What makes investing in China challenging in part is the ‘mini-cycles’. In recent decades, investors’ zeal has vanished typically every three to five years, yet the loss of confidence can be regained again in a short time.
The memory of the regulatory clean-up in 2021 still lives vividly in investors’ heads. One of the most horrendous examples is TAL Education (TAL), as 93% of its market value was wiped out within six months of the government’s unforeseen announcement of a radical ban on for-profit education business on the mainland.
We asked Gold-rated portfolio manager Martin Lau of FSSA Investment Managers about his rules for identifying pockets of alpha opportunities from the volatile market.
Common Sense
Investing with common sense is Lau’s golden rule for managing his bottom-up strategy.
He tends to resist market hype, for example the hype for property management companies.
By nature, property management service is a labor-intensive business and, arguably, faces high employee turnover. What makes Lau skeptical, though, is investor fervor for the entire sector.
“One time I looked up around 30-odd Chinese property management companies on Bloomberg. As I found that their aggregate market cap outsized their developer parents’, that raised some red flags,” says Lau.
Other than steering away from unreasonable investment theses, common sense is his core principle of investing. “Making money for its shareholders is the purpose of a company’s existence. I have never invested in a loss-making company,” he says.
He cited Tencent Holdings (00700), the largest position in the FSSA China Growth Fund as of Mar. 31, 2023. “We take comfort from Tencent’s ability to generate profits from the business. This has given them a nest egg to ride numerous cycles, without asking shareholders for further capital.” In other words, investors should be cautious about company managements with creative energy that continuously raise money from shareholders instead of investing profits.
The Next 30 Years: What’s In Store for Chinese Stocks?
Looking ahead, issues that strain investors are beyond investors themselves. Complicating the investment environment is how the government communicated and implemented draconian regulatory clean-ups in multiple high-growth sectors as well as geopolitics. With these two issues, some investors have expressed bigger doubts about whether the Chinese politburo is still supportive of privately-owned companies as well as whether the China-stocks growth story is still valid.
“Admittedly, confidence in the private sector has been low after the regulations are broadly tightened. I am certain, though, in 10 years, the most successful Chinese company in China will be a private enterprise, as they typically take excess risk and are very entrepreneurial,” Lau says. More-stringent regulations have been acting as speedbumps to ensure orderly industry development, but have made the growth seen in the past two decades in internet firms unlikely to repeat.
Lau continues: “All investors in China today must accept that steady growth is fine. Look at the most successful companies across the world, like P&G, Estee Lauder, and Nestle. Their profits do not typically grow 20-30% every year, but their portfolios of businesses steadily generate profits and reward shareholders with value.” In his 40-stock portfolio, similar examples are China Mengniu Dairy Company (02319) and electric appliances maker Midea Group (000333).
From Growth to Internationalization
Lau thinks Chinese companies will become increasingly internationalized even though few have successfully internationalized to date.
First, most industries in China are fragmented, so companies will have to become competitive internationally with a global production network.
“Geopolitics will stay, and so will the tensions between the U.S. and China. In the next five to 10 years, globally-successful companies – not just Chinese ones – will have to show a sprawling production chain globally that can respond to political changes. This holds especially true for manufacturing companies.”
“From the experience in the developed markets, dollars spent on consumer products – like on P&G, Coca Cola, and Unilever – is massive, and that will help leaders emerge.”
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