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Investors cannot afford to ignore this part of the world
Thursday 03 Dec 2020 Author: Steven Frazer

Experts believe that China will dominate global growth over the next decade as it continues to push ahead with its massive transition into a consumer-based economic superpower.

This outlook, together with the fact it is already home to some of the most exciting and innovative growth companies, means investors cannot afford to ignore it.

In this feature we will explain why China is a must for investors of all stripes. We talk about some of the companies that have helped put the nation on the investment map, and provide three great fund options that make it easy for you to take advantage of this opportunity.

THE MAKING OF CHINA

Invention, international trade success, disputes, civil unrest, wars, famine and much else makes the story of China a fascinating read. But this is not the place for a history lesson, so let’s consider some basic facts that might tantalise the ordinary investor.

China’s average real growth has run at more than 9% a year since 1978, according to IMF figures, and as high as 15% in peak years. World Bank data shows that per capita income in China has increased six-fold since the turn of the millennium.

But unlike most of the UK’s leading companies, which rely on overseas growth for much of their own, the majority of Chinese businesses only operate domestically. That means 1.4 billion-plus Chinese people with more disposable income than ever before buying a greater amount of made-in-China goods and services from Chinese businesses.

That’s a compelling backcloth for rising revenues, soaring profits and surging share prices.

NEGATIVES TO CONSIDER

There are still challenges to overcome. The trade war with the US remains unresolved and continues to simmer, there have been marches on the streets of Hong Kong this year protesting Beijing’s authoritarian rule, and growth has slowed from previous startling levels.

China has seen its share of accounting scandals, including Ruihua Certified Public Accountants, one of China’s largest accounting firms. It was investigated in the summer by the country’s securities regulator after a listed company it audited was found to have inflated profits by about $1.74 billion over four years, according to reports.

Despite these issues, Joe Biden becoming US president could help soothe trade tensions, and while the Covid-19 virus wreaked havoc in China earlier this year (like everywhere else), the country has been quick to recover.

‘China is the factory of the world,’ says Baillie Gifford fund manager Tom Slater. The shutdown of thousands of manufacturing centres in the first half of 2020 slammed the brakes on economic productivity and growth. However, China looks in a stronger position than the Western world to pick itself up following coronavirus.

In the IMF’s October edition of its World Economic Outlook, China was forecast to have 1.9% GDP growth in 2020. That’s its slowest rate since 1976 but also making it the only major global economy to grow in this most testing of years.

IMPRESSIVE COVID RECOVERY

The pace of China’s recovery has impressed fund managers. ‘China is back to normal in so many sectors,’ says Dale Nicholls, who runs the Fidelity China Special Situations (FCSS) investment trust. Even some of the hardest hit industries, like travel, hotels and restaurants are recovering rapidly, Nicholls adds.

Investors might expect this sort of optimism from a China-focused fund manager, yet the IMF agrees. It forecasts China’s growth recovery to deliver 8.2% GDP expansion in 2021. That massively outstrips the respective growth recoveries of other major economies, such as projections for the US (3.9%), Japan (2.3%), Germany (4.2%) and the UK (5.9%).

Yet local stock markets haven’t always kept pace. The Shanghai Composite, China’s largest and the world’s fourth biggest by market value, remains well below 2008 levels even after the Covid bounce-back.

That makes China cheap compared to other major markets, on a price to earnings multiple (PE) of 16.3, according to data from macroeconomics researcher CEIC, marginally cheaper than the FTSE 100’s 16.8.

The S&P 500’s PE equivalent is 28.3, Nasdaq Composite 30, and even the Eurostoxx 50 trades at a hefty premium on 22.8.

BIG EARNINGS GROWTH POTENTIAL

China has numerous companies which offer the potential to benefit from a rising consumer class and domestic economic activity.

What has struck Baillie Gifford’s Tom Slater is the level of entrepreneurship in China. ‘It is the one place creating exponential growth business opportunities comparable to Silicon Valley (in the US),’ he says. Slater expects China to create more growth businesses than Silicon Valley in the future.

‘On a per capita basis, China remains very much a middle-income country at this time,’ says Kepler analyst Callum Stokeld. ‘In my view, there is still plenty of ground to be made up on developed economies and attempts to do so will likely create huge stock opportunities.’

JPMorgan has estimated that Tencent – a Chinese technology group comparable to Facebook – can achieve annualised earnings growth of circa 22% for the coming five years.

Tencent and Alibaba – seen as being China’s equivalent of Amazon – are hugely dominant players in the Chinese stock market, combining social networking, online shopping, gaming, streaming TV, payments and a lot of other activities, absorbing millions of Chinese people into their ecosystems.

Investors shouldn’t expect these sort of growth numbers from every Chinese stock. However, with this sort of growth potential available in China on far lower valuations than equivalent US stocks, it would be ‘regrettable to stand aside and not seek to participate in this single stock potential irrespective of your macroeconomic outlook,’ believes Stokeld.

