Why look for value rather than growth in China?

The general perception surrounding China is that it is an ideal market to search for growth. The reality is that China is a very unique and policy-driven economy. The extent of policy and government regulation make it a complex market to navigate, and the regulatory framework evolves at a fast pace. China is also a competitive market with an abundance of capital and talent, and therefore, any successful business model or approach is quickly replicated. 

Time and again, we have seen investors in China overpay for growth levels that are not sustainable over an economic cycle. Five years ago, Chinese departmental stores fitted the growth story boxes of favourable demographics and growing consumption. Today, these companies have fallen out of favour, as the rise of e-commerce has disrupted the underlying model and new distribution channels take customers away from shopping malls. 

The Macau gaming industry is a recent example where investors were willing to pay premium valuations. With the anti-corruption drive in China, the premium VIP segment shrunk considerably within a short time frame. The gaming industry is expected to be driven by the mass-market segment of consumers, where margins are lower, new capacity creates more competitive pressure and cost inflation is likely to rise.

Consequently, when value emerges in Chinese equities, it usually goes unrecognised. This creates opportunities for a value investor such as myself for researching these out of favour stocks in depth, avoiding value traps and steadily building long-term positions in robust businesses with sustainable growth prospects. I prefer durable business models that offer earnings visibility from a three to five year perspective, are currently unnoticed by the larger market and trade at attractive asset-based valuations. 

For instance, the China A-share market has blue chip stocks representing established business models with strong pricing power and robust cash flows. With retail investors focused on fast-growth ideas, such businesses with relatively steady growth prospects and high dividend yields trade at attractive valuations. Retail investors often do not recognise that many of these companies are also exploring international markets, expanding their product lines and entering new market segments.

Outlook for the year ahead

The Chinese economy has been in a muddling through stage since the investment cycle peaked out in 2010. It will continue to remain so for the next 2-3 years.  In 2017, Chinese policymakers are likely to maintain a pro-growth stance before the leadership changes in late 2017 and 2018.  Monetary policy will shift back to a more neutral stance with inflation returning while fiscal policy will remain very accommodative. The sharp rise in property prices has put Beijing on alert and tightening measures will continue in the first half of 2017.  However, there is a disparity between property markets in higher tier cities with soaring property prices, and tier-3 cities and lower dealing with excess housing inventory. Consequently, we are less likely to have uniform policy response such as across-the-board tightening. Measures aimed at addressing these issues are likely to be city specific, not of the type seen in the past and may require local government intervention. 

Elsewhere, Chinese debt would also remain in focus. In my opinion, debt management in the SOE segment is likely to be the most challenging, as the NPL recognition is in relatively early stages and is expected to be spread over the next two years. The onset of supply side reforms this year is a positive step to potentially lead to the recognition and restructuring of SOE liabilities. Chinese banks have made progress in NPL recognition in the private sector over the last two years, and the local governments have also begun to address this issue with bond issuances. It is quite unlikely that there would be a liquidity crunch in China, with the People’s Bank of China being the largest shareholder in key financial institutions.

Nonetheless, long term investors in China will find opportunities not only in the structural shifts but also among beneficiaries of reforms. I believe that the management incentive programmes and supply side restructuring in SOEs will drive long term returns for well-managed businesses that may currently be out of favour. While the economic shift to ‘new China’ cannot be ignored, investors should also not overlook opportunities in traditional sectors that still continue to be the backbone of the economy. For instance, supply side restructuring in steel and coal will weed out the inefficient players, and I expect to see companies with balance sheet strength, healthy cash flows, strong management teams, and attractive dividend yields deliver returns. 

I believe that the Chinese consumer is important -but it is also crucial to understand that consumer behaviour is changing at a fast pace. For instance, younger Chinese consumers have a higher preference for light luxury goods vs. high premium luxury goods; the newly affluent do not necessarily prefer to spend time in casinos and on gaming, but prefer to travel. It is important to make this differentiation.

Jing Ning manages Fidelity’s flagship China offering the Fidelity China Fund. Since inception¹ the Fund has delivered 13.6% per annum (net of fees) in AUD terms vs. 9.5% returned by the MSCI China Net Index². Jing is a contrarian value investor with 17 years of experience in investing in the Chinese stock markets. She believes that the structural shift towards a consumption-driven economy is steadily underway in China and presents attractive investment opportunities for the long-term investor. She has a clear preference for durable business models that offer earnings visibility from a three to five year perspective, are currently unnoticed by the larger market and trade at attractive asset-based valuations.

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Originally published by Jing Ning, Portfolio Manager Fidelity China Fund