153. When is the best time to invest in China?

30 September 2021 (pre-recorded 23 September 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

James Yardley (JY): Hello and welcome to the Investing on the go podcast. I’m James Yardley and today I’m joined by Martin Lau, the fund manager of the FSSA Greater China Growth fund. Martin, thank you very much for joining us.

Martin Lau (ML): Hello James.

[INTERVIEW]

[0:15]

JY: Now Martin, you’ve got over two decades’ of experience investing in Chinese equities. So hopefully you’re the perfect person to talk about at the moment for the current situation. We’ve heard a lot about Evergrande recently – this huge Chinese real estate company, which has got into a bit of trouble. What are your thoughts on it? What does it mean for the whole Chinese economy?

ML: Yes. Thanks James, for inviting me to talk here. Yes. First of all, Evergrande is the largest developer in China, with a lot of debt – it is estimated that it has 2 trillion renminbi worth of debt. So the fall of Evergrande is a very major event. So being the largest developer having some problems in our view highlights a few facts.

The first fact is that China is a leveraged economy. So for many, many years, our view has been that, you know, there’s a lot of highly leveraged companies in China. China credit to GDP is one of the highest in the world – over 300% of GDP. So China is basically an over-leveraged economy. And because of that it’s always been our view that, you know, in many ways the best area for investment in China is not necessarily a Chinese bank or a Chinese developer. So that’s one.

The second thing that we learned from this incident is that the Chinese government is really quite determined to tackle the property market. So for three years the Chinese government has been trying to curb property price increase and has not been as successful. So they’ve been trying different ways including cutting out the financing or the funding of some of the developers. So it shows the determination of the Chinese government, you know, in tackling the very high property prices. We do not though think that, you know, this is like the end of the world, or some people say it is the Armageddon, you know, Lehman crisis, et cetera.

And the very simple reason is that it was kind of orchestrated by the government in the first place. China is a closed system. There are very little foreign capital in China. It has got a closed capital account and all the banks are owned by the government. So if the government wants, they can always stop the next Evergrande from happening. So they did the similar type of when Lehman happened. It was really the loss of trust, the counter party risk, the complicated counter parties and derivatives that Lehmen brothers had at that point in time. And I think the situation now is different. But then back to the original point is China is, the debt level is high and the fall of Evergrande pretty much reflects that fact.

[3:03]

JY: And we’ve seen the Chinese government increasingly crack down on various different sectors recently, such as technology or education or gambling. What does this mean for investors? Is China still investable at the moment? Does the Chinese government care about the performance of the stock market?

ML: Yes, that’s a very good question. So, first of all, we have also been quite surprised by the frequency of regulation covering different sectors that you just mentioned from the online games to education, to like e-commerce delivery, you know, gambling, et cetera. So it does seem to us that the government is very keen to increase the kind of control on the economy. You know, it shouldn’t be surprising in a way because China has always been you know, relatively top-down economy or top-down government. You know, last year China was credited for managing the Covid situation very well because they control pretty much everything within the economy. So now it’s happened with the regulation, it highlights the kind of risk, which arguably has always been there. There are a few things which we take from the different regulations.

First of all, you know, it is in a way good that investors are aware of this risk. So if we turn back to last year, for example everyone believed China is the area to invest. And within China, you should buy Tencent, Alibaba, Meituan, [inaudible] et cetera, all those tech companies. Of course the sentiment has now changed almost 180 degrees. But we believe that’s in a way quite good because investors are now aware of those risks. It is our view always that the best time to buy China is when people are nervous about China. So for different reasons. So the fact that regulation is now happening and people are concerned about it, is a good thing.

