Last year was a difficult one for the Chinese equity investor, due to concerns that the country’s high level of gross domestic product (GDP) growth could not last. Our contrarian view, however, is that slower growth will prove healthy in the medium to long term, and the market sell-off provides more opportunity to access that growth.
GDP growth in China is levelling off as the overall scale of the economy increases and the government focuses on migrating the manufacturing-based economy to one that is consumption- and service-led.
Following China’s fixed-asset investment growth and subsequent consumption trend, inflated by loose credit policies, this easy money dissipated during 2018.
The economy is still growing, albeit at a healthier pace. Income growth has propelled private consumption in China. This is a trend driven by the country’s large domestic talent pool, supportive government policies and growing capital investment.
As bottom-up stockpickers we have been focusing on domestic growth opportunities in sectors such as consumer discretionary/staples, information technology, life insurance and healthcare companies.
Since last spring, ongoing US-China trade negotiations have triggered economic fears, overshadowing equity valuations and acting as a catalyst for market volatility. As a result, Chinese equities were trading at nearly one standard deviation below their 10-year price-to-earning average by Q4 ’18, based on MSCI China Index data. However, we embraced the market movements in the second half of 2018 and increased our weighting in intellectual property-heavy companies, notably those in the healthcare and technology sectors.
One of the biggest macro-level risks is China’s high levels of debt. Although this is a significant concern for global investors, we do not believe there is an immediate systemic risk.
First, China’s debt remains mostly domestic, its levels of external debt among the lowest among major countries and its emerging market peer group. Second, the Chinese government is making clear efforts to deleverage the economy.
In November 2017, the People’s Bank of China, together with 10 other governmental departments, introduced stringent rules to reduce credit risk within the booming peer-to- peer lending industry and to curb liquidity in the property industry.
The short-term outcome was a reduction in the growth rate for 2018 in large-ticket consumer items such as automobiles and white goods. Despite this, overall consumption grew by more than 8% year on year in 2018, outpacing the country’s GDP growth.
Picture of health
An ageing and increasingly prosperous population is creating stronger demand for healthcare services. Though China’s healthcare sector is still in its infancy, with expenditure per capita low by global standards, recent reform has been aimed at bringing down drug prices, encouraging innovation and increasing healthcare capacity and coverage.
Policy change is motivating the pharmaceutical sector to upgrade, and there is a growing number of biologic drug companies compared with the generic drug makers of the past who focused on distribution.
As always, the key is to be selective. We prefer innovative companies such as 3SBio, which has a solid pipeline, thanks to its strong R&D capabilities. We also look at more basic medical device manufacturers, where scale is a barrier. For example, the leading national syringe, tubing and related consumable manufacturer, Shandong Weigao, faces fewer policy uncertainties due to recent reforms.
The simmering trade dispute with the US has reduced the risk appetite of Chinese equities. While we recognise the complexity of the negotiations, we believe a full-blown trade war is unlikely. The flip side of the trade dispute is that Chinese businesses are increasingly competitive and innovative as they gain in-house intellectual property.
China’s transition from a manufacturing- based economy to one grounded in innovation and knowledge will rely heavily on advancements in science and technological research. There has been a remarkable increase in the number of science, technology, engineering and mathematics graduates in China during the past three decades, providing the country with an abundant, highly educated workforce.
China’s investment in higher education has led to a proliferation of scientific publications, whose share is now second only to the US. With a ‘Made in China 2025’ reform agenda, the government is also determined to support innovation and technological development in the form of government grants and more favourable policy.
Against this backdrop, there is a great opportunity to seek out long-term quality franchises in China. Challenging the developed markets industries will lead to ongoing trade discussions. Investors must cope with these headwinds and factor them into analysis.
China’s economic shifts towards a more consumption- and service-led growth model provides a tailwind for the internet sector, with consumers and businesses demanding more digital services.
Opportunities in the media, e-commerce, cloud services and mobile gaming sectors remain robust. Despite being a late bloomer, China’s web sector is large and sophisticated. However, with nearly one billion people connected via mobile, increasing regulatory oversight is inevitable, and there was a meaningful de-rating of the sector in 2018 as short-term earnings visibility was impaired.
To illustrate this, Chinese regulators halted new gaming approvals for monetisation between March and December 2018, putting a great deal of operating pressure on gaming revenue visibility for Tencent. The stock significantly de-rated as a result.
We believe it is not the government’s intention to displace the industry entirely but rather to enhance oversight through departmental restructuring. Tencent is more than just a mobile gaming company. Its flagship WeChat app is the dominant social networking platform in China, offering solid potential for mobile gaming distribution, social advertising, payment and local services.
Alibaba is another Chinese company that has encountered government policy and weaker macro-headwinds on valuation.
In spite of these examples, we remain confident about the long-term consumption of digital services and entertainment in China. With the fall in share prices we took the opportunity to increase our technology exposure, buying Tencent and Alibaba as well as a lesser known company, 58.com, a Craigslist-type business in China that focuses on local recruitment and property listings.
The opening of the domestic capital market continues to progress well after the initial launch of the Hong Kong-Shanghai Connect Programme in October 2014. The positive progression has led to a quadrupling of the weight of A-share in MSCI indices this year. The much-improved trading environment for equities has been a welcome reward of the Stock Connect Programme.
Despite the fact that domestic A-shares are more volatile, we believe the universe presents an interesting opportunity for stockpickers, especially when certain sectors, such as home appliances and Chinese liquor, are only available onshore.
We have invested in a group of handpicked A-shares-listed businesses that fit our long-term quality growth approach.
China’s promotion of domestic consumption and its economic capacity for innovation show the country will continue to focus on its own strengths in the future. The trade dispute with the US indicates that China’s economy has made tremendous progress over the past two decades.
With attractive valuations, there is clear stockpicking potential despite the economic slowdown and the trade conflict. The middle class hunger for new products and services represents a vast opportunity for Chinese companies and long-term equity investors prepared to hold their nerve.
Baijing Yu is an analyst and portfolio manager on the Comgest China strategy