Known for its volatility, lack of transparency and still-evolving regulatory environment, China’s onshore equity market can be scary for even the most stoic institutional investor.
While market volatility is driven by the appetite for quick returns that local retail investors favour, a number of institutional investors have been seeking opportunities to invest into what they believe is not only a market burgeoning with alpha-generation, but one that will eventually mature into a well-regulated, transparent and stable market.
Luo Jing, a senior fund manager of China equities at Value Partners, discusses his approach to managing China A-Share portfolios for institutional investors and why he believes they can be rewarded for a patient, long-term approach to investing in an otherwise retail-driven equity market.
As a portfolio manager with a long-term investment focus, do you see China offering enough companies that you would consider the “buy-and-hold” type? If yes, then how do you and your team find them?
As a matter of fact, most of the 160 million trading accounts in China are held by retail investors. This cohort does not generally adhere to fundamentals, but contributes most of the turnover. To be able to see through the retail fervour, we adopt an active and bottom-up approach, leveraging forensic accounting, channel checks and supply chain cross-referencing to differentiate the best investment opportunities from the subpar ones. What we are after is a clear picture of a company from the inside out. It is not uncommon for some dishonest management teams to keep information from investors and hide unscrupulous accounting in their books – an issue not isolated to Chinese companies. Diligent cross-checking can draw valuable insights from their suppliers, customers and other stakeholders to solve the puzzle. Our analysts do not stop at information collection, as they are encouraged to debate and challenge each other on their assumptions and investment theses.
What are the key risk factors you take into account and how do you try to mitigate them?
A focus on corporate governance is the key to understanding risks. We gauge the intensity of a firm’s governance practices and culture; the founder and management team’s backgrounds, their capabilities and reputation, and their motivation to enhance shareholders’ value. For each company, it is as critical to understand broad sector trends. Thus, to facilitate that, our top agenda is to groom analysts to be sector experts and build their own network in the covered fields. Moreover, fact-checking with multiple sources is our practice, especially on our key assumptions when constructing our investment theses. While emphasising the people element, we do not toss aside important quantitative indicators. We measure valuation, for example, by not only judging a company’s potential upside, but also the different types of risks that are priced into its share price.
Do you believe the markets will eventually become more stable? If yes, then what would be the benefits and risks?
Capital markets morph into a more mature form over time, and China is not an exception. In general, such a development would see more stringent regulatory oversight and encourage company disclosure. This environment should help keep fraud at bay, support investor confidence and likely attract institutional money to invest for the long haul. In turn, longer-term and fundamentally-driven institutional investors would reward companies with a more robust balance sheet, growth outlook or other fundamental considerations. This also enhances the overall efficiency of the markets.
The other side of the coin is that asset prices reflecting information more efficiently have an effect of deteriorating alpha. Also, as an incremental number of institutions decide to allocate to China (a trend that is already under way), the impacts of concentrated retail participation and its impulsive trading style (a source of short-term alpha and dislocated opportunities) may be minimised. Conversely, fundamentally-driven alpha, captured with in-depth due diligence and on-the-ground research, is rather intact. As an investment manager, our process also prevails, since we can move down the market-cap spectrum. We look for under-researched, lesser-known and smaller-scale companies in sectors where we possess a deep understanding of local supply chains.