The second thing which we take from the regulation is that indeed that the Chinese government some, you know, a lot of the commentators say it has become more Socialist. It is true. But then you will also need to remember China has always been a Socialist country for many years. You know, one could easily argue China is a Communist country, but it is probably, was probably the most Capitalist country in the world. And I think this is more like a normalisation to a more Socialist, you know, stance. And I think this is also quite right in a way. So when you say the government talks about “common prosperity” you may not like this term, because whenever you know, you tap this into this term you think about doesn’t it mean that it would hurt the investors. You know, it doesn’t mean that no one can make money. Our interpretation of that standards of common prosperity is that the government wants everyone to get more equally rich as in people become also richer but then the disparity may not be as big as before.

I do believe this is one of the challenges for different governments, especially after Covid, and with property prices going through the roof in many other countries, that the wealth disparity is getting bigger and bigger. So the government really wants to address that, but it doesn’t mean that they want everyone to be poorer. It doesn’t mean that they want economic growth to be net negative. It doesn’t mean that they want to destroy innovation, industrial development et cetera. It just means they want to adopt a more balanced approach, help try to make sure that the lower income people are also taken care of.

[6:38]

JY: And I think the fall in the value of the Chinese stock market has caused Tencent to drop outside of the world’s largest top 10 companies. This is for the first time, I think, since 2017, what does this mean for China? Will we see Chinese companies bounce back and return to the top 10 again soon?

ML: Yeah, I think it is it is quite possible. So first of all, in many ways we actually quite, we actually think the fact that a Chinese company dropped out of the top 10 is actually quite good. Because if you look back to the past, it is almost like a curse, if you become the largest in the world. I believe ExxonMobil was once the largest company in the world, for example, and PetroChina, the same, and the banks were once the largest in the world, China Mobile, et cetera. So I think the fact that it’s out of the top 10 reflects the fact that Chinese stock market has actually fallen quite a lot in recent months. Again, you know, it is in a way good.

Whether they will come back to the top 10 again really depends on, you know, the stock market, but we’ll probably focus on why Chinese companies become the largest in the first place. And whether you, if it ever come to the top 10 what would happen? The reason why Tencent became one of the largest in the world in the first place in the top 10 is first of all, China is a very big domestic market. It is 1.4 billion people. And secondly, of course, Tencent has got something, has done something right, as in it created a successful and very huge ecosystem led by WeChat and therefore they start to do different things. And more importantly is how, you know, when you are given some Chinese incentive, how certain people can apply innovation and create a more successful business.

So if those are drivers like big market innovation and the right people with the right incentive, et cetera coming to place, I do believe there’s every chance that, you know, China you know, company can be big in the world, but it may not be Tencent, it could be another company.

[8:52]

JY: Now, looking more closely at your portfolio, you’ve got about 16% in Chinese A Shares, at the moment. Can you briefly explain to our listeners what those are and the opportunity with them?

ML: Yes, that’s a very good question. First of all, you know, within China, the thing which can be most exciting or get the team most excited, are the Chinese A Shares companies. For those of you who are not as familiar, Chinese A Share companies were actually closed to foreign investments for many years, until around 10 years ago. It is the domestic market of China and why it is important is first of all, the Chinese A Shares is a very deep market. There are actually more than 4,000 companies listed on the A Shares and in market cap terms it’s actually more than 4 trillion US Dollars, essentially the second largest stock market after the US market. So it is a big and deep market. And for us FSSA one of the excitement is that we want to stock pick from, you know, a huge universe of different companies. It’s always very exciting to find an entrepreneur introducing his or her company, and you can feel the drive and the passion of that individual.

So A Shares is an area that we would continue to invest into. And this number 16% will continue to increase over time, depending on the opportunity. Within A Shares we identify different opportunities because of the A Shares are so big. There are different leaders in different industries. For example, in the home appliance industry, we invested into a company called Midea Group it’s actually the largest home appliance company, a bit similar to Whirlpool or General Electric in the Western world. And the reason why we like this company, just to elaborate into more details, is because we like the management, it’s a professional management, it’s family owned. It’s owned by a family with a surname He, it’s not that important, but it’s Mr He.

