China-focused fund managers are emphasising company valuations as key to investing in the country’s turbulent markets.
Concerns over China’s property sector and a raft of regulatory actions against firms in multiple sectors have damaged investor sentiment towards Chinese markets in recent months.
Fund managers are interested in the country’s growing markets as a source of potential higher returns, but remain wary.
A monthly survey of fund managers in November by Bank of America found that one fifth of investors view China as the “biggest tail risk”.
Nevertheless, the same survey also revealed that emerging markets assets are expected to be the best-performing asset class in 2022.
“When asked ‘is it the right time to buy China?’ we would say, which China?” says Rob Brewis, a fund manager at Aubrey Capital Management.
“Bottom fishing in the highly leveraged and largely bust property sector? Not a chance. Given that the private sector is under the government cosh what about the SoEs? No thanks, as few meet our cash return and profitability criteria.”
Brewis says that there are “rafts of entrepreneurial companies” in China for investors that “dig a bit deeper” into sectors including local cosmetics and sportswear brands, and makers of electric vehicles.
Many of these firms are operating in areas of the economy witnessing structural growth, have little or no debt, have strong or improving operating cash flow and return on equity, and are “now very attractively valued”, according to Brewis.
“To lump all of China together is often to miss the huge opportunities available within,” says Brewis.
The broad MSCI China index slumped by almost 14 per cent in the year to the end of October, a turnaround after the same index grew by nearly 30 per cent last year.
Weakness in the broad Chinese market has been driven by the underperformance of major Chinese tech firms, Tencent and Alibaba, according to Guinness Asset Management.
“Tencent and Alibaba make up 10 per cent each of the benchmark, and a lot of China funds will also have at least 10 per cent in those two stocks – which is great if they're having a really good run, but at the same time, unexpected things can happen,” says Sharukh Malik, co-manager of Guinness Asset Management’s Best of China fund.
Tencent and Alibaba’s share prices have fallen this year due to antitrust fines and tougher regulations introduced by the Chinese government.
Guinness’s equally-weighted fund had much lower exposure to stocks like Alibaba and Tencent than many rivals, which helped the fund to outperform in the market sell-off.
“Internet stocks haven't had the best time – but there are various other areas which are growing very nicely and that don't really conflict with the common prosperity push,” says Malik.
China is pushing to achieve ‘common prosperity’ and narrowing its wealth gap. At the same time, domestic businesses have been faced with increasingly aggressive action from regulators across multiple sectors, including gaming, education, healthcare and finance.
“A lot of China's development in the past was about getting rich fast and making the pie bigger, but not worrying too much about the distribution of the pie,” says Malik.
Malik says that the era of 10 per cent yearly economic growth in China is now “over”.
China’s economic expansion slowed to 4.9 per cent year on year, in its third-quarter growth figures, down from 18.3 per cent and 7.9 per cent growth in Q1 and Q2 respectively.
“The 4 to 5 per cent growth era is coming, and that's needed if China is to rebalance its economy. So previously, there was a lot of debt funded growth which was becoming increasingly less productive,” explains Malik.
The growth slowdown means that “paying attention to the valuations” is increasingly important for China investors, says Malik.
“We're looking for companies with strong balance sheets, debt to equity less than 1.5 times, and market cap of more than USD500 million,” he explains, adding that Guinness is looking at various investment themes in China from the growth of the middle class, to sustainability and artificial intelligence.
“ESG is important for important everywhere, and definitely in China,” adds Malik, adding that it is important to “sense-check” whether potential investee companies align with the wider interests of society.