China’s silver linings

Wilfred Sit, chief investment officer for Asia at Baring Asset Management, shares his thoughts about post-crash opportunities on the A-share market.
Wilfred Sit
Wilfred Sit

Wilfred Sit is chief investment officer for Asia at Baring Asset Management. Based in Hong Kong, his specialisation is equities, particularly for Greater China. He spoke with Jame DiBiasio about post-crash opportunities in the A-share market.

What kind of exposure do you have to China A shares?
We have a dedicated A-share fund. Our other portfolios don’t have a lot of exposure because it’s difficult to get access.

Do you manage onshore China stocks any differently to stocks in other markets?
No. Our style is ‘quality Garp’; growth at a reasonable price. We focus our China portfolio on quality stocks. Our strategy worked well for most of the past five years, from 2010 until the first half of last year. Then it didn’t work well during the rally, which was driven by lower-quality names.

What happened in this spring’s bubble?
By April of this year the rubbish stocks were outperforming. Concept names went up 50% or 60% in a single month, especially after China began talking about ‘One Belt, One Road’. This is a new policy initiative, at a nascent stage, and there were no fundamental changes to the nature of these stocks. We couldn’t quantify any improvement in them. It reminded me of the TMT bubble in the US in 2000. Companies changed their names and their stock prices shot up massively.

[One Belt, One Road is China’s long-term policy initiative to boost development along the ancient trading routes running through Central Asia between China and Europe].

What were the worst offenders?
A lot of names had been trading at low valuations. China’s economy has been slowing down and construction and materials companies, for example, were not exciting stocks. But then the ‘One Belt, One Road’ concept made them suddenly shoot up. We didn’t chase the market, however. The ChiNext index was trading close to 100x P/E, which was just ridiculous.

[ChiNext is a Nasdaq-style technology-heavy board set up by the Shenzhen Stock Exchange to attract fast-growing firms]

So how did you manage the portfolio?
We just stuck to the names we already liked, which continued to trade at reasonable valuations. In April our fund underperformed the index by about 8%, but that was fine because we have to stick to the fundamentals; stick to our beliefs. We know the A-share market is driven by retail investors. Just like the TMT bubble, we saw people start to justify stocks after their [price-earnings ratios] became ridiculous by using other measurements such as price-to-sales. [We could see] it was going to end in tears.

And it did – at least until the government intervened. What did you do during the correction?
We made money back in terms of performance against the index. Our returns were up 10% per month for one or two months versus the index, and year to date we are now above the index. That’s not because our portfolio has been volatile but because the index is volatile.

What was your reaction to the mass suspension of stocks in June?
We’ve had stocks suspended even before the government intervention. China is accelerating its reforms. I don’t mean just [state-owned enterprise] reform. It’s affecting private companies too. There is a lot of asset injections going into listed companies and they have to suspend trading during that period. The parent company has to report this to the exchange, and it takes time for it to show the results so that the regulator agrees to allow a stock to resume trading. China is more strict than Hong Kong in this regard.

But when trading resumes there is often a period of outperformance because the company will benefit from its restructuring. The government is pushing groups to put more of their assets into their listed companies and once that happens the stocks often experience a rally to catch up with the rest of the market.

But in June we’re talking about roughly half the market going offline – and I don’t think these were all because of restructuring.
No, it was done because the share prices had become too volatile. You can actually do the same thing in Hong Kong but not at the scale we saw in China. Today there’s still around 18% to 19% of companies that remain suspended from trading, which is a lot, but it’s many fewer than at the peak in June.

These companies must now improve their corporate governance. They must be more clear and transparent about plans for share buybacks and institute more incentive schemes for managers. They have to focus more on shareholder value. This is going to take some time. The authorities have been asking managements to do this sort of thing for a while but most companies haven’t embraced such changes: the managers are usually the owners, who haven’t cared much about minority shareholders. But now they need the approval of the China Securities Regulatory Commission to lift their suspension.

