China’s promising long-term prospects: Aberdeen Standards’ Nicholas Yeo

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This is a sponsored article from Aberdeen Standard Investments.

Nicholas Yeo
director and head of equities, China and Hong Kong
Aberdeen Standard Investments

Aberdeen Standard Investments’ Nicholas Yeo, director and head of equities, China/Hong Kong, discusses investing in China amidst trade tensions, the potential of China A-shares, and the asset manager’s investment philosophy.

Nicholas, is it time to invest in China in spite of the potential trade war with the US? Why do you think investors should consider this country?
The case for investing in China remains compelling. We’re confident that its growing middle-income population will power local company earnings and valuations for years to come, particularly given how China is still at the start of its economic recovery in historical terms. Authorities are committed to shifting the economy away from reliance on industrial manufacturing and exports towards domestic consumption and service efficiency. It is designed to foster more sustainable, higher-quality growth. Separately, we expect more long-term institutional capital to enter the equity market as A-shares are incrementally added to widely tracked MSCI indices. Global institutions place emphasis on company fundamentals such as earnings consistency and good governance — this will raise the bar for local firms and create a more rational market in which investors back companies based on fundamental strengths, not short-term prospects. That gives us grounds for optimism.

How are Chinese assets being impacted by current trade tensions?
To understand the impact of a trade war, it’s important to adopt a bottom-up approach in scrutinising the revenues and costs of the businesses we invest in. Although the share prices of aluminium, steel, and electronics companies have been volatile given the prospect of US tariffs, our holdings’ direct and indirect exposures to these raw materials and components remain very manageable. Many of our holdings have strong brands and so good pricing power. In addition, the majority of A-share stocks we hold are domestically focused. Their customers and supply chains are largely based in China and so the bulk of their revenues and costs are renminbi-based, helping to insulate these businesses in the event of a full-scale trade war. Still, we’re not anticipating a major escalation in this US-Sino dispute. Proposed US tariffs will take time to come into effect, leaving room for renegotiation. If consumers start to suffer in subsequent rounds of levies, public displeasure will likely dampen policymakers’ propensity to up the ante. As things stand, the goods affected by tariffs are mostly industrial and intermediate ones that represent only a sliver of each country’s GDP. The direct impact on Chinese companies remains negligible, because only a very small percentage of their revenues are directly sourced from the US. We continue to monitor the situation and any potential impact on our holdings.

On top of this situation, why do you think China A-shares present a compelling investment opportunity now? Where does the potential come from?
We retain faith in China’s long-term prospects. We applaud authorities’ efforts to steer the economy towards domestic consumption and services. Although not all industries are feeling the benefits of that shift just yet, we are seeing a pick-up in segments such as internet technology, travel, and healthcare some of the things that people demand as they get richer. This is boosting earnings in the services sector and presenting stock-pickers like us with opportunities to invest in companies with good long-term growth prospects. We target industry leaders with durable earnings, competitive advantages, and a strong market share. They are best-placed to benefit from China’s enduring growth.

Despite China being the second biggest economy, these shares have only recently been added to MSCI indexes. Why has it taken so long for them to include these shares and how will this recent inclusion affect China’s weight in emerging markets funds?
MSCI takes the opinions of institutional users of its benchmarks into account as it reviews index composition. Evidently, it felt further progress was needed on reforms, notably on market accessibility. The game-changer was Stock Connect, the trading loop directly linking the exchanges of Hong Kong, Shanghai, and Shenzhen. By swapping the framework through which global investors would access China’s market from restricted quota schemes to Stock Connect, MSCI sidestepped a number of constraints and helped to assuage foreign investor qualms. By September it will have added a couple of hundred large-cap A-shares into its Emerging Markets Index, accounting for less than 1%. The initial weighting is so small that we don’t anticipate any immediate market impact. We would expect it to go up gradually in accordance with further improvements that meet international norms in areas such as liquidity. It might be years before Chinese A-shares have a material impact on regional and global allocations. But over time, China’s liberalisation has the potential to reshape international capital markets. It would, after all, make up 40% of the MSCI Emerging Markets Index if all Chinese stocks were included, including those listed outside of mainland China.

What is your macro picture for China? Where do you see the main risks?
China has been among the worst-performing stock markets in the world this year. A catalogue of worries are weighing on investors’ minds, including the Sino-US trade dispute and a deleveraging drive by authorities that has crimped economic growth, squeezed corporate funding, and led to record debt defaults. But our analysis suggests China’s economy isn’t on the cusp of a slowdown that might warrant such aversion. Recent indicators such as land purchases by developers or property and auto sales paint an altogether more positive picture. Rising incomes lie behind a recovery in production volumes and average selling prices — continued demand for basic goods shows consumers are still spending. Policymakers’ deleveraging drive to rein in excessive debt should help to reduce risks in the financial system. Yes, it will likely cause China’s growth to slow, but we view this positively because the quality of growth is improving. What remains a challenge is finding companies with good standards of financial transparency and investor protection. Many have too short an operating history for us to gain comfort in their track record. For now, the investable A-share universe — that is, quality companies we trust in — remains limited. Of a notional onshore universe of around 3,500 stocks, we invest in just over 30 — those we believe will be winners over the long term. But we have been scoping the market for more than a decade, visiting firms and meeting managers. We believe if you look hard enough, you can still find quality companies with healthy prospects.

Could you briefly describe your investment philosophy?
We invest in quality companies with a view to owning them for the long term. We would define quality as a strong balance sheet and consistent, diversified earnings, good standards of governance, and an experienced management team with a strong track record. Additionally, we take valuations into account to help us determine the level of stock exposures we want.

What kind of companies do you like now?
We are seeing more consolidation among companies in traditional sectors such as steel, cement, and power, as well as in consumer retail. This is reducing some excesses in the system and improving the quality of stocks to choose from, which is good news from a corporate governance perspective. We can see that China’s increasing spending power is driving consumer demand for premium products, ranging from electric appliances to cars and even the liquor Baijiu. We are heavily invested in the consumer sector, which is contributing strongly to our outperformance.

Could you explain some names you are currently holding and why you like them?
We seek exposure to quality companies well placed to capitalise on rising wealth and consumer spending in China. China International Travel Service offers travel packages and runs duty-free shops, including in Sanya on Hainan Island. Given that Sanya is the only city in China that permits duty-free shopping for domestic tourists, in practice that gives the firm a quasi-monopoly on duty-free. We also invest in Aier Eye Hospital, the largest private health care operator in China with a nationwide network of hospitals. It has the leading market share in a fast-growing segment that public hospitals don’t specialise in. There is a trust issue about health care in China owing to how short-staffed and underinvested the sector is. Aier’s services are affordable and in effect receive tacit government approval as valuable and necessary. In the tech sector, we like Hangzhou Hikvision, the world’s leading manufacturer of CCTV cameras and video surveillance products. Its strong track record stands in contrast to tech stocks whose earnings models remain unproven, making their growth forecasts aspirational. It enjoys a structural tailwind from Chinese urbanisation, with government-backed smart-city projects supportive of future product demand nationwide.

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This is a sponsored article from Aberdeen Standard Investments.