This past March, FEG welcomed attendees to our inaugural FEG CIO Corner: An Approachable Asia. Select FEG representatives and clients spent several days in Hong Kong to learn more about the nuances of investing in Asia, specifically China.
We were inspired to host this event because we expect that most institutions will be underweight China as their capital markets grow in tandem with their increasing percentage in various benchmarks. It is our opinion that this growth will provide numerous alpha opportunities for patient investors. While FEG is optimistic about this market, caution is still warranted, as this growth may not always be steady amidst concerns regarding the relatively high debt levels.
From the beginning of its market-oriented period, China has funded development internally through domestic savings and bank lending. This led to amazing growth but also a large build-up of internal debt. The solution to this problem was to develop a fully functioning capital market for public issuance of both equity and debt. While there has been progress on both fronts, the most headway has been made in relaxing capital mobility and restrictions on equity trading. In recognition of these improvements, MSCI officially announced the long-awaited A-shares stock inclusion list in June 2017. A-shares are the shares of domestically listed Chinese public companies, as opposed to H-shares, which are companies listed on the Hong Kong Stock Exchange. There are well over 3,000 A-shares on the stock inclusion list, and the number continues to grow.
Bo Meunier, emerging markets portfolio manager (PM) and partner at Wellington Management, focuses on China equities and walked us through the implications of this event. Currently, the MSCI Emerging Markets Index has a weight to China of about 28%, comprised mainly of Hong Kong listed shares and ADRs, or shares of Chinese companies listed in America. With the A-share inclusion, the weight of China in the Emerging Markets Index will surge to about 40%. This will happen gradually over the next several years, but the broad implication is that many institutional investors who use this index as a benchmark could become underweight China.
Equity Opportunities and Risks
Both Meunier and Munib Madni, PM of Morgan Stanley’s emerging markets team, spoke of some of the opportunities and risks associated with Chinese equities. One of the potential advantages of an active equity approach to A-shares is how dominated they are by the retail investor. We believe alpha is a zero-sum game. To achieve alpha, you must take it from somebody else. In the U.S., and in most developed markets, smart, sophisticated, institutional money flows dominate the investment landscape—up to 70%-80%—with retail investors making up the remainder. China, however, is the exact opposite in that retail dominates, creating an untapped opportunity.
On average, China also looks more attractive from a valuation perspective, at least on the surface. Old Economy names in industrials and banking are able to trade at 5x P/E, while New Economy names in healthcare and technology can trade at 40x-50x P/E’s. Again, this may lend itself to a more active approach in the A-share market.
FAANGs vs. BATs
In the U.S., the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) and in China, the BAT stocks (Baidu, Alibaba, and Tencent) have come to dominate and heavily influence the performance of the broader market. A handful of high growth tech companies dominating Chinese market performance may come as a surprise to some investors. Many still view China as a low-cost, low-quality manufacturer; however, that reality is no longer. With the China 2025 initiative, China looks to become the world leader in cutting-edge areas like high tech manufacturing, artificial intelligence, quantum computing, and biotech. Even now, China boasts world-class technology companies that are bringing competition to U.S. companies based on market capitalization.
It is amazing what Alibaba and other Chinese tech leaders have accomplished in the last few years, from e-commerce to mobile payments. During our event, we were lucky enough to hear directly from Alibaba senior executive Michael Yao who detailed the company mission—to make doing business easier—and strategic vision. The sheer size and scale of the company, with more than 515 million active users and 1.7 billion products, provided the group an appreciation of the data-driven technology platform. The dominance of BATs, especially domestically in China, was further elaborated on by Carl Huttenlocher, founder and CIO of Myriad, long-time investors in Chinese technology companies, including the pre-IPO shares of Alibaba.
One example of Chinese technology is Alipay which is increasingly used to facilitate business through mobile payments as opposed to cash or credit cards. Linked directly to a Chinese citizen’s bank account, it is now so prevalent that Chinese tourists visiting Europe can receive their value-added tax (VAT) refund through the app.
Strong Private Market
While a lot of focus has been on the liquid markets, China also has a vibrant private market. Realizations may sometimes take longer in Asia, however, strategic acquisitions and initial public offerings (IPOs) have remained robust of late. In 2017, for example, there were a record 440 IPOs in the domestic China market, and another 80 in Hong Kong market.
Rebecca Xu of Asia Alternatives helped to educate our guests on the private equity landscape in China. While traditional buyout strategies are still nascent, the venture and growth equity markets are extremely vibrant. China private equity dry powder totaled $293 billion in 2017 and is further increasing into 2018. Technology, new retail, health care, and industrial 4.0 continue to be popular sectors and themes.
Eyes Wide Open
Although there are many opportunities in China, they are not without risk; therefore, investors must proceed with eyes wide open. John Pinkel, partner of Indus Capital & PM of the Asia Pacific and Select Funds, led a fireside chat with Jamie Allen, secretary general at the Asian Corporate Governance Association. Both gentlemen helped to explain the difference in governance and focus of the various Asian markets, many of which have already adopted stewardship codes. China has made many strides—especially in enforcement—but they remain behind Asian peers in terms of overall corporate governance levels. Hong Kong—which is a part of China but has the privilege of running a different economic and governing system—continues to be highly rated. Therefore, Hong Kong maintains prominence and importance as a doorway for the rest of the world doing business with China.
Besides corporate governance challenges, China’s amazing growth has been fueled by debt. This debt, while large by Western standards, is serviceable if China continues to grow GDP in the 6% range. Much of this debt resides on bank balance sheets as non-performing loans associated with industrial conglomerates and real estate developers. China must strike the perfect balancing act of maintaining continued growth while also enduring the restructuring of bad debts. This is akin to pressing hard on the gas pedal while simultaneously slowly stepping on the breaks. Luckily, as mentioned above, most of the debt is held domestically, and it is far easier to restructure without having to deal with foreign enterprises—especially when the government may also control both the bank and the industrial company debt in need of said work-out.
Lastly, when thinking of debt in China, the inevitable images of “ghost cities” comes to mind. During our trip, John Saunders from BlackRock Real Estate gave the group an overview of Chinese real estate. While issues remain in certain cities, most of the more egregious, unoccupied, real estate developments have remarkably been absorbed. Perhaps this should not be surprising given the millions upon millions of people who migrate every year to Chinese cities from the neighboring rural areas. The need for new housing in China on an annual basis alone could fill a mid-sized country. Thus, when building these ghost cities, Chinese developers are merely pulling forward demand from the future. This is not to say that there is not waste and obsolesce in this practice, which is why Saunders points out that investors must be targeted in their approach. Money can still be made in China real estate, especially in the tier-one cities of Shanghai, Beijing, Shenzhen, and Guangzhou. Investors will simply need to practice caution to ensure they are not burned.
A Hike to Reflect
After two days of boardroom-style educational sessions and numerous manager meetings, we finished our journey with a hike around Victoria Peak to relax and reflect upon all that we learned.
While a single visit cannot truly encapsulate the complexities of China, trips abroad provide meaningful context and can serve as a springboard for further research. This trip was informative and inspiring, and we hope that you will consider joining us for a future educational journey.
This report was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department.
The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. FEG, its affiliates, directors, officers, employees, employee benefit programs and client accounts may have a long position in any securities of issuers discussed in this report.
Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities.
Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses.
Past performance is not indicative of future results.
Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors.
This report is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report.
Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.
The Financial Times Stock Exchange 100 Index, also called the FTSE 100 Index, is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization.
Published May 2018.