And it really a place whereby the company moved from a kind of cheap and cheerful. It was actually a fan company many, many years ago, into now a business spanning from home appliance, smart devices, and also they are also in the robotic. They brought a robotic company in Germany a few years ago. So this is a very good example of how a Chinese company can move up the manufacturing value added. And this is one of the major themes that we identify it’s not, lets say 20 years ago, China was very good in making shoes and garments, and is now trying to move into you know, more value added products led by the example of Huawei, which is really the leader in smart phones and connectivity equipment. So Midea is a good, is one example.

[11:39]

JY: And your fund of course is a Greater China fund, meaning you can invest in Taiwan as well. In fact, you’ve got about a third of your portfolio in Taiwan, at the moment. Is that a defensive move or are you simply finding better opportunities there?

ML: Yes, that’s an interesting question. So, historically we’ve told our clients that a Greater China fund is different from a pure China fund in the sense that it is a more diversified set of opportunities. You probably know, and can appreciate it in recent months, that China is actually a very volatile you know market. It is either the best performing or the worst performing if you think about the China A Share market and very rarely in between. So for the last two years, it was the best performing. And then now it’s become, you know, at least up to now one of the, not as good performing markets in the whole world.

So by introducing Taiwan and Hong Kong into it, into the mandate of the portfolio, first of all, you create diversification. There is often the case, for example, this year, let’s say China is not doing well, is Taiwan Semiconductor stocks have actually performed extremely well. By that I, you know, it creates the kind of like diversification and also the room to maneuver away whenever you feel there’s a kind of like a bubble in certain areas. We do believe, for example, last year there was a little bit of a bubble with China tech, and then maybe you can move the money into Taiwan. And this year we believe Taiwan Semiconductor is a little bit of a bubble. And the reason for that is the whole world is a belief that there’s a severe shortage of chips, which will last for, you know, maybe two or three years. Whether that concern is true or not, you know, the likes of TSMC has appreciated significantly.

So as a portfolio, right now, what we have done is that we be we used to have, we have trimmed a little bit of TSMC, it’s still our favorite you know, still the largest position in the portfolio, but because it’s done so well at a time when China hasn’t done well, you kind of like can capture the opportunity. Should it be a pure China fund, you properly would struggle to maneuver because everything is already put into China.

The same with Hong Kong by putting Hong Kong into it. It introduces another perspective. In terms of investment, Hong Kong is a more mature economy. The more international, more focused on properties and banks, and it’s also Hong Kong in terms of the companies, they are usually more westernised, more developed. You’re kind of like replicating the business model into China. So it’s a totally different, you know, kind of segment in terms of characteristics as compared to China and Taiwan. So by combining the three, we believe the risk could be reduced, therefore volatility could be reduced, and some somehow if you manage it well, you can try to allocate between different markets to generate better risk-adjusted performance over time.

[14:33]

JY: And what is your outlook for the Chinese stock market over the next 12 months or so? It sounds like you’re reallocating capital back towards it, is that correct?

ML: Yes. Yeah, it is quite difficult to predict what’s going to happen for the next 12 months or so. Usually, we take a three to five years or more and the intention has always been that we identify those stocks that we like. And if we are, if we can find those stocks and valuation is appropriate, we just buy more of those stocks. For the last two months, we have identified more stocks that we like at the right valuation in China, for the simple reason that everyone is now concerned about China. So we do think from that perspective, even though we don’t want to give a number to the possible return, that the risk/reward for the Chinese stock market as of today is actually better than let’s say 12 months ago. But I’m actually referring to a more like offshore market whereby foreigners own a lot of stocks, stocks listed in Hong Kong. But then for the A Share market, which I just talked about, A Shares have actually been holding up very well because the domestic investors are not as concerned. So we believe the offshore China market, which accounts for the majority of the you know of our Greater China fund, we believe the risk-reward is actually better now than 12 months ago.

JY: Martin, that’s being very interesting. Thank you very much for joining us today.

ML: Thank you, James.

JY: And if you’d like to learn more about the FSSA Greater China Growth fund please visit fundcalibre.com and please remember to subscribe to the Investing on the go podcast.