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Look to the long term with China

Despite concerns about US protectionism, increasing debt and slowing growth China still offers long-term opportunities
January 26, 2017

This time last year worries about China's slowing growth and rising debt burden plunged global stock markets into the doldrums. The Chinese economy is still growing, but at 6.7 per cent in 2016 - the slowest rate since 1990. And US President Donald Trump has threatened to impose 45 per cent tariffs on imports from China and denounce it as a currency manipulator.

Jason Hollands, managing director of Tilney Bestinvest, has been cautious on the Chinese market for several years. "I would be extremely wary of investing in China, as deep cracks are appearing in its economic model," he says. "While China is often perceived as a country that has retained a Communist political system but effectively embraced capitalism, the latter is merely a cosmetic veneer. Chinese authorities are prone to intervening in economic activity and boards of listed companies are stuffed with state appointees, usually with the state as the dominant shareholder. Chinese economic growth statistics - often cited by bulls - need to be handled with care. There are widespread doubts about the efficacy of the data and, in any case, much of the headline growth is in uninvestible areas, and the result of the Chinese state dragooning companies and banks into inefficient investment."

The country's aluminium production is an example of the Chinese state chasing a higher growth rate, he argues. "While aluminium prices have crashed in recent years, China has just ploughed on vastly expanding its production capacity. In a true, free market economy the opposite would happen, but China is probably having to do this because it needs cash flow just to service interest costs on debt and sustain 'growth' figures."

Chinese debt is rising - up from 160 per cent of gross domestic product (GDP) in 2005 to over 250 per cent in 2015 and continues to rise, points out Adrian Lowcock, investment director at Architas. "The Chinese government has allowed cheap borrowing in order to protect the country's slowing economic growth," he explains.

The working population in China shrank for the first time in 2015, and Mr Lowcock says that within 10 years the working population in China will have fallen by more than 30m, more than the total working population of the UK.

Corporate reform is also needed: the profits of state-owned enterprises in the first half of 2015 were 2 per cent, compared with 18 per cent for private companies, while sales growth and capital expenditure were both negative.

"China has a rapidly ageing population and rising debt," says Mr Lowcock. "The country could be running out of time and money, and get old before it gets rich. Investing in China is not for the faint-hearted."

 

Long-term opportunity?

But despite these problems, over 2016 China and Greater China funds had returned an average of 36.1 per cent, according to Trustnet data.

David Liddell, chief executive of online investment service IpsoFacto Investor, says: "China is a great market to have some exposure to if you've got a 10-years-plus horizon and can look through volatility. It still looks pretty attractive in terms of big-picture issues such as the growth of the middle class, the ability of the rural population to move to urban centres, and the impetus that will give to services and local retail."

The percentage of Chinese GDP made up of exports has been falling in recent years, with over 50 per cent of Chinese GDP now created from domestic consumption, which also accounts for 90 per cent of GDP growth.

"You are seeing what you'd expect with a growing emerging economy becoming more domestically focused, and the growth of services and domestic retail becoming a growing proportion of the economy," continues Mr Liddell. "But companies that are dependent on exports and sub contracts, which US businesses are employing to put together their products, may be more at risk."

However, Ed Smith, asset allocation strategist at asset manager Rathbones, believes that "other emerging markets are far more vulnerable to American protectionism than China, which has already gone a long way towards reorienting its economy towards more internal drivers: the services sector accounts for 52 per cent of the economy, and that is highly likely to be an underestimation, given the poor collection of data from the private sector".

Eric Moffett, manager of T Rowe Price Asian Opportunities Equity Fund (LU1044875489), argues that investors should focus on finding growth opportunities that result from China's transition to a consumption and services-led economy, and that recent economic data suggests the country's economy is stabilising, although China will need to undergo more structural reforms to successfully transition to an economy with high-quality, albeit lower, growth.

Dale Nicholls, manager of Fidelity China Special Situations (FCSS), believes there are good investment opportunities, particularly within private companies operating in so-called new economy areas. These include consumer-focused areas such as accommodation, business services, information technology, science and research, transportation, and retail.

"China remains an inefficient and undercovered market that is well suited for a consistent approach to bottom-up stockpicking," says Mr Nicholls. "While there are signs of improvement, broad macro concerns continue to effect sentiment, and this has taken valuations to attractive levels on both an absolute and relative basis. Some of these concerns are warranted, particularly those related to the significant expansion in credit that we have seen in China. It is also natural to expect headline growth in China to slow down as the economy matures and shifts away from investment towards a more sustainable consumption-led model. There is also great variation in trends between different parts of the economy.

"[But] broader long-term trends such as the development of the middle class remain in place, and this creates stockpicking opportunities."

Alongside new economy companies, the trust has recently increased its holdings in some state-owned enterprises (SOE) that the manager considers undervalued and have the potential for a growing return on assets they own. Infrastructure companies operating within areas such as airports, ports and toll roads also feature in the trust's portfolio, with airports continuing to benefit from strong travel trends both domestically and overseas.

