China equity market update with Bin Shi

This year has been a tough one for China equity investors. On the face of it, investors had a lot of reasons to expect a good year: the Chinese economy is doing well relative to other economies, peoples’ lives are back to normal, and production has returned. However, the reality in the markets are different from what people expected because of regulatory measures taken by the government.

But one thing I want to bring to everyone's attention is that policy in China has cycles and the government also cares about GDP growth, unemployment, and economic stability. We've seen recent macroeconomic indicators pointing to a deceleration in the Chinese economy and we think the numbers will have some impact on the government’s mindset in fine-tuning the policies.

Even though we have already seen some signs of change in tone, it might not be enough to convince investors to come back to the market right away, but I think we probably have seen the worst and from this point on we will probably hear some positive signals from the government.

In our view, Chinese equities are much more attractive from a valuation perspective compared to markets in the US and elsewhere. But just because the market is cheap it doesn't mean the stocks will automatically go up. The big question for international investors is policy risk. We need more clarity and more consistency from the Chinese government to convince them to come back to the market.

When market sentiment is weak, new ideas like “common prosperity” normally lead to different types of interpretations compared to when the market is strong. My personal view is that “common prosperity” is not a policy to “rob the rich and help the poor”.

The “common prosperity” direction is targeted at reducing the gap between rich and poor, which is a common and noble policy target for many governments in the world. If “common prosperity” is focused on policies such as providing more social insurance and health coverage for poorer people, it will likely mean more sustainable long-term growth for China.

When the economy is doing well, the Chinese government has the confidence and consensus at the top level of policy making to attend to issues which have accumulated over the years. China’s rapid recovery from the COVID-19 situation gave the government confidence to deal with many issues, like high levels of debt in the financial systems and other social concerns.

China’s political system is top down. Once consensus is reached at the top, middle and lower-level officials must act fast to maintain the party line. So, when the policy swing happens, it feels very strong. That said, you can’t make a linear prediction and expect policies to continue tightening. The government isn’t trying to deliver a sharp economic slowdown. Once consensus is reached at the top about dealing with the slowdown, a lot of supportive measures will come out as a result.

The signals are not 100% explicit, so you really need to ‘read the tea leaves’ to make a conclusion. Vice Premier Liu He made two statements to stress long-term government support for the private sector. We have also seen Fang Xinghai, the Vice Chairman of the China Securities and Regulatory Commission (CSRC), the top capital markets regulator, saying that the Chinese capital market will remain open to foreign capital and - if anything - the door will be opened wider.

These statements are intended to reiterate the government’s long-term commitment to reforming and opening the Chinese economy. However, investor sentiment is still quite weak, and it will probably take more than statements from the two officials to boost market confidence. We will need to see more specific policies to do that.
I believe people should be patient. Policies swing to the left and to the right, but at the end of the day the Chinese economy has enjoyed many decades of growth and I believe it will continue to do so.

Initially many companies were impacted by new regulatory policies - then fear of further government action began to feed on itself. I don't think the government has made any major new statements recently, but sentiment continues to be weak

If you have been a long-term investor in China equities, you have probably seen several policy cycles. If you are relatively new to the Chinese equity market, you need to realize that the system is very different to the normal practice in other countries, so that's why you might get surprised from time to time.

I don't have a crystal ball to tell you when the turning point will come, but one thing I believe is that the Chinese government cares about the economy and people’s wellbeing, so it is just a matter of time for them to start to deal with the issues we have seen recently.

Recent headlines around the healthcare sector may appear harsh. Some government measures have forced companies to cut prices for generic drugs by 70%-80%, which has raised fears that many health care firms will become unprofitable. But we should look in more detail to get a proper sense of the policy impact. It is worth remembering that the Chinese government continues to raise healthcare spending and, importantly, has imposed much smaller price cuts for innovative drugs.

The government needs health care companies to develop innovative new drugs: firstly, to serve increasing demand as incomes rise and the aged population grows and, secondly, to reduce reliance on more expensive, imported drugs made by foreign multinational pharmaceutical companies. As such, it is unlikely that innovative companies in the health care sector will be much impacted by the heightened regulations and price curbs because they are very important to the government’s long-term policy goals.