Areas like renewable energy, artificial intelligence, e-commerce and electronic payments promise to power many of China’s digital economy companies and create new stock market superstars. ‘China has some of the most exciting and innovative growth companies, not just in emerging markets, but in the world,’ says Sophie Earnshaw, joint manager of the Baillie Gifford China Growth Trust (BGCG).

Despite these attractions, China remains incredibly under-invested as an asset class. According to Baillie Gifford’s calculations, China accounts for around 18% of world market cap, 30% of listed stocks, but only 2.5% of global fund allocations. ‘This is a big anomaly,’ says Earnshaw. ‘As the market continues to open up and China’s vast potential is realised, we think this simply has to change.’

China is already 40% of emerging market indices, 50% of Asia ex-Japan, she adds. ‘It’s simply becoming too big to ignore and already, investors are starting to talk about China ex-EM and China ex-Asia. So, we think investors would be wise to consider allocating directly to China now to get ahead of this substantial anomaly.’

 

ELEPHANTS IN THE ROOM

Governance and state interference remain two major objections for investing in China, but ‘stewardship laws have changed for the better,’ says Chetan Sehgal, director of emerging markets at Franklin Templeton.

There remains ‘a list of complex issues that are slowly being worked out,’ says Baillie Gifford’s Tom Slater, but the government is ‘reasserting its power to pursue what they think the population wants and needs.’

The recent stock market listing postponement of payments giant Ant Financial was a good example of Chinese regulators flexing their muscles. ‘China’s authorities are ensuring that it retains control over its own financial system,’ states Slater.

Franklin Templeton’s analysts take their time running due diligence checks on companies before investing, and then spend a lot of time with company management teams over years getting the know the nitty gritty of investee companies’ culture.

‘Deep engagement with management, board composition – this is the most important part of assessing companies, and building trust,’ says Sehgal.

‘Although China’s markets have moved up a lot [since the Covid-19 crash in March], there are still many stocks that have been left behind on good valuations,’ believes Fidelity’s Dale Nicholls.

With bonds yields at unattractive levels, experts argue that China is as good a market for income as the US, Europe and the UK. ‘There are companies on free cash flow yields in the high single-digit to low-teens,’ says Sehgal.

The insurance sector is an area Nicolls likes a lot. ‘This is a classic area that is underpenetrated,’ he says. ‘As people get richer, they’ll want protection and cover, particularly in healthcare. Such growth is not in valuations.’ That’s why his special situations fund is overweight the sector.

Global economic normalisation, or at least continued recovery, should continue to benefit domestic economic activity in China. With growth dynamics hard to fund elsewhere, particularly from mature economies like the UK, Europe, US and Japan, fund flows into China are likely to accelerate, powering China’s share prices higher.

‘I think overseas investors have been historically quite gun-shy of investing in domestic Chinese equities,’ says Devan Kaloo, head of global emerging markets at Aberdeen Standard. ‘That has started to change.’

He firmly believes that China’s listed companies are more receptive to foreign investors and now take their responsibilities to all shareholders seriously. While investing in China does come with risks, ‘I think the nation’s outlook is still very good,’ concludes Kaloo.


THREE CHINA FUNDS TO BUY 

Baillie Gifford China (B39RMM8)

From the highly-rated Baillie Gifford stable, this £535 million China fund aims to find growth for the longer-term, holding stakes for at least five years.

Managers Mike Gush and Sophie Earnshaw have done an outstanding job to date, beating the performance of the Investment Association’s China index over one, three and five years, returning a fraction less than 200% over the longer time frame versus 123% for the index.

The fund provides large exposure to the digital commerce/social media platforms, with large stakes in the likes of Tencent, Alibaba, delivery platform Meituan and JD.com.

Fidelity China Special Situations (FCSS)

Manager Dale Nicholls is a big fan of insurance with key holdings including Ping-An, China Pacific and China Life. He also has big stakes in Alibaba and Tencent, stocks that have helped the £1.2 billion investment trust achieve a 177% return over five years, according to Sharepad data.

The trust takes a slightly different approach to many other China funds in that it will invest in non-Chinese companies as long as they have significant exposure in the country.

The downside of the trust being so successful this year (63% return in the first 10 months of 2020) is that the shares can no longer be bought on the cheap. The stock now trades almost exactly in line with net asset value, whereas over the past 12 months they’ve averaged a 7.8% discount, according to Winterflood.

Matthews China Small Companies (BJN4L97)

Finding little-known smaller companies in China to fuel good returns is a specialist area and one best left to professionals with on-the-ground resources rather than ordinary UK investors stock-picking themselves. Matthews China Small Companies Fund is a good solution.

Joint managers Andrew Mattock and Winnie Chwang have a built a portfolio that holds stakes in a broad mix of businesses in semiconductors, new energy, property and pet food.

The small caps expertise does come at a price, with ongoing charges of 1.5% a year for the sterling-denominated version, which launched at the start of 2020. The A class US dollar-denominated version (as featured in the accompanying chart) has a longer track record and has beaten the MSCI China NR USD benchmark by 31.5% in 2020 with a 57.1% return year to date, and outperformed the benchmark by 6.6% last year.

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