“Sometimes valuations are enough of a catalyst to justify investing somewhere.” The aforementioned quote is something that has been attributed to me in the past, most recently when it comes to Chinese equities.
After more than two years of constant pain for investors, many of the managers we have spoken to have been more measured in their outlook recently, citing attractive valuations and improving fundamentals at a company level, while the strength of the consumer must not be overlooked.
We have spoken in this column before about the regulatory crackdown by the Chinese government and the difficulties facing the Chinese property sector. However, there was hope that 2023 would be better for the region — only for the Covid recovery to slow, while the crackdown on entrepreneurs continues to hit businesses and consumer confidence hard.
No one should be surprised by any market meltdown caused by the Chinese government simply flexing its muscles — it has form for this throughout history. If you understand and appreciate these corporate governance risks, then the market is markedly cheaper than it was two years ago.
However, the news that the Biden administration issued an executive order aimed at restricting certain investments in advanced technologies in China, in the areas of artificial intelligence, quantum information technologies, and semiconductors and microelectronics, has led us to question any further investment in the country in the short to medium term.
In a nutshell, the move is narrowly targeted at investments in highly sensitive technologies and products for the purposes of protecting US national security.
Is China now uninvestable?
Regulatory concerns, coupled with geopolitical uncertainty, have weighed heavily on Chinese equities. Since February 2021, the MSCI China Index has fallen by 44 per cent, while many of its peers in the emerging markets arena have risen, including Mexico (64 per cent), India (27 per cent), Brazil (22 per cent) and Singapore (2 per cent).
To put this into wider context, the MSCI Emerging Markets Index as a whole is up 1 per cent over the same period, despite the pull-down effect of China, its largest country constituent with an almost 31 per cent weighting.
It just goes to show you shouldn’t invest in GDP numbers – they often don’t translate. We’ve seen much better returns in many of the other markets in the regionJason Pidcock, Jupiter Asian IncomeChallenges with China, coupled with the growing belief that it requires its own distinct allocation away from emerging markets, have resulted in a number of asset managers launching ex-China Asia/emerging market funds to distinguish between the two.
Others are taking advantage of the headwinds facing the country. Mexico, India, Vietnam and other locations are replacing it across global manufacturing supply chains. The same names are also tapping into the waning of China’s export dominance. Meanwhile, some investors are simply tapping into better growth stories, like Brazil.
Jupiter Asian Income manager Jason Pidcock sold his last remaining mainland China stocks in 2022, citing political concerns. He had previously been underweight the country for some time, citing lower expectations of corporate profitability relative to the rest of the region. He also felt valuations in China deserved to be de-rated, given a long period of regulatory clampdowns and travel restrictions.
He says: “So many other countries in the region have exciting investment opportunities where we’re comfortable with the political system. We also like the businesses themselves, some of whom sell their goods and services into China, so we do not feel the need to invest directly in mainland Chinese companies.”
Pidcock says, with hindsight, he wishes he could have invested even less in the past decade. “(Chinese equities) been serial underperformers and they’ve performed badly compared to the higher GDP growth rate of China, which is better than many other countries,” he says.
“So it just goes to show you shouldn’t invest in GDP numbers – they often don’t translate. We’ve seen much better returns in many of the other markets in the region.”
For foreign investors, there is also the added issue of diversification. Many will have significant technology exposure through the US and may not want to double up with further exposure to tech stocks in China. The likes of Tencent and Alibaba account for more than 20 per cent of the MSCI China.
Why being fully active in China is the only sensible way forward
FSSA Global Emerging Markets Focus co-manager Naren Gorthy says his portfolio currently has around a 30 per cent allocation to China — this is based purely on the attraction of individual companies, available at low valuations, based on the impact of wider macroeconomic sentiment.
He points to businesses that have little to do with the troubled property or banking sectors as examples of good investments for the long term. These include the likes of Yum China (a fast food company) and China Resources Beer — both of which have reported strong results recently, he says.
There is no doubt that what has happened to China has made it slightly less attractive versus other markets that do not have those external pressuresEmily Whiting, JPMorgan Asset ManagementJPM Emerging Markets trust investment specialist Emily Whiting says the recent challenges highlight the need to invest in active managers, rather than just back the China story. She says that while the heightened political sensitivity is having a material impact on industries and sectors, there remain a number of companies that are growing their margins and market share.
“Ultimately, it comes down to whether we as investors feel comfortable paying a certain price for a company and if we believe its thesis remains intact,” Whiting says.
“By contrast, other countries are benefiting. Take India as an example, it may look far more compelling, but you are having to pay a lot more for companies as a result. There is no doubt that what has happened to China has made it slightly less attractive versus other markets that do not have those external pressures.”
China does have challenges, but for long-term investors it is incredibly cheap versus its own history — it does not have to worry about the threat of inflation, and is expected to become the world’s largest economy by 2035.
Over the past decade, the country has also accounted for about one-third of global growth — a greater contribution than the US, Europe and Japan combined.
Yes, the growth of other countries in emerging markets is likely to dilute exposure to China to a degree, but it remains a country littered with great companies allowing active managers in Asia and emerging markets to take advantage in the long term.
Funds to consider
Ex-China portfolio – Jupiter Asian Income
Well-known Asian income manager Jason Pidcock combs the breadth of the Asia-Pacific market in search of large companies with reliable dividends that can deliver both income and growth for investors. The fund aims to capitalise on the opportunities of today, as well as the potential of tomorrow, and is not afraid to hold much more or less of certain countries than its benchmark in pursuit of this aim. Pidcock will predominantly focus on the more developed countries in the Asia-Pacific region, including Australia and New Zealand, which, together with the fund’s income mandate, make it a relatively defensive option in this region.
Active/Core Holding – Fidelity Asia Pacific Opportunities
Fidelity Asia Pacific Opportunities is managed by Anthony Srom. It is a concentrated portfolio of 25 to 35 stocks, with the sole focus of finding the best companies, rather than focusing on an industry or theme. Srom also aims to lower potential volatility by making sure the portfolio is diversified, while correlations of underlying stocks are monitored closely, with the fund performing well in down markets. Some 30 per cent of the portfolio currently sits in Chinese equities.
Dipping the toe in the water – GQG Partners Emerging Markets Equity
GQG Partners Emerging Markets Equity is a concentrated portfolio of high-quality companies with durable earnings. The emphasis is on future quality, rather than companies that have simply done well historically. The team has a strong investment resource, including investigative journalists and specialist accountants to give it an edge. The fund currently has a 16 per cent exposure to China (well below the MSCI EM Index) and has greater exposure to India (29 per cent) and Brazil (22 per cent).
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre
