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Value is a good China strategy

Jing Ning  |  26 Jun 2017Text size  Decrease  Increase  |  

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Jing Ning, manager of the Fidelity China Fund, shares her thoughts on A-shares and her outlook for the Chinese markets following MSCI's decision to include A-shares in its global indices.

 

Opportunities arising from inclusion of A-shares in MSCI China Index NR

China's domestic A-share market is the second largest stock market in the world (See Chart 1). Across the Shanghai Stock Exchange, Shenzhen Stock Exchange, and ChiNext, it is home to a range of blue-chip stocks representing well-established business models with strong pricing power and robust cash flows.

Many of these companies are also exploring international markets, expanding their product lines and entering new market segments, but this is not widely recognised.

So far, this market is dominated by retail investors, who are influenced by short-term swings in sentiment as well as willing to overpay for growth levels that are not sustainable over an economic cycle.

The long-awaited inclusion of A-shares in MSCI China will help institutionalise this market and make the opportunity in A-shares more widely recognised.

This will potentially increase the liquidity levels, introduce comparatively stable flows into the market, and overall it would be a noteworthy positive development for the smooth functioning of the market.

I have had a positive view of the government's efforts so far towards increasing institutional participation in the Chinese stock markets--the Stock Connect programs in recent years were a step in the right direction to facilitate it.

 

Chart 1: The second largest market in the world


chart

Market cap data as at 30 April 2017
Source: Bloomberg, May 2017

 

A-shares have been key component of Fidelity China Fund

I prefer durable business models that offer earnings visibility from a three to five- year perspective, are currently unnoticed by the larger market and trade at attractive asset-based valuations. A-shares have been an attractive ground for investment ideas for a contrarian value investor such as myself.

China is widely perceived as an ideal market to search for growth. The reality is it is a unique and policy-driven economy. The extent of policy and government regulation make it a complex market to navigate, and the regulatory framework evolves at a fast pace.

China is also a competitive market with an abundance of capital and talent, and therefore, any successful business model or approach is quickly replicated.

As retail investors seek quick growth, they tend to rotate away from value in A-shares--the generally less-exciting businesses with relatively steady growth prospects, high dividend yields, and attractive valuations to their global peers.

Such a backdrop is suitable to my investment approach. It allows me to research these stocks in depth, avoid value traps, and steadily build long-term positions in robust businesses.

Several stocks that are listed only in the A-share market provide a route for the long-term investor to benefit from the structural shift towards a consumption-driven Chinese economy. For instance, Chinese home appliance manufacturers only have domestic A-share listings (see Chart 2 below). 

 

Chart 2: No. of stocks in sectors listed only in the domestic A-share market


chart

Source: Bloomberg, May 2017

 

I have been a long-term advocate of the mainland Chinese market, even though it is not represented in the MSCI China Index this far.

Fidelity's US$1.2 billion QFII (Qualified Financial Institutional Investor) quota, the largest quota available to a foreign buy-side asset manager, has provided access to the A-share market since the beginning of my tenure (See Chart 3 below which shows the fund's exposure over my tenure).

 

Chart 3: Fidelity China Fund A-share exposure over Jing Ning’s tenure (1 November 2013)


chart

Source: Fidelity International, May 2017

 

How have A-shares contributed to fund performance?

Selected A-shares positions in Gree Electric Appliances, China CNR Corporation (now CRRC Corporation), SAIC Motor, Zhejiang Supor Cookware, and Fuyao Glass have been among top contributors to returns over my tenure (1 November 2013).

I stayed invested in these off-benchmark names despite the extreme swings in sentiment during 2015 in the Chinese A-share market. I continue to retain exposure to these positions as I favour the prospects of these A-share names.

Gree is the market leader in air conditioning and a technology innovator, and continues to be a top holding.

Railway equipment manufacturer China CNR merged with locomotive manufacturer CSR to form CRRC Corporation. This merger was well received amid expectations of operational synergies and greater export competitiveness, and the holding made a noteworthy contribution to returns.

SAIC Motor is a beneficiary of Shanghai government being an early mover in state-owned enterprise (SOE) reforms and its strong global partnerships with renowned automobile manufacturers.

Zhejiang Supor relies on its French parent's SEB research and development as well as product innovation to capture domestic market share. It also serves as a production base for SEB's international demand.

Fuyao Glass is the world's only pure automobile glass player going global and steadily gaining global market share.

Outlook for remainder of 2017

The Chinese economy has been in a muddling through stage since the investment cycle peaked out in 2010. The government is focused on the twin objectives of growth stabilisation and reforms.

Since the second quarter of 2016, we have seen an improvement in the real economy aided by corporate capital expenditures, consumption, and exports. China is also emerging from a period of industrial deflation, and the unique supply-side reforms have helped in better supply dynamics and removing excess capacity.

So far, we have seen these state-led capacity cuts in coal and steel. Industries such as glass, cement, paper, and refining are next on cards.

We are also seeing a shift in the outlook towards shareholder returns, with institutionalisation of the domestic market as a clear goal.

For instance, China does not have a dividend culture, but we saw signs of change early this year--our preferred holding, China Shenhua, the lowest cost coal producer in China, issued a special dividend for the first time in its history, as it benefited from higher coal prices following the supply-side reforms.

At the same time, China has a huge and complex financial system. This year, the government is likely to focus on deleveraging and regulation. The People's Bank of China (PBoC) has been more proactive than prominent Western central banks, and raised its interbank lending rate over 100 basis points in nine months.

This tighter liquidity environment is favourable for the big banks with stronger balance sheets and reflects that the economy is stabilising, which will allow the government to pay attention to reforms.

Current positioning of the fund

I do not prefer any themes (such as old China versus new China, SOE versus private sector)--I go where the value opportunities are to invest in stocks that fit in my framework.

At the end of May 2017, the fund had noteworthy exposure to the energy and materials sectors as an aggregate of my bottom-up security selection. Cement producer Anhui Conch offers better regional exposure and is supported by a high-quality management team, low costs, and a strong balance sheet.

Among energy positions, CNOOC and China Petroleum & Chemical are key overweight holdings.

The fund also has key preferred holdings in financials, where China Life Insurance is the fund's largest overweight holding. China Life is likely to gain new business at higher value, while the government has a favourable policy approach to grow the insurance sector in China.

The fund is overweight in its exposure to China Merchants Bank given management's focus on risk control. The bank has been ahead of its peers in recognising non-performing loans and maintains prudent lending standards.

Meanwhile, Gree Electric, discussed above, remains a top conviction holding. I also retain my conviction in railway equipment companies ZhuZhou CSSR Times and Guangshen Railway as beneficiaries of the state's emphasis on high-speed railways infrastructure.

I remain optimistic about the prospects for state-owned real estate developers. China Overseas Land and Investment is held for its strong revenue prospects, low debt, and solid execution track record.

Its strong balance sheet can support future land acquisitions and potential merger and acquisition opportunities.

As a bottom-up stock picker, my investment decisions are driven by research and analysis. The fund remains notably underweight information technology sector given my concerns about the underlying fundamentals being able to sustain valuation premiums.

Instead of increasing the fund's exposure to internet names as a response to the change in the index's composition, I diverted this exposure to A-shares.

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Jing Ning is portfolio manager of the Fidelity China Fund, Fidelity's flagship China offering. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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