximately $1.6 trillion of active and passive assets under management follow the MSCI Emerging Markets Index, while nearly $3 trillion follow MSCI ACWI benchmarks.i
China A-shares are going to be something that allocators of capital can no longer ignore.
The China A-share market is highly inefficient due to the greater presence of retail investors. They make up over 80% of the daily turnover of the market and often make behavioural errors when investing, such as herding. Foreign institutional investors only hold around 1.5% of the market. This represents a unique opportunity for investors with a disciplined bottom-up process, such as our 4Factor™ process, to find great quality companies on reasonable valuations. Retail investors tend to perceive these companies as ‘too boring’, in their herd-like quest to own the next big growth stock. This stands in contrast to global markets where investors have to pay a premium for quality stocks.
China A-shares can add growth and quality at a reasonable price as the market is inefficient.
A-shares represent an exciting avenue for global investors to participate in the next stage of China’s growth dynamic. Although the MSCI has included only 222 companies, investors can access almost 1500 companies under the Connect programmes, particularly in fast-growing segments of the market such as consumer durables, automobiles, leisure and entertainment, consumer staples, pharmaceutical and technology sectors.
Larger investment universes represent a greater opportunity to add alpha in portfolios.
In the long term, A-shares have tended to exhibit greater volatility than developed markets, but correlations are significantly lower. For example, in the last five years the Shanghai and Shenzhen markets have a correlation co-efficient of approximately 0.23-0.25 to the MSCI ACWI Index versus 0.90 for the MSCI Europe Index. Of course these benefits will diminish over time as China’s capital markets open up.
In the meantime global investors can benefit from diversification efficiencies.
We believe that eventually China will achieve full inclusion e.g. 100% weighting. When it does so, China will represent a very large component of the MSCI Emerging Market index (some 37% on our estimates) and will become a unique asset class in its own right.
We believe we are well placed to take advantage of this trend and that our 4Factor™ philosophy is ideally suited to this large exceptional asset class. We aim to find good quality companies that are cheaply valued, with improving profitability and that the market’s behaviour is anchored in its reluctance to believe this change, while the share price is in a positive uptrend. This process, alongside a talented team of investment professionals, has driven our exemplary long-term track record in All China, Asia and emerging market equities.
We believe this may prompt asset allocators to pick dedicated specialist managers who have a demonstrable track record in this area.
1 Source: Goldman Sachs estimates, 1 June 2017.
In investment circles, Chinese banks are a divisive topic. Bearish investors distrust the book values that the banks report, as they believe non-performing loans are likely to be understated. This seems likely, they say, because headline national debt is high (over 250% to China’s GDP) with falling marginal productivity per dollar of capital spent. As banks play an outsized role as providers of capital in China, and given the high degree of government ownership of lenders, it could be plausible that reported non-performing loan levels of 1.7% are indeed understated. So, don’t be fooled by the offer of headline returns on equity (ROE) of 15%, stocks trading at a 15% discount to book value, mid-single digit price to earnings ratios and 3-5% dividend yields. “Avoid!” they warn.
While we understand this argument, we believe investors need to adopt a more nuanced, bottom-up approach, and seek to uncover the good opportunities provided by the Chinese banking sector. It is important to assess each banking franchise, the strength of balance sheet and access to funding, as well as a bank’s ability to grow fees and control costs. On the credit quality side, we adopt a more pragmatic view. China is seeing an economic recovery that is becoming broad-based (it’s not just about an infrastructure investment cycle, exports and domestic consumption are also recovering). Income growth, too, is picking up and corporate profitability is improving. During the economic downturn of 2015, companies (i.e. the borrowers) have been focused on cutting costs, improving operating cashflows and cutting capex. Thus free cashflows have improved dramatically in corporate China.
All of this has improved the borrowers’ ability to repay debt (and, indeed, corporate debt has fallen over the last two years) and hence we envisage non-performing loans (NPLs) being less of an issue in the future. The evidence is that NPL levels peaked in 2016 (while bearish investors may argue that reported NPL’s are too low, there is no denying that, directionally, they have been falling since the beginning of 2016). Secondly, you have to be pretty bearish on credit quality to believe that a bank such as China Construction Bank (that we currently own in the portfolios) -which earns a ROE of 15%, with a Tier 1 ratio of 13.1%, and a NPL coverage ratio of 159%,- is capital deficient.
The tough lending environment of a few years ago has made management teams more focused on fee generation and cost cutting – cost to income ratios have been falling and staff numbers have also reduced. On net interest margins, those banks with a cheap and stable sources of funding (such as China Construction Bank) are enjoying rising net interest margins as interbank interest rates move upwards. We believe that the combination of improved profitability, falling NPL risks and attractive valuations is irresistible, especially as the Chinese banking sector is under-owned by global investors. Regardless of what the bears say.
