China remains the growth engine for the global economy. With the revival in full swing, Chinese economic growth is beating expectations once again, with GDP growth of 6.9% year-on-year to June 2017. This has helped lift the Chinese stock market by 28.4% year-to-date.
The question is whether this sentiment is warranted and what might happen in the future; We know that finding investment opportunities requires an investor to think beyond economic growth prospects. After all, the link between equity returns and GDP growth is notoriously weak.
Valuations therefore carry increased importance. Sizing of any emerging market positions are also important, as risk and reward must be considered, especially the way the exposure may act under stress relative to other core holdings in a portfolio.
Where's the Greater Opportunity?
While it is tempting to compare the greater growth opportunity in terms of economic metrics, an investor is better placed framing the discussion around the investment opportunity. From a growth story perspective, an investor should focus on the fundamental developments that matter to the investment universe in question. In this regard, China and Hong Kong are two very different markets.
Profit margins are a key fundamental input, but are likely to be misleading in Hong Kong as they have become very elevated following the property boom and the consequent gains in residential development, significant because approximately 60% of the Hong Kong market is invested in real estate and financials. In mainland China, diversification means that profit margins are less influenced by the property boom.
Therefore, investors need to take special care when attempting to compare the fundamentals of mainland China and Hong Kong. Ultimately, an investor should attempt to understand the sustainability of earnings and dividend growth, and while there are selected opportunities to invest in both Hong Kong and A-shares, we find that mainland China is slightly more attractive once adjusted for the price you pay. In fact, our asset class work shows South Korea and Taiwan as potentially better opportunities based on current pricing.
It is worth noting that mainland China’s A-shares market potentially represents a greater opportunity for active managers. This is more structural than opportunistic, simply because this universe is so much larger than the number of Chinese companies listed in Hong Kong and the analyst coverage is far less advanced.
From a portfolio construction perspective, it is worth noting that the A-shares provides a better representation of the broader Chinese economy through access to a more diversified range of industries/sectors. While Hong Kong has been the typical access point for those that wanted access to the China story, exposures have typically been concentrated in financials, internet and real estate companies.
What are the Risks of Mainland China?
Perhaps the most frightening risk to an investor in Chinese equities is government intervention. We have seen Chinese authorities move on more than one occasion to distort prices, with trading halts and short-selling bans used to stem capital flows.
Moreover, there are hidden layers of government intervention from within private companies and capital allocation. The most notable has been the use of privately-owned banks to implement government policy.
To put this into context, the reality is that one can’t be guaranteed as to whether the state-owned enterprises (SoEs) will receive preferential treatment. There are also well-documented concerns about Chinese debt levels and so-called ‘shadow banking’, and a bad debt cycle could potentially wreak havoc. This could all impact the exchange rate of the Chinese yuan, where an investor is required to consider the sensitivity of any currency moves to their portfolio outcome. Therefore, while market regulations have been improving, mainland China exposure carries many risks that warrant a margin of safety.
More broadly, one should also be cognizant of the risks that affect emerging markets more generally. China is not immune to these risks, with untested management, weak financials, poor ESG, liquidity concerns and geopolitical/policy risks well-known points to consider.
From an investment selection perspective, there is scope for active management to add value in mainland China if fees are contained. In this regard, passive holdings may be susceptible to weakness, especially with highly leveraged state-owned enterprises to consider.
Lastly, the choice between a standalone allocation or as part of a broader emerging market allocation must be contemplated seriously. Emerging markets are a very diverse opportunity set, with Asia, Latin America and emerging Europe all offering different things. In this regard, emerging Europe may offer a better long-term opportunity based on current valuations and thus requires an investor to think outside of the China growth story.
