14 Nov 2024
A more thoughtful and far-reaching set of stimulus measures by the Chinese authorities has nullified some of the negative perception among global investors when it comes to China. David Perrett, Co-Head of Asia Pacific Equities, suggests that the continued caution could be creating some compelling long-term opportunities for stockpickers. He explains why he thinks Chinese equities have the potential to become one of the investment stories of the next decade.
When it comes to investing in China today, weak sentiment and depressed valuations abound, and the prevailing narrative encompasses pessimism and uncertainty. News headlines and commentary tend to focus on the country’s challenging economic situation, including its troubled property sector and weak consumer demand, and geopolitical tensions with the US. These concerns are arguably reflected in the low valuation of the country’s stock market, which has retreated materially from a peak in 2021.
However, to paraphrase a well-known saying, the time of maximum pessimism could also be the best time to look for opportunities. Although there are genuine concerns about the economic picture in China, we believe it is possible to construct a different, positive view. Bursting a property bubble or going through a major economic transition is a messy, painful experience. It takes time but, as seasoned investors, in our experience, these periods can lay the seeds of structural change and improvements that potentially deliver outsized returns over the coming years.
The problems in China today are better understood and policymakers have delivered new and far-reaching fiscal and monetary programs which go beyond simply repeating the established playbook of increasing spending on infrastructure. Measures seem more targeted at boosting consumption and shoring up the balance sheets of local authorities and banks; moves that have underpinned the negative slide in the stock market. The policies have served to mitigate high levels of uncertainty and low expectations and we believe that discerning investors can potentially identify some very promising long-term opportunities in an environment that is improving for investors.
We are not suggesting that investors allocate a large portion of their global assets to China. However, given our view that, in many cases, the risks are already reflected in share prices, we believe there are several reasons why contrarian investors might wish to take a closer look at their China equity allocation.
We would point out that China represents around 18% of the global economy but Chinese equities (even with a good run of performance) only account for around 3% of the MSCI ACWI global index. In our view, this is a disproportionately low level for such an important economic power. Even though we believe that stock markets are driven by corporate profits rather than economic growth, we feel that China is being widely overlooked by global investors.
Change in corporate focus
Turning to focus on how corporate China is being run from a bottom-up basis, we see an encouraging picture. Quality Chinese firms have adapted to the tough operating environment of recent times. They are increasingly focusing on their core businesses and importantly, in a region that has historically prioritised growth at all costs, profitability. This shift in focus from top-line growth to bottom-line growth is a big structural change that is great news for long-term shareholders.
We are also observing weak and uncompetitive companies going bust, which means greater market share and increased revenue for companies who prove to be best in class.
Improving shareholder returns
Another welcome development to highlight is Chinese firms increasing their returns to shareholders. Across the board, companies are buying back more shares and paying out an increased portion of their profits in dividends. Many state-owned enterprises (SOEs) are leading this trend, with the government, who is the main shareholder, keen to receive cash to fund stimulus measures and to care for an ageing population. In the past this money might have been invested in low return projects. As a minority investor, we are happy to invest in those SOEs (and private enterprises) that are boosting their dividend payments and returning a greater portion of their profits to shareholders.
It’s not just through dividends that Chinese companies are engaged in efforts to return cash to shareholders. With equity valuations at depressed levels – where, in some cases, the value of companies is less than the cash on their balance sheet – we are seeing a sharp increase in share buy backs. These buy backs should boost future returns on equity, while sending a powerful message that many Chinese companies see their shares as undervalued.
Industries of the future
A factor that many global investors might not be aware of is that China is leading the way in many of the industries of the future. At the recent policy meeting, the Third Plenum, the government outlined its prioritisation of technology and innovation in the economy, with a focus on advanced manufacturing.
One area where China is at the forefront is in electric vehicles (EVs), with firms like BYD gaining wider recognition – efforts to raise brand awareness beyond China were arguably helped by BYD’s role as an official partner of the UEFA Euro 2024 tournament.
There is a lot of talk about subsidies and unfair competition and the European Union (EU) has provisionally proposed tariffs on imports of Chinese EVs to protect domestic production. However, China is not alone in providing subsidies. The real issue is that China‘s EV industry has built huge economies of scale. This is because China never had a traditional auto industry; instead it had joint ventures with Western firms. Therefore, it had nothing to lose by becoming the first mover in mass EV production. In July, half of all vehicles sold in China were either EVs or plug-in hybrid, illustrating the country’s significant progress in EV adoption.
China is also a dominant player in solar and wind power, batteries and many other industries. In addition, it’s the leading economy in supply chain management. We believe these are all going to be very important for the future.
Although geopolitics might mean Chinese firms struggle to operate in the US, we believe that there are plenty of other markets for them to expand into. Over time we are likely to see innovative, future-focused Chinese companies become dominant in Latin America, the Middle East, Africa and Southeast Asia. We believe their current valuations do not reflect this exciting potential.
Investment story of the next decade?
Investor sentiment towards China remains cautious despite the renewed policy focus, which is reflected in equity valuations. Indeed, the majority of market participants remain heavily focused on policy announcements and very near-term economic and consumption data points.
Our focus is on positive emerging structural trends that are happening at the company and industry level.
China has a leading role in the industries of the future
Corporates are increasingly focused on their core business and generating strong bottom line, rather than top line, growth. We are also seeing industry consolidation as the weak are pushed out by the strong.
Meanwhile,
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