The Chinese onshore equity market, mainly the ‘A-share’ market, has grown into one of the largest in the world, but one that historically has tightly regulated the access of global investors. As a result, the onshore market tends to be volatile due to the short-term sentiment-driven investment behaviour by domestic retail investors and onshore institutional investors.
This provides a significant opportunity for disciplined, process-driven, bottom-up investors. This is particularly true during the early stages of market liberalisation, such as is the case with the China.
The 4Factor™ philosophy aims to find good quality companies that are cheaply valued, with improving profitability which the market has failed to recognise, while the share price is in a positive uptrend.
We focus on finding companies with management teams that have displayed a strong track record of shareholder wealth creation, care about return on capital, display good capital discipline, make sensible investment decisions and have good governance structures. We seek to own these companies when the market is sceptical of their potential future profitability, while disbelieving behavioural evidence of changing profitability.
Critical to our philosophy is a disciplined investment process that employs an objective stock screen. This is necessary as there is simply too much information in the market, much of which is just noise and of little relevance to the investment case.
The screening process helps us to research only those companies that fit in with our philosophy. In that way we can be focused and opportunistic in an objective and dispassionate way. By using a disciplined, bottom-up approach that ignores market volatility, it is possible to identify compelling investment cases for individual stocks.
Often these are in high-quality companies riding the wave of growing domestic consumer growth, or those firms that have taken advantage of Beijing’s policy to encourage corporations to invest abroad and compete on a global scale. Finding these companies may provide a reliable exposure to the Chinese growth story.
To shed further light on whether our objective screen could add value over time, we back-tested the process on the Chinese A-share market. We used the screen to rank and divide the universe into quartiles then measured their performance since 2002. This showed significant outperformance for the top-scoring quartile by just following a blind numbers-based approach.
Cumulative return of the China universe
Source: Investec Asset Management 4Factor™ Research, 31 December 2016. This data is updated annually. 1
This process, along with a talented team of investment professionals running robust qualitative analysis on the top score stocks, are the key inputs that have helped create our long-term track record in Asia and emerging market equities. The outperformance we delivered over the last three years has been significant and the team have managed to add substantial alpha above the blind screen itself.
1 This chart does not represent the actual historical performance of the 4Factor™ Investment Strategy and is not based on actual trading or investments; rather, it illustrates how the current 4Factor™ scoring system would have ranked stocks within the investable universe over a longer period of time. It has been calculated on a backward-looking basis and shows the performance of the 4Factor™ screen which ranks stocks in the Investment Strategy’s Universe on four factors (Strategy, Value, Earnings, Technicals) and then sums those scores to give a total from 4-16. Those scores are then ranked and placed into quartiles. The average 1 month forward return (in USD) for each quartile is then compounded on a monthly basis to form cumulative return charts – with returns rebased to 100 at the start of the historic model in 1995. The 4Factor™ investment process was developed in August 2000 and is periodically enhanced. The universe of stocks used in the chart is based on all stocks as selected and presented by FactSet®. This selection is then subject to further adjustment by the 4Factor™ Team. Stocks are equally weighted and rebalanced monthly. The calculation is replicable but relies on the most recent FactSet® data which is subject to change. The chart is created with the benefit of hindsight and subject to the data updates in FactSet® and the changes to the 4Factor™ model. The model does not reflect the qualitative analysis, material economic and market factors that may have had an impact on the decision making of Investec Asset Management 4Factor™ Team nor does it reflect fees, transaction costs and other expenses a client would have to pay which would reduce returns. It is not necessarily an indicator of future results and investment returns in the actual portfolios may vary significantly. There is no guarantee that investment strategies employing the 4Factor™ investment process will make profits; losses may be made. Supplemental information for GIPS purposes. For illustrative purposes only. For further information on indices, investment process and performance target, please see the Important Information section
Investec Asset Management’s 4Factor™ team has been investing in China for 18 years, through our global, Asia and emerging-market strategies. The offshore China market currently represents over 35% of the team’s US$6 billion dedicated Asian mandates.
The onshore market has become a major new area of focus for the 4Factor™ team. We started to invest in A-shares three years ago and we are building a Hong Kong-based investment capability. Through this process we have gained a deep understanding of the range and behavioural tendencies of local-market participants, including institutional investors, pension-fund consultants and Chinese retail investors.
The retail investor is by far the biggest driver of the market, accounting for about 85%* of the daily market volume. Retail investors typically have shorter investment horizons and tend not to use disciplined investment processes. Instead, they are prone to invest on the basis of thematics, stories and top-line growth, placing relatively less emphasis on a company’s long-term track record, profitability, corporate governance, dividends and valuation. Consequently, retail investors can drive market volatility as we saw in June and July 2015.
Institutional, long-term savings vehicles such as mutual funds and life insurance companies comprise only 11% of the A-share market, while foreign institutional investors own around 2% of the market. Domestic fund managers tend to exhibit a trader mentality – for example, 500% to 600% turnover ratios are common – as they are evaluated over very short time periods. So domestic managers amplify the momentum-driven nature of this market.
The consequences of such investor behaviour create opportunities for those willing to take a long-term view. In this market, price action periodically decouples from company fundamentals. Valuation dispersion, a key measure of when there are good opportunities for active security selection, reached an all-time extreme in 2015. At that point, the ChiNext board on the Shenzhen Stock Exchange – China’s version of the NASDAQ – traded on price to earnings multiples in excess of five times that of the less-exciting blue-chip CSI 300 Index.
The sentiment-driven and momentum nature of the A-share market provides a significant opportunity for disciplined, process-driven, bottom-up investors. The 4Factor™ philosophy is to find good quality companies (Strategy) that are cheaply valued (Value), with improving profitability and that the market’s behaviour is anchored in its reluctance to believe this change (Earnings), while the share price is in a positive uptrend (Technicals).
We focus on finding companies, whose management teams have displayed a strong track record of shareholder wealth creation, care about return on capital, display good capital discipline, make sensible investment decisions and have good governance structures. We seek to own these companies when the market is taking a dim view of their potential future profitability, while disbelieving behavioural evidence of changing profitability.
The domestic equity market in China (Shanghai and Shenzhen stock exchanges, ex. Hong Kong) is already huge, exceeding RMB60 trillion (US$9.9 trillion) in size. This article explores why we think it still has a long way to grow.
Stocks are probably still under-represented in domestic retail investors’ portfolios. Equities account for about 11% of Chinese household assets and cash 55% (Figure 1). China Household Finance Survey data reveals that the majority of Chinese households held no stock at all in early 2015.
Chinese savers’ overall equity holdings roughly match those of Japan and some European countries. However, they fall well short of Taiwan, where retail investors allocate 24% of their assets to stocks. US retail investors lead the way globally, holding over a third of household savings in shares. Domestic institutional investors, such as insurance companies, are also underweight stocks, relative to their peers in Europe and the US.
Source: CEIC, Wind, European Central Bank as at Q4 2016, CHFS, China data to end 2015. Note: 1. Household financial assets include cash and deposits, stocks and other equities; investment funds/trusts; insurance and pension; and others. Household total assets also include non-financial assets, i.e. real estate and cars. 2. CHFS means China Household Finance Survey.
Chinese investors still don’t trust the local equity market. Having mis-timed investing in the past, they now prefer to invest in property and so-called ‘trust’ products, which are essentially high-yielding deposits sold by banks. But this appears to be changing. The property market is cooling and investors are beginning to question the safety of trust products. This puts the equity market back on the radar.
Interest in equities on the part of domestic investors should find support from the continued economic expansion. Although Chinese GDP growth has halved from over 14% annually in 2007 to 6.8% in 2016, this rate remains strong, especially compared to developed economies, where growth has been sluggish.
As the economy grows, more domestic savers will have larger asset pools to invest in the stock market. We believe this dynamic will feed the increasing domestic capital flows into the Chinese equity markets.
The onshore stock markets will also grow as Beijing allows greater international participation on the Shanghai and Shenzhen stock exchanges. As a larger number of foreign investors allocate a greater proportion of their portfolio to Chinese stocks, the leading index providers are likely to start including the onshore market in their global indices, which should support further capital inflows.
As of May 2017, if domestic A-shares were fully included in the MSCI Emerging Market Index, the weighting of China would double to 40.1%. According to an analysis by Deutsche Bank, an additional US$450 billion could flow into domestic Chinese equities upon their full inclusion into MSCI indices by 2020.
We believe China’s stock market is poised for substantial growth in the coming years as domestic, retail investors allocate more money to stocks and market liberalisation reforms enable foreign capital to buy securities on the Shanghai and Shenzhen exchanges. In the long term, this trend should help make the market more liquid and less volatile. Currently, we believe the ability to benefit from a disciplined, bottom-up investment process in the volatile onshore market, creates substantial opportunities for global investors. But in the long-term, we believe that the market will become more mature and more widely held, making the case for a rising allocation to Chinese equities in global portfolios.
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. There is no guarantee that views and opinions expressed will be correct, and Investec’s intentions to buy or sell particular securities in the future may change. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third party sources. 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. Any decision to invest in securities or strategies described herein should be made after reviewing the prospectus and conducting such investigation as an investor deems necessary and consulting its own legal, accounting and tax advisors in order to make an independent determination of suitability and consequences of such an investment. This material does not purport to be a complete summary of all the risks associated with this Strategy. A description of risks associated with this Strategy can be found in the Prospectus or other disclosure document for the fund or Strategy. Copies of such documents are available free of charge upon request. Investec does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.
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