Hermes: The China Question.
Investors who enjoyed the exuberant rally in Chinese stocks before Black Monday and its aftershocks now face the question: sell or stay the course? China bears argue that the market is overvalued and the nation’s economic model is fragile. Gary Greenberg, Head of Emerging Markets and Lead Portfolio Manager, Hermes Investment Management, disagrees.
We were bullish on China all last year and through to May of this year, but became cautious as the rally progressed, and cut our exposure closer to neutral late in the second quarter. Little had come from the promising reforms outlined in the Third Party Plenum in late 2013. The economy continued to grow but only due to increasing levels of debt. And furthermore, the government’s plan to recapitalise the banks and state-owned enterprises – by issuing shares to foreigners who would be driven into the A-share market after its inclusion in the MSCI Emerging Markets Index – seemed to have stalled.
The robustness of the vendor-financing scheme called ‘One Belt One Road’, intended to create new outlets for China’s old industries like steel and aluminium to countries across Eurasia, the Middle East, Africa and south-east Asia, had come under question. China’s targeted transition to a market economy is still possible, but with every passing quarter this becomes more difficult to achieve as debt levels and industrial overcapacity increase. It is concerning that the recent volatility in Chinese equities, which provided an early test of the government’s resolve to liberalise markets, spurred an official intervention preventing the market from determining reasonable valuations. Such action, though understandable and not unprecedented, looks misguided and casts doubt on China’s ability to embed reforms.
From a top-down view, therefore, China looks very risky. And yet, from a bottom-up perspective, we are finding compelling stocks to own. And not all of the top-down conditions are bad. Financial deregulation, to name one important reform, continues apace, with important reforms to local government financing and the market is being allowed to play a greater role in setting both lending and (very recently) deposit rates. China’s new exchange-rate policy, in which the value of the renminbi will be fixed each day based on the previous closing spot rate, is a significant step towards liberalising the currency. It is a necessary move, too, as a rigid dollar peg is not a long-term solution for the world’s second-largest economy.
From a bottom-up perspective even if the market is overvalued – and this point, we believe, is arguable – there are individual companies with good long-term growth prospects that remain undervalued. The dispersion of valuations between the Hang Seng China Enterprises Index (Hong Kong-listed mainland companies, mainly state-owned), the ChiNext (small-cap, early stage, fast-growth companies), the Shenzhen Stock Exchange (more mature, but mainly ‘new economy’ stocks) and the Shanghai Stock Exchange Composite Index (a combination of SOEs and private companies) is enormous, from 15x to 70x. In addition, the sheer size of the Shanghai market, with more than 1100 companies, along with the Shenzhen bourse and its 1,700 names, gives plenty of scope for stock picking.
Opportunities in Chinese companies that we have identified over the past three years include some H-shares such as China Mengniu Dairy and Shenzhen International Holdings, dual-listed Anhui Conch, Shanghai-listed stocks Kweichow Moutai, Daqin Railway and Huayu Automotive, and Shenzen-listed stocks Gree Electric and Hangzhou Hikvision. These are fundamentally profitable companies with good balance sheets and competent management teams, at reasonable prices, that should prove to be good long-term investments, even if the Chinese economy slows. And some of our companies are manufacturers that sell products overseas, providing some insulation from domestic events.
Is value a mirage?
China sceptics will continue to say that the country’s growth is one big fabrication, in which the vast majority of companies invent their sales and earnings figures, and that what appears to be value is just a mirage. But for those of us who have been investing in China for decades, we have heard such carping from day one and have subsequently disregarded it after observing first-hand how people’s lives changed: how rice paddies became factories and office blocks as part of the truly staggering development that has taken place.
Despite what the naysayers may proclaim, there is real development in China. On the ground, we are seeing energy, enterprise and effort in education and innovation. We are not minimising the challenges facing the nation’s economy, or whitewashing the heavy-handed market interventions that the authorities have orchestrated in recent weeks. We cut our overweight in June, avoiding the worst of the downdraft. We will wait until the government steps back, and the market again becomes the primary arbiter of valuations, before increasing existing holdings or building new positions.
As long-term investors, we continue to focus on China’s economic reform process, which will determine the destiny of the country over the next several decades. In fact, pivotal decisions that will shape the investment environment in China – and the country’s future – are being made right now.
Notes to Editors:
About Hermes Investment Management
Hermes is focused on delivering superior, sustainable, risk adjusted returns for our clients – responsibly.
Hermes manages assets on behalf of more than 200 clients* across equities, fixed income, alternatives and real estate, with £29.8 billion* assets under management. In Hermes EOS, we have the industry’s leading engagement resource, advising on more than £115.7 billion* of assets.
We believe in Excellence, Responsibility and Innovation
- Excellence: We aspire to excellence in everything we do. This manifests itself most visibly in our investment performance. We will only offer products to our clients where we believe there is a strong investment thesis and where we can deliver sustainable alpha.
- Responsibility: We believe it is our responsibility to lead discussion and debate about the fiduciary responsibilities of fund managers to our clients, their stakeholders and, ultimately, society at large. We have always sought positive engagement with the firms in which we invest.
- Innovation: We have the entrepreneurial culture to identify forward-looking products that meet those needs, along with the resources and speed-to-market mentality to develop them rapidly.
Our structure gives clients globally the benefit of access to a broad range of specialist, high conviction investment teams operating within an established and robust operating platform.
Hermes' investment solutions include:
- Equities: Global, Emerging Markets, Small & Mid Cap, Europe, Asia Ex Japan
- Fixed Income: Absolute Return, Multi Strategy, Inflation-Linked, Government Bonds, Investment Grade, High Yield
- Real Estate: Segregated, Unitised, Debt, UK, US Residential, European, UK PRS
- Alternatives: Multi Asset, Infrastructure, Private Equity
*Please note the total AuM figure includes £3.7bn/€5.2bn/US$5.8bn/A$7.6bn of assets managed or under an advisory agreement by Hermes GPE LLP (“HGPE”), a joint venture between Hermes Fund Managers Limited ("HFM") and GPE Partner Limited. HGPE is an independent entity and not part of the Hermes group. £0.2bn/€0.3bn/US$0.4bn/A$0.5bn of total group AuM figure represents HFM mandates under advice.
Source: Hermes as at 30 June 2015 with exception of four portfolios totalling £0.8bn/€1.1bn/US$1.2bn/A$1.6bn dated as at 31 May 2015.
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