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Why investors should think small in China

An expanding universe of small-cap companies offers a unique opportunity to tap a hotbed for innovation within a segment that for too long has been undervalued, said Tiffany Hsiao of Matthews Asia.
Tiffany Hsiao, Matthews Asia

For a country steeped in culture and history, China in recent years has been able to breed a mindset of entrepreneurship and innovation among an ever-growing and urbanising middle class.

Add the mainland’s unprecedented scale to the mix, and the foundations for small businesses to compete with much larger peers are easy to see.

“This could be a technology [led] innovation that results in an intellectual property moat, or a business-model innovation where the smaller company has figured out a better way to do business,” said Hsiao, portfolio manager at Matthews Asia.

China’s relatively young and tech-savvy population is a welcome recipient of such progress. Migration trends, policymaking and demographics have combined to create a flexible, mobile workforce that embraces new business models and products.

One out of every two citizens uses a mobile device, for instance, and around 70% of online sales are now made via a smartphone, according to the McKinsey Global Institute. At the same time, while the average smartphone featured just one camera lens three years ago, newer phones contain multiple lenses so that users can record in 3D.

Meanwhile, efforts driven by regulation and various initiatives to expand renewable sources of energy including wind and solar are spawning new industries such as electric vehicles, along with the batteries to power them.

Attention all sectors

These examples barely scratch the surface of the potential investments that China’s wave of innovation creates. Further, small-cap opportunities exist in all sectors of the mainland’s market, not just in technology.

In particular, Hsiao said, ongoing reforms create prospects for companies focused on all sorts of sectors, ranging from industrial automation to health care to consumer discretionary.

And in areas such as pharmaceuticals discovery or diagnostics, no longer can China be labelled in the West as a “copycat.” Initiatives to foster innovation, for example, have led to research and development programmes that would be envied in many countries.

“We believe small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments such as manufacturing, infrastructure and real estate, and toward innovation, consumption and services,” Hsiao explained.

Indeed, she added, the smaller Chinese companies tapping into the entrepreneurial spirit across cities and provinces tend to thrive mostly in productivity- and value-enhancing industries such as automation, health care, e-commerce and education.

Still on solid ground

There was no shortage of alarming headlines in 2018 for investors in China. Trade war tensions, geopolitical risks and worries about a structural domestic slowdown impacted the performance and volatility of the equity markets.

Yet the People’s Bank of China has been responding by implementing accommodative measures, such as lowering interest rates. This highlights what Hsiao said is a determination by the government to steer China’s longer-term structural reform in a positive direction.

Sustainable growth for both the wider economy and corporate earnings should keep smaller companies on the right track–especially those that are innovative and capital-efficient, given their domestic focus and lower dependence on financial leverage.

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