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Look beyond China's mega-caps and recent regulatory actions

Atiqah Mokhtar
Atiqah Mokhtar10/14/2021 12:18 PM GMT+08  • 7 min read
Look beyond China's mega-caps and recent regulatory actions
Look beyond the big names like Tencent Holdings, Alibaba Group Holdings and Meituan.
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Wenli Zheng, portfolio manager of T.Rowe Price’s China Evolution Equity Strategy fund, has one tip for investors when it comes to Chinese stocks.

Look beyond the big names like Tencent Holdings, Alibaba Group Holdings and Meituan, he says. Instead, investors should seek opportunities from China’s smaller companies.

Zheng argues that the wide universe of Chinese equities outside its mega-caps contain a significant pool of stocks that are underappreciated.

Thus, his fund aims to allow investors to tap into this segment. “Our first objective is to provide clients unique access to that underexplored asset class,” he tells The Edge Singapore.

With over 5,000 companies listed in China, Hong Kong and offshore markets like the US, China’s equities universe is huge. However, investor attention has largely concentrated on just a small group of China’s largest stocks.

The top 100 listed Chinese companies are valued from around US$30 billion ($40.4 billion), going all the way to up to roughly US$600 billion for Tencent, the country’s largest listed company.

Given the sheer size of these companies, Chinese mega-cap stocks are often at the forefront of the broader investment landscape. For example, Zheng highlights that roughly 70% of the MSCI China Index is attributable to the top 100, or 2% of all Chinese listed entities.

The large fixation on a relatively small cluster of companies has resulted in a crowded space with investors only exposed to a narrow group — be it through shares held directly, through China-focused funds or via indirect exposure such as through global or emerging market funds.

Zheng says the fund offers a clearly differentiated product given its pursuit of opportunities beyond the well-trodden path. “[Our portfolio only has] 5% overlap with the benchmark index compared to our peers, who often have 50% to 60% overlap,” he adds.

As of Aug 31, the fund has assets totalling US$136 million, with annualised returns of 23% since its inception in August 2020, beating its benchmark the MSCI China All Shares Index, which recorded 5.3% annualised net returns over the same period.

Casting a wider net

Year to date, the MSCI China Index has declined 16.7%, making it one of the worst-performing global benchmarks.

However, Zheng says there is a “huge divergence” within the China market. For example, the ChiNext Index — which tracks the 100 largest companies on Shenzhen Stock Exchange’s Nasdaq-style ChiNext board — has actually risen 3.8% year to date, while the Shanghai Composite Index has risen 2.5% year to date.

This divergence highlights the need for investors to cast a wider net, he argues. It also serves as a reminder for investors to be nimble and discerning. “[We] need to have a multi-dimensional framework and multiple toolkits to adjust to different market environments and to recognise opportunities,” he explains.

Such a framework allows the China Evolution Equity fund to identify what Zheng calls future winners, rather than the mega-caps, which he views as incumbents that have already won. Identifying such opportunities will enable investors to generate superior returns over the long-term.

To do this, look for good businesses backed by strong management and competitive advantage that have a long growth runway spanning across a 10 to 15-year timeframe.

But Zheng acknowledges that more immediate opportunities are out there, adding: “There are many companies [where] the quality of the business is not the best. But where the fundamentals are improving, we often see earnings upgrade and multiple expansion. So they may not be great stocks for ten years, but they can be great stocks for two to three years”.

In terms of stock picks, Zheng explains that the fund’s selections are driven by the trends they see on the horizon for China, one of which is China’s aging population.

“I think everyone knows that China’s demographic dividend has ended,” he says, noting that the country’s rising education levels have meant a shift from labour-intensive to technologically-intensive industries.

To that extent, innovation has become a very important source of wealth creation in China, with the emergence of the internet, biotech and other new economic sectors.

Even within traditional industries, Zheng notes that higher education levels have helped many companies move up the value chain, expanding from being just manufacturers to turnkey solution providers.

Another trend he highlights is the rise of local consumer brands. While foreign brands have previously held a prominent position in China, Zheng points to a trend common in the past five to six years — there has been a growing focus on domestic brands, thanks to a more receptive younger generation and a shift in the operating environment towards social media and internet-based marketing, which local companies have been better able to adapt to.

Another area of interest to note is the services industry. China’s huge market has resulted in a very fragmented one, but Zheng says some businesses are starting to change this. “We have already seen some of the leading players figure out a way to scale their business, [giving them] strong competitive advantage,” he says.

Citing property service companies, hotel chains and pharmacy chains as examples, these companies are able to replicate their business model across more services, enabling them to gain scale.

As of Aug 31, China Evolution Equity Fund’s top 10 holdings include automation solutions provider NARI Technology, real estate management firm Country Garden Services Holdings, sportswear company Li-Ning Company, auto components maker Zhejiang Shuanghuan Driveline, furniture manufacturer Jason Furniture Hangzhou, healthcare equipment supplier Qingdao Haier Biomedical, ship builder Yangzijiang Shipbuilding, metal components maker Guangdong Kinlong Hardware Products, online recruitment platform Kanzhun and hotel management firm Huazhu Group.

Healthier ecosystem

China’s shifting regulatory landscape over the past months has unnerved investors, not least because many blue-chip Chinese stocks — especially those in tech, healthcare, education and property — have been significantly impacted.

Zheng says the market correction was not solely driven by the regulatory crackdown, citing that many blue-chip stocks were overvalued near the start of the year and already primed for a pull-back.

A case for investing

The regulatory changes seen this year are not the first time the market has faced such pressures, noting that a downturn instigated by policy or structural reforms has been a recurring theme in China.

But over the long-term, these changes have resulted in strong gains.

In an Oct 4 Financial Times article, Jeffrey Kleintop, chief global investment strategist at financial services company Charles Schwab, made a case for investing in China, pointing out that the MSCI China Index produced annualised total returns of 12.3% over the past 20 years as of August, compared to the S&P 500’s 9.3%.

Regulatory shifts aside, Zheng says a number of industries have actually “done very well” in terms of stock performance.

This includes emerging industries such as renewables, electric vehicles and semiconductors. He also points out that some of the more traditional sectors have also shown similarly positive performance, such as shipping and utilities.

Overall, he underscores that the regulatory changes are being made with the intention to create a healthier ecosystem with a more even playing field. Even within sectors directly impacted by the crackdown, he argues that investment opportunities are still present.

An example of this is Chinese delivery company ZTO Express. While Zheng views the Shanghai headquartered company as one of the most efficient players in the courier space, there has always been concerns that the dominance of China’s large tech companies may impact its ability to capture market share.

Companies like ZTO should benefit from the regulatory changes, he adds. “If there’s a level playing field, we think that the most efficient and competitive players will accelerate consolidation of the industry”.

Photo: Bloomberg

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