So you’re saying the CSRC is requiring companies to agree to certain corporate governance reforms before it allows their stock to resume trading?
I believe this is what they CSRC wants them to do. [The mass suspension of trading in June] may not turn out to have been such a bad thing, although the outcomes will be company-specific. But the government may be using this opportunity to accelerate corporate restructuring.

Are you concerned about the degree of intervention?
International investors never like it when a government intervenes – but this is always going to be the case with China. This is a heavily regulated market. But if companies can become more transparent or align managers’ incentives with those of shareholders, the crisis could be a positive long term, no matter how bad you feel about it now.

How long will that take?
Well, I don’t know. But investors have short-term memories. If they feel like they can make money in a market, they’ll forgive and forget.

In the meantime we stick to our fundamental, bottom-up approach. Over time we assume the market will continue to open and abide more by international levels of behaviour. In the meantime there will be opportunities for us to buy more, because good-quality stocks may well decline in price for no particular reason.

You know, international investors were very bearish on China because the economy’s been slowing. Many investors said the government was too slow to change its monetary policy. But China began to loosen its policy in November, with its first cuts to interest rates and to bank reserve-requirement ratios. China has shifted its monetary policy from tightening to loosening, which is what international investors have asked for. But investors didn’t believe it until the market had already begun to rally.

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So is the Chinese market attractive?
China still has plenty of room to further loosen monetary policy, and there will be more easing to come. These policies will support equities. China’s abundant with liquidity, which is also conducive for equities.

At some point investors will revisit China. Most of them under-own China but the US market is trading at high multiples, while Europe’s markets are now trading in the mid-teens and so [are] Japan’s. At some point investors will realise China’s market is too discounted. But in the meantime there is opportunity. To buy these markets you have to be a bit of a contrarian.

China’s been the centre of the action this summer, but what else in the region is of interest to you?
We have three key themes for the region as a whole. First is consumption as a long-term secular trend. This applies to China, to Asean, and to India. Second is technology; Asian companies have historically manufactured components but now they are becoming global brands and globally competitive. Just look at all the suppliers to Apple; those have become global companies. The technological revolution is a long-term trend. Our third trend is reform, which is not just about China but also includes Indonesia and India, where improving infrastructure is a major priority of both governments.

How do actually play those stories?
We find stocks in areas such as construction that will benefit from increased government spending on infrastructure.

Are you concerned by the difficulties India and Indonesia’s governments seem to have in actually implementing laws to support infrastructure investment?
There are going to be speed bumps but in the long term the trend is sustainable, and these companies will benefit. So will those banks in a position to provide financing to these projects.

I hope that with the Asian Infrastructure Investment Bank and the One Belt, One Road policy, China will be able to export its overcapacity to countries that need it. Chinese companies are good at building roads, railways, and airports in a cost-effective way. If they can work with companies in Indonesia and India, it should be a good match. If these initiatives work it’s a win-win situation from my point of view.

Are there other positive stories regionally?
We also favour some consumer names in markets such as Indonesia, because of its huge population.

China has overcapacity in many things but in countries such as Indonesia, a handful of companies dominate many industries. Their barriers to entry are high and their competitive pressures are lower than on companies in China.

In the case of India, many bigger companies are gaining market share from the mom-and-pop stores. They’re building brand names.

And what do you tend to avoid?
Companies of the past. We like new China stocks, those benefiting from a consumer-driven economy. The traditional backbone industries, in things like telecoms, energy, and some banks, you can only pick the winners. Chinese banks are the biggest in the world by asset size, so they aren’t going to grow more unless they become international groups like HSBC or Citi. It’s the same in telecom: China Mobile’s already the biggest telco in the world, so it’s not exciting unless it becomes more international. It’s the same with, say, state-owned banks in India, which are now losing market share to the private sector. Avoid the remnants of Asia’s past, no matter if these companies are a big part of the index.

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