Charlie Awdry, manager of Henderson China Opportunities Fund (GB00B5T7PM36), admits that the macroeconomic background on China is challenging, but says there are stockpicking opportunities among cyclical and growth companies.

"Portfolios that are significantly underweight financials, with no banks, have the potential to perform well," he says. "[The fund's] focus on the best companies with strong cash flows still appears appropriate in an economy that muddles through just as it has done in recent years.

"We have a blend of top-quality growth stocks exposed to long-term trends such as mobile internet and life insurance, including Alibaba (Baba), Tencent (HKG:700), NetEase (US:NTES) and AIA (HKG:1299). We are also investing in more cyclical value stocks where return-on-equity may have bottomed and is set to improve, such as Daqin Railway (SHH:601006). While we have a less favourable view on auto shares, we are still positive on BMW's joint-venture partner Brilliance China Automotive (HKG:1114) and steering systems supplier Nexteer Automotive (HKG:1316)."

Mr Lowcock adds that valuations of Chinese shares are now reasonable.

 

China and Asia Pacific funds

Darius McDermott, managing director at FundCalibre, suggests caution on China as he believes the risks outweigh the benefits. But he says that investors who can stomach likely volatility could consider First State Greater China Growth (GB0033874321) and Invesco Perpetual Hong Kong & China (GB00BJ04HS18). These funds are run by managers who are based in Hong Kong and have performed well in down markets.

"Invesco Perpetual Hong Kong & China's experienced team has the resources to visit companies on the ground and do its own in-house research," say analysts at FundCalibre. "This gives it a major edge versus many of its peers. The managers have a solid investment process, which focuses on fundamentals. They are not afraid to hold positions that are substantially different from their benchmark, which is dominated by old state-owned companies."

First State Greater China Growth looks for well-managed businesses with good corporate governance across Hong Kong, China and Taiwan. The fund takes an absolute return approach and invests in quality companies for the long term. "This is an excellent fund in a very specialist area of Asian equities," says FundCalibre. "The team has shown that it can consistently produce the goods in any type of market environment."

Mr Liddell suggests Fidelity China Special Situations (FCSS), which he says "has got a good spread of exposure to both onshore-listed 'A' shares and the internationally listed china stocks. Its performance has been strong and it's trading a reasonable discount to net asset value (NAV) of 12.5 per cent, but the trust has been very volatile in terms of price and discount."

He also likes JPMorgan Chinese Investment Trust (JMC), which has not performed well over the past two to three years, but has done well over the longer term.

In the light of his concerns about the Chinese market, Mr Hollands suggests investors generally steer clear of pure China funds, and get limited exposure via broader Asia and Global Emerging Market funds. Options include JPMorgan Emerging Markets Investment Trust (JMG), which has 18.7 per cent of its assets in China and 9.1 per cent in Taiwan.

Mr Lowcock suggests JPMorgan Emerging Markets Income (GB00B5N1BC33), which has nearly a quarter of its assets in China, and around 8 per cent in Taiwan.

"The focus of the fund is very much on stock selection with a bias to quality value stocks which then drives exposure to countries," he explains. "This means that Chinese exposure features in the portfolio on merit alone. This fund is more suitable for more cautious investors wanting to access the Chinese markets."

Mr Hollands says another more defensive alternative way to get exposure to China is via a fund that can use derivatives to mitigate downside. He says: "I like Schroder Asian Total Return Investment Company (ATR), which has 21 per cent in mainland China and 25 per cent in Hong Kong, and in which the managers, Lee King-Fuei and Robin Parbook, are very defensively positioned."

 

Fund performance

Fund/benchmark1-year share price/total return (%)3-year cumulative share price/total return (%)5-year cumulative share price/total return (%)Ongoing charge (%)
Invesco Perpetual Hong Kong & China*34.439.285.50.89
First State Greater China Growth 41.245.982.41.08
Henderson China Opportunities 46.355.183.40.89
Fidelity China Special Situations54.070.7138.32.22
Schroder Asian Total Return Investment Company47.262.076.00.99
JPMorgan Chinese Investment Trust46.931.564.31.44
JPMorgan Emerging Markets Income 54.127.4NA0.93
JPMorgan Emerging Markets Investment Trust44.135.632.91.16
IA Global Emerging Markets sector average48.230.329.0
IA China/Greater China sector average40.840.359.6
AIC Country Specialists: Asia Pacific sector average43.071.4124.5
AIC Asia Pacific - Excluding Japan sector average42.229.033.6
MSCI China 10/40 NR USD index43.945.853.6
MSCI AC Asia Pacific Ex JPN NR USD index46.341.553.3
MSCI China GR USD index44.747.355.9
MSCI Golden Dragon NR GBP index47.249.668.1

Source: Morningstar

Performance data as at 20/01/17

*Performance is for a different share class to that mentioned in the text