How T Rowe Price approaches China small-caps

Asset Class in Focus

Traditional and new companies alike strive to innovate as a way to stand out in China’s new-look economy. This is where T Rowe Price portfolio manager Wenli Zheng finds investment opportunities.

Wenli Zheng, T Rowe Price

Around eight years ago, Zheng believed the mainland’s economic growth to be based on a mix of exports and vast investment in infrastructure projects. To differentiate from their peers, companies in China had to scale-up to access more resources and lower costs. But with the shift towards a service- and consumption-oriented economy, the emphasis today is on adding value and on innovation, he explained.

Against this backdrop, he said he needs to be selective with his stock picking. “What we focus on are the companies that can generate products that are well-received by the mass market while sustaining a durable competitive advantage to capture economic value,” said Zheng, who is responsible for the Asia ex-Japan allocation in T Rowe Price’s small-cap fund.

In his investment thesis, he tends to avoid companies that have products with a low entry barrier because their competitors can easily duplicate the invention and eventually the profit margin will suffer. Therefore, testing product prototypes, talking to customers, investigating alternative ways of making the same product, are key parts of Zheng’s research process.

“What we tend to find in service and consumer products is a market penetration between 15-50%, which is the sweet spot for investors,” he said. “Between that range, the product is likely to turn into a mainstream product.”

In addition, for each investable stock, he said he also looks for under-priced opportunities. He evaluates the company on whether the market either over- or under-reacts to the share price versus the intrinsic value.

In his fund, the investable companies typically have a market capitalisation below $5bn. The smaller scale of the investable stocks does not necessarily make the due diligence process more difficult than researching a big company, as Zheng said he believes industry networks will help.

“Even with larger companies, you cannot rely only on what management tells you. If the company closes its doors to investors and their competitors know about any negative news, then competitors are very willing to tell you,” he continued.

Apart from early-stage innovative companies, Zheng’s fund also bets on companies in traditional industries that revamp their existing business via innovation.

In China, a considerable number of small-scale companies are exploring how innovation affects existing business, hoping to differentiate from peers through technological disruption.

Zheng takes a mainland furniture-maker and one of the portfolio holdings as example. To improve overall manufacturing efficiency and upscale the products, the furniture-maker installed a flexible manufacturing system to provide product customisation. The system also turns historical orders logged every day into data for analysis, enhancing the cost efficiency of each product.

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