Spotting the bull in China equities

It is no longer about whether investors are comfortable with investing in China but about how they actively manage their exposures to make use of Chinese reforms going forward, writes Jonathan Wu.

The Chinese economy and its growth trajectory has been a source of fascination for investors for the last decade.

However, whether investors actually invest in the region is a different story.

It also holds true that whether or not a person is well-versed with the Chinese markets, they will have an opinion. Unfortunately, in both scenarios, investors take a sample size of one, and make generalisations and exaggerated assertions.

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For instance, it would be imprudent to say "I saw an apartment block in China which was empty, hence China is full of ghost cities…", or "my head of Asia Pacific came back from China last week and when buying fruit, saw the vendor trading on a Bloomberg screen, so Chinese equities are in a bubble".

If you were a subscriber to any of these opinions, it would also be fair to say "I saw three homeless people in Martin Place in Sydney. Therefore Australian unemployment is at an all-time high".

Isn't that absurd?

Investors must change the way they perceive China. It is no longer about whether investors are comfortable with the concept of China as that is simply assumed.

It is about how they actively manage their exposure to China to capitalise on future reforms, keeping in mind Chinese equities have rallied significantly in the last 12 months

Government action

Let us first explore a theory. If investors ever based their invesment philosophy on China on gross domestic product (GDP) growth, they must stop.

They are unrelated.

Between 2010 and 2014, Chinese equities were underperforming compared to the rest of the world but growth was still strong.

However, gradually declining growth will mean the market will begin to rally.

The Chinese government has implemented a range of reforms since assuming power in 2013, which opened up the capital markets, resulting in more opportunities and capital depth.

Markets started opening up in mid-2014, when the government announced the launch of the Shanghai-Hong Kong Stock Connect Program.

The markets started to rally, and this continued through to the beginning of the second quarter of 2015.

It has been very interesting to look at how the market achieved this sustained rally path.

Whenever there was a profit taking of three to five per cent, the government took action the following weekend by either cutting the interest rate or the RRR rate.

They even did something as unusual as launching mutual fund recognition between China and Hong Kong.

These actions improved sentiment.

Going forward

We looked at where we've been, but we need to look at where we're going to go from here.

There are many commentators who are declaring that Chinese equities are in a bubble but this is a huge generalisation.

What many people fail to remember is that the Chinese equity market is, in fact, the sum of many parts, otherwise known as share classes.

These include A, B, and H shares, as well as red chips, and state-owned enterprises (SOEs).

As both a fund manager and a financial adviser to retail mums and dads, I believe we owe it to ourselves and our clients to truly reconsider what investment blueprint we want to follow from now on.

These share classes, offered in the Greater China Region, make up 20 per cent of the global equity markets by market caps in US dollar terms, compared to the rather tiny two per cent that is made up by Australia.

It was the A share market that brought about the rally, which has been a major lagger to other equity markets over the last five years.

If we compare the different current share class valuations against the rest of the world, it paints a very interesting picture (see chart 1).

What we see is that while China A is one of the most expensive in the world, China H and China in general are the world's cheapest markets.

Strategically, conventional wisdom would say that investors would be better off with China H.

Therefore, it would be unwise to generalise that Chinese equities are in a bubble

Reforms — what's in store?

In November 2015, the International Monetary Fund (IMF) will vote on whether or not the Chinese RMB should be given the special drawing rights or reserve currency (SDR) status.

If it goes ahead, China's currency will become the fifth reserve currency, alongside the US dollar, British pound, Euro, and Japanese yen.

This has driven the Chinese government to fast track the internationalisation of the Chinese RMB.

Thirty per cent of all global trading done with China today is settled in RMB, compared to nil five years ago.

The Shanghai-Hong Kong Stock Connect Program and the impending Shenzhen-Hong Kong Stock Connect, are other ways the Chinese government is opening the local capital markets and increasing the foreign flow of RMB.

China's economic growth will come from increased productivity rather than increased deployment of labour. This means incomes will increase as people's value-add increases.

The long-term goal is that global trading countries will hold Chinese RMB as part of their foreign reserve basket, thus allowing a more natural and progressive appreciation of the currency.

Tactically, what would you want to hold over the long-term? Simply put, the answer is Chinese RMB-denominated assets.

Ongoing discussions about the Chinese property market bubble are also fascinating. Once again, commentators have jumped to conclusions, predicting a bursting bubble in the near future. They have been calling it for the last four to five years.

This is another generalisation. It really depends on the markets investors choose to target.

It is important to remember that the first tier cities, including Beijing, Shanghai and Shenzhen are running out of land supply. Beijing is now on to its eighth ring road.

In the current environment, investors should avoid developers who are developing third tier cities, where there is a clear over supply of property.

First tier cities, coupled with good quality developments, are where investors should aspire to be as they are selling off the plan at an extraordinary rate.

Beyond the headlines

There is also a lot of talk around Sydney's inflated property market among commentators, but does this mean the rest of the country's property market is inflated as well?

A good fund manager would understand the market and navigate around the issues confronting the industry.

Similarly, when I talk about the incredible investment opportunities of the Chinese property developer bonds, people brush me aside and deem it ludicrous based on media reports.

But what is a property developer's job? They acquire land, develop it, and then sell it for a profit.

The evaluation is homogenous across the industry and incredibly transparent. For instance, if the development had an internal rate of return of 25 per cent, then the developer would be conservative in issuing a two-year bond at a nine per cent cash yield.

What is so ludicrous about that? The smart money is flowing there now.

We have been discussing the addition of China A shares to global indices for some time now but it has probably occurred faster than we initially anticipated.

The FTSE was the first mover in late May with a five per cent inclusion into its emerging market index, with an aim of increasing that to 32 per cent per cent over time.

Vanguard followed only a week later with a 5.6 per cent allocation to its emerging market fund.

A week later, MSCI presented its case, saying that while they were not comfortable with adding China A to their emerging market indices just yet due to technical issues, they would add it the moment those issues were resolved.

The amount of money that will move into Chinese equities will be significant, and with that, the market will gain greater depth, with more Chinese SOEs seeking to be on board.

So, once again, where do you want to be? Would you consider moving into Chinese equities now, ahead of everyone else, or would you wait around to see the so-called "proof in the pudding"?

Ultimately, the key to China's growth is urbanisation, and investors need to bear this in mind to keep things in context.

China's economic growth will come from increased productivity rather than increased deployment of labour. This means incomes will increase as people's value-add increases.

This then feeds into demand for better goods and services, which finally leads to the economy becoming independent from the rest of the world as it relies more heavily on internal demand.

Seeking companies that play in any of these four quadrants (see chart 2) will serve investors well for many years to come.

Remember, Chinese growth is looking to be smarter, not faster.

Thinking twice about what you want

As both a fund manager and a financial adviser to retail mums and dads, I believe we owe it to ourselves and our clients to truly reconsider what investment blueprint we want to follow from now on.

Is it the classic DFP-balanced portfolio asset allocation, which starts at 100 per cent and divides it amongst all the asset classes?

Or should we consider starting from a blank piece of paper at zero per cent, and work out where the best five investment ideas are today, so that investors can still achieve diversification, but not just for the sake of diversification?

China should be first or second on the list for investors.

For those considering an index exposure, be warned: you may get caught up in all the bull of the Chinese equities market bull.

Jonathan Wu is the associate director/head of distribution and operations at Premium China Funds Management.