The degree of negative sentiment towards China is based largely on false pretences, according to manager of the Matthews China fund Richard Gao, who highlights four key misconceptions about the so-called “hard landing.”
Chinese equities had a strong run in the lead up to and immediately following the financial crisis, delivering returns in excess of 250 per cent between 2001 and 2011.
Performance of indices over 3yrs
Source: FE Analytics
However, money has been pouring out of China in recent years, with many fearing that the country is in bubble territory following such a strong run. FE data shows that the MSCI China index has lost 7.51 per cent over a three year period, compared to a gain of over 23 per cent from the MSCI AC World index.
Slowing GDP growth and the controversial shadow banking system are all seen as significant headwinds to the region.
However Gao (pictured), who heads up the $33.4m Matthews China fund with Henry Zhang, has moved to play down many of the these fears, highlighting two key advantages for the region that many investors are overlooking.
Here are the four reasons why he remains more optimistic than the consensus.
First reason: Falling growth does not mean falling investment opportunities
Falling GDP growth has been the principle reason why investors are looking at China with a wary eye at the moment. The region has grown on average 10 per cent over the past two decades, but this figure has been at the 7 and 8 per cent mark more recently.
Sceptics see falling GDP growth as a sign of slowing demand, which will stop stock market performance in its tracks; however, Gao says investors shouldn’t tar all sectors with the same brush.
“There is a misunderstanding that the fact that there is falling growth means there are no investment opportunities in China anymore,” he said.
“It depends on the area of investments. Yes, there may not be good investment opportunities in the infrastructure in general, exporters, manufacturers or general labour intensive industries, but we still see good investment opportunities outside of these areas.”
“China has been slowing growth intentionally because the central government wants to change its focus to maximise the quality of growth rather than the quantity of growth. They are rebalancing the economy so that it doesn’t only rely on export and infrastructure growth, but also domestic consumption.”
“It has always been our belief that domestic consumption will be a key driver for China’s sustainable economic growth.”
This has been reflected in the construction of the portfolio over the years as domestic consumer companies have always been the key area of focus. Gao still has a big skew towards service industries such as healthcare, education, leisure & travel and IT, and elsewhere has found plenty of stock-specific opportunities.
“You might see some cyclical downturn in the current environment in the consumer area, but if you take a three to five year view we think there will be many companies in the consumer areas that will keep growing,” he said.
Despite the recent selling, consumer discretionary and consumer staples remain Matthews China’s biggest sector overweights, followed by healthcare and IT. The four sectors have combined exposure of 50.9 per cent as of 31 March 2014.
The sectors more associated with infrastructure spending – namely basic materials and energy – are underweights, as is financials.
Second reason: Concern over the banking system have been overdone
Gao accepts that there are big problem areas in the Chinese financial system, but thinks an all-out collapse is very unlikely.
“There is a very big concern outside of China about the overall financial system especially the shadow banking system and defaults in the bond market,” he said.
“We share the concern about the overall banking sector, and believe that the current disclosures do not properly reflect the true picture. If you look at the numbers, the banks still look very solid growing both their top line and bottom line; however, there are a lot of loans off of bank balance sheets, and I think if they were included the picture wouldn’t be as positive.”
“Even so, we do not believe that the overall banking system is very close to a crisis stage. There are some problematic areas in the trust, loans and wealth management areas, but it’s not like the whole system is at risk of crashing.”
Gao says he has confidence in the Chinese government to deal with the issue.
“One reason that we are more positive on this than others is because we saw the government are very serious about reforming the system,” he explained.
“The third plenum in November 2013 really rolled out a blueprint for the overall economic development until 2020.”
“The implementation may have a short-term negative impact on the banking sector but if you look toward 2020, the reform measures will allow banks to lend at more market-oriented flexible rates and compete in a more equal footing.”
“Eventually, this will help build a more stable system and so we are positive in the long-term development of the system.”
Third reason: Valuations are at historically low levels
“The overall valuations of Chinese-related equities have come down to very low levels compared to historical averages,” said Gao.
“Chinese equities are currently selling at high single digit P/E [price-to-earning] ratios, and historically they have been trading at much higher levels.”
Performance of indices over 3yrs
Source: FE Analytics
The strong long-term growth prospects in certain areas make these single-digit P/E ratios even more attractive, Gao says.
He specifically highlights the significant sell-off of Chinese consumer stocks in recent years as an area of interest.
“Chinese consumer stocks were selling at between 30 to 35 times P/E three years ago, but now they are trading at an average of low-teens and this looks quite attractive to us,” he added.
Fourth reason: New trading platform between Hong Kong and China
Gao highlights news earlier this month that the Hong Kong stock exchange will have a mutual trading platform with the Shanghai stock exchange is a massive boost for trading activities between mainland China and Hong Kong. It also opens up a new investment universe for foreign investors to invest in China’s domestically listed A-share companies, he says.
“In six months’ time Chinese investors will be able to invest in Hong Kong and vice versa, which is a very positive development for markets,” Gao said.
“First of all it will improve liquidity and it will also improve the exchange of information as well as increasing the investor base – especially for domestically listed A-share companies.”
“The quality of investor in China will also improve, with more institutional and sophisticated investors coming into the market. All in all, it is a big step towards China’s capital market liberalisation and we view it quite positively,” he finished.
Gao has run the Matthews China fund since its launch in February 2010. He is slightly ahead of his IMA China/Greater China sector average over the period with returns of 8.5 per cent.
This article was written in collaboration with and is sponsored by Matthews Asia.