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China patrol

27 May 2015

Emerging market fund manager Wasatch Advisors is buying more Chinese shares – very selectively.

You may have noticed that China’s Shanghai Stock Exchange Composite Index has risen more than 45% during the past three months and over 130% in the past year.1 More recently, Hong Kong’s Hang Seng Index has joined the party. So what’s going on?

There have been two important influences on Chinese stock prices recently. The first is the mutual market access (MMA) programme. Announced a year ago and formally launched last November, this establishes two-way stock-market access between mainland China and Hong Kong.

As a result, Hong Kong investors, and other international investors who trade through Hong Kong, can now buy certain Chinese A-shares that were previously available only to Chinese investors. And conversely, mainland Chinese investors can now buy eligible shares listed on the Hong Kong Stock Exchange.

The second main factor in the rise of the Chinese stock market has been monetary stimulus. Since November 2014, the People’s Bank of China (the central bank) has cut interest rates three times. It has also announced the second reduction in reserve requirements in two months, freeing up extra money for Chinese banks to lend. Central bank governor Zhou Xiaochuan raised expectations for new measures to support the economy a couple of months ago when he said that China’s growth had slowed “too much”.

While the MMA programme has benefited Hong Kong stock prices, these shares had already been available to a diverse group of international investors. Chinese shares, previously off-limits, have profited more dramatically from the new regime.

Historical caution

For several years, our emerging market strategy has been substantially underweight to China. While this has clearly detracted from performance more recently, there have been important reasons for our caution.

As fundamental, bottom-up investors we’ve struggled to find Chinese companies that meet our investment criteria. We look for high-quality companies with good returns on capital, the ability to generate significant cash flows and which have headroom for long-duration growth. Furthermore, we look for businesses with sustainable competitive advantages; in China’s hyper-competitive business environment, companies can lose their competitive advantages quickly.

Underpinning all this is our focus on valuation. Chinese shares have historically been very volatile and subject to extreme speculative activity; valuations for attractive companies can be, in our view, excessive. Consequently, many fundamental investment managers have been underweight to China for quite some time.

While the latest rally was not easy to predict, we did consider it a possibility when MMA plans were announced in April last year. So we stepped up our research on Chinese companies, making several trips to China. In November 2014, Chinese authorities made about 560 mainland stocks available for purchase by non-Chinese investors through the Hong Kong Stock Exchange. After running them through our quantitative and qualitative screens, we found only a small number that met our criteria. So we’ve added those names to the portfolio when able to do so at valuations that are not excessive. But we have generally kept our holdings in individual Chinese companies smaller than our typical position sizes.

"Flash sales"

One such stock is Vipshop Holdings, a liquidation sale retailer which offloads unsold stocks of brand name products at discounted prices. Unlike Western equivalents, however, it operates exclusively online, with no walk-in stores. It is very proficient at creating ‘flash sales’ for limited periods, selling large quantities of products. We think it can grow by more than 30% annually for the next few years.

We have also bought shares in Value Partners, the first asset management firm to be listed in Hong Kong. Founded in 1993, it focuses on the Greater China region, with offices in Beijing, Chengdu, Shanghai, Singapore and Taiwan, and has assets under management of $14.7 billion. We believe its knowledge and experience will make it a leading beneficiary of the MMA programme.

From a portfolio management standpoint, China still presents challenges. But the MMA programme is a sign that it will continue to open its economy and financial markets to foreigners, and will continue to liberalise access to its currency.

We’re approaching Hong Kong with a similar balance of caution and optimism. Hong Kong stocks can give us access to companies operating in mainland China, often at more reasonable valuations than the Chinese A-shares.

Wasatch Advisors is the manager of the St. James’s Place Emerging Markets Equity fund. The opinions expressed are those of Wasatch Advisors and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.

1 Financial Express, figures to 27 May 2015

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.


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