Greater China Equities – In or Out?

Despite concerns over slower growth, shadow banking and corporate governance issues in China, the Greater China Equity panellists at our inaugural Morningstar Investment Conference in Asia were bullish on the market. 

Germaine Share 23.06.2014
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Despite concerns over slower growth, shadow banking and corporate governance issues in China, the Greater China Equity panellists at our inaugural Morningstar Investment Conference in Asia were bullish on the market. They outlined how they identified opportunities and some of the key issues investors faced in this challenging market.

Christina Chung, Head of Greater China Equity at Allianz Global Investors, Nicholas Yeo, Director and Head of China/Hong Kong Equities at Aberdeen Asset Management and Sam le Cornu, Senior Portfolio Manager of Asian Listed Equities at Macquarie, shared their thoughts on the Greater China equities market. Chung and Yeo each manage a Morningstar Bronze-rated Chinese equity fund at their respective firms while le Cornu manages a Bronze-rated Asia ex-Japan mandate with a strong Chinese tilt.

The panel kicked off with the panellists sharing their views on China. Chung stated that structural challenges and overinvestment in certain sectors would present a weak short-term outlook for China and therefore advised people to be patient when investing in the country. However, she expected government-driven reforms would increase productivity and efficiency in the market, benefiting investors in the long term.

Yeo was also positive on the long-term prospects of China and saw investment opportunities from the rising middle class and increasing demand for services. He added that a slowdown in GDP growth after years of robust growth might not be a bad thing. However, he said the current problem with investing in China lies in its generally poor corporate governance practices, which is a key concern for Aberdeen when selecting stocks.

Quoting Warren Buffett, le Cornu thought that “be fearful when others are greedy and greedy when others are fearful” applied when investing in China. He said China currently has “the lowest P/E ever, with a P/B of 1.2 times” and the attractive valuations had prompted the team to overweight China in the Macquarie Asia New Stars Fund. Moreover, he stressed that bottom-line EPS growth of Chinese companies remained robust despite the poor performance of H-shares, which he saw as a result of negative sentiment rather than weak fundamentals.

Corporate Governance
The discussion then turned to corporate governance in China. Unlike most of its competitors, Aberdeen accesses China through Hong Kong companies with mainland China exposure. Yeo explained that given that China is a relatively young capital market, most local companies have short track records. This made it difficult for him and his team to ascertain the quality of these companies. “The more you see, the more frightened you are,” Yeo commented, with non-existent factories and fraudulent accounts being some of the issues encountered by the team when assessing mainland companies. Consequently, the Aberdeen Global Chinese Equity fund consistently had more than 70% of its assets in Hong Kong companies, which Yeo believed  were subjected to more stringent corporate governance standards and regulations.

Macquarie also has a high standard for corporate governance when selecting stocks for its portfolios. Le Cornu pointed out that of the 4,000 small-cap stocks listed in the Asia Pacific ex-Japan region, only 15% passed Macquarie’s qualitative screen, in which corporate governance is one of the important factors.

While Chung agreed that Hong Kong companies are historically of better quality, it came down to “what price you are willing to pay”. This highlighted the current environment where Hong Kong companies are trading at a premium over those in China. She said investors considered mainland Chinese companies “a basket of bad eggs”, which presented opportunities for active managers to do their own due diligence and discover “gems” among these “bad eggs” at favourable valuations.

Investment Opportunities
The panellists also talked about where they found the most attractive investment opportunities in China. Chung steered away from large-cap industries and invested in non-cyclical sectors that have stronger secular growth potential than the broader market. These included environmental protection and clean energy companies, which were prominent in the Allianz China portfolio. However, she emphasised that it was still important to pick the right companies with, among other things, effective execution of their business strategies and good corporate governance. In other words, investors should not just buy into themes.

When asked whether he preferred the “old” or ”new economy” sectors, Yeo remarked he did not divide his investible universe in such a way and that traditional stocks may also become ”new economy” one day with technological advancements, such as e-commerce in supermarkets. He added that the life insurance sector looked interesting given that it remained underpenetrated. Furthermore, Yeo addressed Aberdeen Global Chinese Equity’s large exposure to real estate at our Q&A session. He explained that instead of traditional developers, he liked property companies that tied into the China consumption story, such as Swire Properties.

Similarly, le Cornu said “domestic demand is the way to play China”. Therefore, the Macquarie Asia New Star Fund had been overweight in Chinese consumer discretionary and healthcare stocks while having zero exposure to Chinese banks. In addition, le Cornu stated that China’s neighbours were also poised for growth. For example, the fund was overweight in South Korea, with Seoul being the third most visited destination for Chinese tourists. A key portfolio holding mentioned was Hotel Shilla, a Korean hotel operator.

In addition, there were a number of important takeaways from the panel. Notably, economic growth does not always translate into stock market returns. Despite some differences on how to approach the Chinese market, it is fair to say that all of our panellists are optimistic about investing in China and the long term potential it offers.

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Germaine Share  Germaine Share is a Senior Manager Research Analyst with Morningstar Investment Management Asia.

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