Asia is no longer a cyclical area of the market to invest in, according to Guinness’s Edmund Harriss (pictured), who believes Chinese equities in particular offer attractive value and strong dividend growth prospects. 
This is despite the fact many investors are concerned about the country’s rapidly rising debt levels and the subsequent potential for credit rollover risk.
In fact, Standard & Poor’s (S&P) downgraded China’s credit rating from AA- to A+ in September, while other Asian markets – such as India – have experienced upgrades. Just two days ago, Moody’s Investor Service upgraded India’s credit rating and changed its outlook on the country’s debt from ‘stable’ to ‘positive’.
However, Harriss – who runs the five FE Crown-rated Guinness Asian Equity Income fund alongside Mark Hammonds – said China is the most attractive market out of all four BRICs (Brazil, Russia, India and China) because its economic complexity – the labour know-how, technology and infrastructure needed to manufacturer their goods and services – is increasing exponentially.
Performance of indices over 5yrs
Source: FE Analytics
“Several years ago, textiles dominated and the total output value for China was worth £230bn. Today, computers, smart phones, broadcast equipment and engineered products are the quintiles that dominate. Its output is £2.3trn,” Harriss reasoned.
“But in the cases of Russia and Brazil, you will find they are still driven by commodities. The cash that rolled in as a consequence of higher commodity prices, was it reinvested in the industrial base? No. Nothing happened.
“You simply got a credit boom and it rolled over. That’s why it is not a terribly sustainable model and that makes them more volatile.”
When it comes to India, the manager said the economic backdrop looks favourable but is likely to remain static, meaning opportunities for growth over the long term are minimal.
This is despite the fact prime minister Narendra Modi is focused on reforming the country’s economy, which has sparked hope among many investors.
“If you are a youngster operating in an economy like that, you have to think that your prospects are very good,” Harriss said. “You would think that your salary is going to go up and, in three years’ time, you will be able to buy a car and in five years’ time, you will be putting a payment down for an apartment.
“Life is looking pretty good but if it’s all static and nothing ever changes – or worse in the case of Russia and Brazil – then there are going to be very different dynamics.
“The story about India is all about what Modi is going to do, what the reforms are going to achieve and how it is going to be great. Whereas China is about the cash that is already being generated, but people focus on China’s debt issues and say ‘how much debt have they got? That is unsustainable’.”
Harriss isn’t the only Asian equity manager to favour China over India. In an article published last month, Franklin Templeton’s Carlos Hardenberg told FE Trustnet that the strengthening Chinese economy is set to overtake India in spite of Modi’s proposed reforms.
“India has seen a lot of talk and its reform agenda is very ambitious and very impressive [in] what they are talking about. But it has a huge mountain to climb in terms of different tax systems between the states and layers of bureaucracy and corruption,” Hardenberg said.
“We think in terms of execution of creating an attractive operating environment they are far behind [China], it’s just not happening.”
In terms of fears surrounding China’s debt levels, Harriss argues that they are actually more sustainable than many believe. Because it is a more cash-generative economy than many of its peers, he reasoned that it is better equipped to sustain higher levels of debt.
“If you look at somewhere like Greece it has a higher debt to GDP ratio, but its economy is dominated by agriculture. They are never going to be able to service that,” the manager explained.
“However, China is a production-based economy focused on physical and merchandised goods which are being upgraded over time.
“That’s the story of China; the upgrading of products plus the improvement in the quality of management following the 1997 Asian financial crisis, which saw a recovery in the returns that these businesses were capable of generating.”
Data from FE Analytics shows that, since 1998, the MSCI China index has outperformed the MSCI World index by 425.69 percentage points with a total return of 585.95 per cent. This is a comfortable outperformance of the MSCI Brazil and Russian indices, but nevertheless a 59.6 per cent underperformance of the MSCI India index.
Performance of indices since 1998
Source: FE Analytics
Over the last one, three, five and 10 years, however, Chinese equities have significantly outperformed their emerging market peers.
“China has had a strong run but still, on a P/E basis, it’s trading in line with its 10-year average on a reported basis of around 15 times,” Harriss continued.
“To some extent, because of the nature of the benchmark itself, you have one or two heavier-weighted stocks trading at elevated multiples as well which are pushing up valuations. The likes of Tencent and Alibaba – which are fairly new constituents – have had quite a big impact.
“If you exclude those, China is still a little bit below average on a P/E basis. The reason for that is the strength of these earnings numbers.”
Despite strong returns from the broader market, the manager remains positive that he will continue to generate attractive levels of income for his investors.
While the net yield of the fund has fallen slightly as holdings have risen in price, Harriss said he is comfortably able to generate a yield of between 3.5 to 4 per cent while the broader market is yielding 2.7 per cent.
He does so through a concentrated, equally-weighted portfolio of 36 stocks which are chosen on a bottom-up basis. While the fund has an income mandate, Harriss and Hammonds focus firstly on company quality. Their initial screening process allows them to only hold companies which have a cash flow return on investment [CFROI] greater than 8 per cent over the course of the last eight years.
Their investment process has clearly stood the fund in good stead as, over the last five years, Guinness Asian Equity Income has returned 93.95 per cent compared to its average peer and benchmark’s respective gains of 68.56 and 67.11 per cent.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
“Without too much of a strain, we have still put together a portfolio that yields between 3.5 and 4 per cent versus the market which is, on a net basis, is at around 2.7 per cent,” Harriss said.
“There are opportunities around. They’re not as cheap as they used to be, because you have to remember the kinds of lows which were coming from Asia.
“We have had a strong rise in prices but earnings have come through so it’s the case that there is still value. But, Asia is not dirt cheap. When it was dirt cheap, nobody wanted to know.”
The £59m Guinness Asian Equity Income fund has a clean ongoing charges figure (OCF) of 0.99 per cent.