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Morningstar likes China consumer and utility sectors

The firm has identified several stocks from four sectors as good opportunities, despite ongoing regulatory tightening.
Crowds walk below neon signs on Nanjing Road. The street is the main shopping district of the city and one of the world's busiest shopping districts.

Value is emerging, but equity markets in China are expected to remain volatile in the near term until there is further clarity about future regulatory measures, Morningstar said in a report.

“While we believe the majority of regulatory policies are already out for the Chinese internet companies, we think that regulatory overhang will remain until the first quarter of 2022,” Lorraine Tan, Morningstar’s director of equity research in Asia, said in the report.

The internet sector in China will continue to see pressure as concerns over tightening regulations have not faded away, and as the government calls for internet companies to play a larger role in creating “social value”, both of which would put pressure on profit level, according to Tan.

But Tan believes the next year will be better in terms of the number of negative regulatory news flows. Her top pick in this sector is Tencent, although recently Morningstar has lowered the fair value estimate by 3% to HK$778 ($99.98) from HK$800.

In terms of consumer cyclicals, Morningstar sees weaker retail sales during the summer could potentially lead to stronger pent-up demand and online clearance after Covid-19 is contained. This could help the topline for e-commerce companies. 

In the consumer discretionary space, there is significant room for fast food penetration to go up, driven mainly by long-term secular trends such as longer working hours for urban consumers, rapidly rising disposable income, and smaller family sizes.

Morningstar’s top picks include Samsonite, as it is expected to post rapid sales recovery in the remainder of this year and in 2022, and its valuation remains reasonable. Yum China, following its recent successful revitalisation of Pizza Hut, should continue to boost the group’s overall profitability.

“We see downside for selective financials and real estate companies as priced in, while value remains in the utilities space,” she added.

Utilities supported

Utilities is a promising sector as robust economic activities, along with strong export growth have boosted power demand in 2021, with nationwide electricity consumption rising 13.8% year-over-year in the first eight months. Coupled with an accelerating shift of fuel mix towards greener energy sources, the increase in power supply is lagging demand growth, Tan said.

China is now temporarily entering into a power shortage condition, which has resulted in restrictions on electricity usage in many provinces recently. The tight supply/demand dynamic is ikely to continue in the fourth quarter, amid the start of the heating season in north China from November, and full year power demand will grow 10-11% year-over- year in 2021, Morningstar estimates.

China Gas Holdings, given its undemanding valuation, and CK Infrastructure Holdings, because of its defensive income stream, are Morningstar’s top picks in the sector.

Property blues

Meanwhile, the tightening policy environment in Chinese real estate sector will persist as the government continues to rein in the debt-laden sector and capping residential property price increases.

Smaller developers in the “red zone” under the three red lines policy are facing very high near-term risk given their particularly weak short-term debt coverage. There are signs of a slowdown in the physical market in the second half of this year, while a prolonged slowdown for the rest of the year may see some alleviating easing measures by the government, Tan noted.

Morningstar’s top pick in the sector is China Overseas Land & Investment, which has a strong balance sheet and growing recurrent income.

Part of the Mark Allen Group.