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The investment case for China

09 April 2024

We believe that select China-based companies have been oversold, although their fundamentals remain strong.

By Chetan Sehgal,

Templeton Emerging Markets Investment Trust

The overall emerging markets index has experienced some challenging times in the recent past; but most of the major markets barring China have done reasonably well. China has remained the only major market which has disappointed.

Its ageing demographics and declining population poses longer-term structural challenges to domestic consumption growth. There are concerns about China’s slow consumption recovery and geopolitical tensions between China and the West. There have also been property sector woes, which have weighed on consumer sentiment and local investor sentiment.

These have overshadowed early signals of China’s recovery. While government policy has become more supportive, we are cognisant that more substantive policies and a rebound in consumer activity is required for a sustained improvement in Chinese equities.

However, it’s not all doom and gloom. The country has not experienced the hiking of interest rates and inflation like the US and Europe, and there has been some improvement in business confidence with some companies undertaking share buybacks.

There are new growth drivers that can replace China’s traditional sectors including electrification of transportation and growth in its supply chain, import substitution of advanced technology hardware and green energy solutions.

Supply chain disruptions, triggered by the Covid-19 pandemic, geopolitical tensions, and export restrictions on cutting-edge semiconductor and artificial intelligence (AI) technology have led companies to re-consider their reliance on China as the manufacturing base for the world.

Chinese companies, however, remain technology leaders in many of the new emerging sectors of electric vehicles and renewable energy and reliance on them cannot be completely cut out. Many of these Chinese companies are working on setting up international manufacturing bases, to alleviate some of these concerns.

China’s sizeable domestic consumer market, albeit not growing, also provides these companies with a customer base that is too large to ignore – China today is the largest electric vehicle market in the world, for example.

There’s been quite some noise about the Magnificent Seven in the US, which have driven the rally in the US market. However, many of them are facing challenges in China and many of the domestic Chinese companies have come forward with competing products.

For example, Apple is being replaced in China by Huawei and Tesla is starting to see competition come through from other electric car companies. Chinese companies certainly have a competitive edge in the electric vehicle sector.

Chinese internet platforms such as Alibaba and Tencent remain strong technology companies with large international presence. Bytedance has also emerged as a leading short video platform globally. In fact, a meaningful part of China e-commerce is now going through Douyin, Bytedance's short-form video offering in China. These are just a few of the companies in China that are leading the way in their sectors.

Current valuations reflect many of the challenges being faced by China. We do see upside; in particular in the internet sector, which has adjusted to the new operating environment as China has eased its regulatory crackdown on the sector.

The large internet platforms remain technology leaders and best placed to leverage the benefits of AI. The growth for these companies is likely to be slower but we expect returns to be supported by efficiencies, strong cash flow generation and corporate actions.

We remain hopeful that this year China will re-emerge, the market is not looking for foreign investors to invest but for the locals. The locals remain cash rich following the pandemic, they have the savings and China hasn’t experienced a spike in interest rates therefore leaving cash in savings accounts is not beneficial due to the very low returns.

The assets in China are currently looking reasonable and cheap, and we’ve witnessed companies buying back shares. China has a good chance of returning to higher earnings per share (EPS) growth this year, which in turn will lead to a good prospect of it returning to positive returns in the current year on an absolute basis.

While some investors have voiced concerns about the level of volatility in the Chinese equity market, as a longer-term investor, we believe that this provides a good opportunity to build positions in companies that we favour but are being unfairly punished alongside the broader market.

This is particularly the case now where valuations have come off their longer-term averages and expectations are not high.

Overall, China’s economic outlook remains challenging. While a swift rebound in growth is unlikely, clear signs of a bottoming in the country’s economic growth will be welcomed. We believe that select China-based companies have been oversold, although their fundamentals remain strong.

Chetan Sehgal is lead portfolio manager of Templeton Emerging Markets Investment Trust. The views expressed above should not be taken as investment advice.

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