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ASI and First State profit from A-share surge

Inefficiencies in China's onshore equity markets give quality-focussed foreign investors an edge, according to leading fund managers.
Nicholas Yeo, Aberdeen Standard Investments

China is not an obvious investment choice at the moment. Certainly, there is a strong case for exposure based on the country’s rapidly increasing wealth, urbanisation, industries moving up the value chain, potential for new economy sectors and its shift in demographic preferences.

But, the opportunities offered by these long-term, structural changes can appear less compelling than the wall of discordant noise that investors face every day.

China’s economy is slowing, its trade dispute with the US is escalating, the renminbi is depreciating, the current account is deteriorating, onshore corporate defaults are rising, the shadow banking system is wobbling and protests in Hong Kong are ongoing.

Yet, the CSI 300 index of leading A-shares is up 30% year-to-date, almost three-times the return of the MSCI China index, which is dominated by Chinese companies listed offshore, according to FE Analytics data.

“Domestic consumption and services are driving GDP growth now, not exports. The A-share market has a far larger exposure to domestic consumption than offshore Chinese markets. It explains why A-share earnings are holding up relatively well,” Nicholas Yeo, head of China equities at Aberdeen Standard Investments, told FSA.

“China’s onshore markets are also inefficient, dominated by retail investors who tend to be influenced more by news headlines than fundamentals,” he said.

“We seek to take advantage by investing in ‘quality’. Of a notional onshore universe of some 3,500 stocks, we invest in little more than 30. They have strong financials, a defendable competitive advantage and are able to pay dividends sustainably.”

Yeo helps manage the top performing $2.74bn Aberdeen Standard China A Share Equity Fund. It has achieved a 68.62% three-year cumulative return, which is more than any of the other 106 dedicated China funds authorised for sale to Hong Kong and Singapore retail investors, and is also top of its class year-to-date, gaining 30.89%, according to FE Analytics.

The fund’s managers tend not to focus on market direction, said Yeo, which is probably a good discipline because the fund has an annualised volatility of 19.28%. That’s in line with the CSI 300 index, but clearly attempts to follow a momentum strategy would mean high turnover and transaction costs for the fund.

Instead, Yeo focusses on individual companies where “earnings prospects look relatively good”, he said.

“We see the brightest prospects among consumer-oriented stocks in line to benefit from the nation’s structural growth of an increasingly wealthy, ageing population. As a result, we are overweight consumer, life insurance and health-care stocks.”

Top holdings include China International Travel Service, Ping An, Kweichow Moutai, Shanghai International Airport and China Merchants Bank.

The Lau view

The last two stocks are also favourites of Martin Lau, the Morningstar gold-rated lead manager of the five-star rated First State China Growth Fund, which has returned 44.05% over the last three years with an annualised volatility of 19.46%, according to FE Analytics data.

“From a bottom-up perspective, our positions in Shanghai International Airport, Midea Group and China Merchants Bank were among the major contributors to performance year-to-date,” said Lau, managing partner at FSSA Investment Managers, in an email reply to FSA.

“Shanghai International Airport has benefitted from rising passenger volumes, increased tourist spending at duty-free shops  and it also managed to negotiate a higher revenue share agreement earlier in the year. Midea improved its profitability metrics on its medium and high-end product range due to consumers’ preferences for “premium-goods”.

“Both companies have secular growth drivers underpinning the investment case and have not been too affected by trade war concerns, renmimbi depreciation, debt problems or other broad concerns,” he said.

On the other hand, China Merchants Bank would have been more affected by the macro challenges and the domestic economic slowdown had it not implemented more conservative lending policies and improved asset quality, he noted.

External influences

Of course, there are other reasons why the China A-share market has performed so well this year.

Fiscal and monetary stimulus policy measures launched in late 2018 and now again ahead of the 70th anniversary National Day celebrations on 1 October have provided domestic liquidity that has supported the onshore equities markets.

China A-shares have been performing resiliently largely due to supportive policy in the background,” Eric Bian, investment specialist for emerging markets and Asia-Pacific equities at JP Morgan Asset Management told FSA at the end of August.

“The authorities have started to implement meaningful fiscal and monetary measures to stabilise the economy, including cutting bank reserve requirements and reducing VAT in the first half of the year. We expect more to follow,” he added.

Also, the decision of the MSCI to raise the inclusion factor for newly-added A-shares in its emerging market index throughout this year is a factor in the outperformance of the CSI 300.”

Certainly, passive capital inflows due to the inclusion of A-shares in the widely followed MSCI benchmarks have provided a boost,” said Yeo.

“The index is mainly made up of domestic blue chips, which would have been bid up by passive inflows,” agreed Lau.

China concerns

As active stock-pickers, Lau and Yeo share similar concerns about what might derail their portfolio strategies.

“Our main risk is on valuations. The [high] quality companies we like to own tend not to be cheap. We often find it challenging to find companies that meet our investment criteria and are sufficiently well-priced to earn a decent return over the long term,” said Lau.

As a result, Lau tends to manage high-conviction, concentrated portfolios and not worry about short-term performance too much.

Companies also still have a lot of progress to make to improve financial transparency and enhance investor protection, while poor governance standards leave investors exposed to company-specific risks that lead to capital losses, according to Yeo.

“The biggest risk in the A-share market is buying a poor quality company or overpaying for a good one,” he said.

Aberdeen Standard China A-Share Equity Fund and First State China Growth Fund vs indices and sector

Source: FE Analytics. Three-year cumulative returns in US dollars. The MSCI China index is benchmark for First State fund. The MSCI China A index is benchmark for the Aberdeen Standard fund, but was only created in March 2018, so CSI 300 is used as proxy.

Part of the Mark Allen Group.