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April 14, 2014

China – the smart way to invest

The investment case for China sounds deceptively simple:

  • China experiences much higher GDP growth than the developed economies of the US and Europe. In fact, in the last 10 years, China grew around 10% p.a. while the US and Europe barely managed to exceed 3% p.a. even in good years.
  • China boasts more than 1bn consumers and with growing wealth, there is an insatiable demand for goods and services for years to come

Both arguments are undeniably correct. However, it is not possible to make a direct link between high GDP growth and superior equity performance. In fact, in the last 6 years, the S&P500 rose nearly 40% while the China Index ETF FXI declined by approx -25%!

FXI

A good story line does not make a good investment!

Still, as devoted value investors, we get curious when an equity market like China underperforms for so many years. At one point, all the bad news are in the price and it becomes an attractive investment. In our view:

  • US equites are no longer cheap. The future returns for a long-term index investor will likely be below 5% p.a.
  • The Chinese equity market trades on only 8x forward earnings, while the US market trades on twice the multiple, i.e. 16 times.

As with so many other Emerging Markets, the devil is in the detail. Investors should not simply compare the index valuation between different countries without adjusting for the index composition. If you compare the following three sectors, suddenly China looks anything BUT cheap:

 China 2014 P/EUS 2014 P/E
Consumer goods23x17x
Technology26x15x
Healthcare21x18x

If these sectors trade at much higher multiples, what then causes the difference at the index level? In the case of MSCI China, the index is dominated by banks and energy companies.

China MSCI ETF English

Banks and energy companies are in most cases so-called SOEs (state-owned enterprises), which often act according to the wishes of their political (pay-) masters but not according to the wishes of foreign minority shareholders. Generating shareholder value is probably not the main priority for the mangement of most SOEs. Those sectors which are heavily weighted in the index and where most companies are SOEs, trade at much lower multiples than in the US.

 China 2014 P/EUS 2014 P/E
Financials5x13x
Energy8x14x
Utilities12x16x
Industry11x16x

Over time, SOEs tend underperform private companies.

SOE weigh on MSCI EM performance

This is the key issue if you consider investing in China

  • interesting private companies in growth sectors are already very expensive while
  • unattractive SOEs trade at low multiples but nobody wants to own them.

Conclusions:

  • We are generally big fans of investing via ETFs but the index that they replicate is not suitable in many Emerging Markets such as China. Hence we would suggest looking at actively managed funds that can and do invest off-benchmark.
  • Investors should focus on small- and midcaps. In Asia, many markets are less liquid and so institutional investors focus on large cap names while small and medium sized companies are less crowded. Since the small and midcap segment is generally more volatile, this asset class is only suitable for long-term investors (5 years and longer).

The author covered institutional clients in Hong Kong.

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