We are positive on the EV (electric vehicles) sector, but don’t own a lot of EV manufacturers currently because we think expectations are way ahead of reality. During the peak in January and February, some EV manufacturers were trading with the same market cap as General Motors, despite only producing a few thousand units per month.

The sector is receiving a lot of government support. In the gas engine era, most technology was owned by companies in the US and Europe. The Chinese government feels that the outlook for the EV sector offers domestic producers an opportunity to get a head start on global brands, so many investors see little policy risk in the sector.

But just because the government supports the sector, it may not necessarily be attractive over the longer term. High-flying players in the sector will be subject to significant competition and expectation risks in the coming years, and that’s where long-term investors must be careful. So, we think the market was too excited about EV. We think it will take some time for the industry to develop and we would rather wait for the market to settle and for valuations to come down to more reasonable levels.

I don't think China will ever be completely self-reliant and I don’t think it would be efficient for it to be either. The semiconductor industry is a global operation, with different countries focusing on different things and with different levels of competency. China is trying to raise its leverage and reduce risks when negotiating with other nations. To do that, it is looking to achieve a situation where its semiconductor companies can source as many components domestically as possible, and where more technology is developed in the home market. Technology is very much driven by talent. The US semiconductor industry is more advanced because it has a lot of talent from all over the world. If China is to narrow the gap, it will need an influx of talent. The good news is that we are seeing more talent come to China from the US and other countries because of the government’s strong support for the semiconductor sector and the size of the domestic market.

Theoretically yes. The government is fostering more competition and supporting smaller companies. But you must look at companies individually and on a case-by-case basis. You can’t just blindly buy small caps. Just because small companies receive government support, it doesn’t mean they will be successful in the long run.

We have made some adjustments in the sense that we have put more weight on policy risks due to the regulatory issues we have seen this year. But we continue to believe that companies with a strong competitive edge will do well in the long run. In the future we will try to identify more leading companies in different sectors and make the overall portfolio more balanced across sectors rather than being concentrated in a few.

Our cash levels have come down because we have seen better opportunities in the market. Overall, we are comfortable with the cash level we have at this point. If we see another step down in the market, we will likely reduce our cash levels even further.

Highly leveraged property developers will have a tough time and the largest names will most likely have to go through a restructuring process. We have looked at the real estate sector for a while. Deleveraging is not a new idea for the sector, but we feel that it needs time to play out. If officials move too quickly to impose tough deleveraging policies, it could damage the target companies and their peers and suppliers.

Investors may be worried about the impact on insurance companies from the current situation. However, there are strict regulations on how much investment exposure they can have to the property sectors. If the crisis with individual real estate companies is contained, I believe the situation will remain manageable for the larger insurers.

We build our portfolios on a bottom-up basis and look at companies individually on their merits and prospects. A-shares have done well against H-shares recently, but this may not always be the case. If you look at this question from a long-term perspective, you will not make changes based on the performance of a particular market. We try to make long-term strategic decisions based on individual stocks and their potential returns over a three-to-five-year horizon.

Theoretically, only a few truly outstanding companies can do well consistently over the long term. I think there was a study which showed that 1% of companies were responsible for 98% of total wealth created in the world. We believe that if you focus on the 1%, that's how you do well. If you spread yourself too thinly and invest outside of that 1% you will do less well. So that's why I think concentration itself sounds riskier but, in reality, it can create more value. It all comes down to your investment philosophy and your judgment of the quality of the company and how much upside you see in the long run.

My impression is that China is doing very well, and that people's lives are very much back to normal. When I was in Shanghai, all the hotels and restaurants were largely full, and people weren't wearing masks. It was only after the Nanjing airport COVID-19 outbreak in July that people reverted to wearing masks or being more careful in terms of protecting themselves. I took high speed railways to different cities in China and most of the time the entire cabin was full, with huge flows of people within the railway stations. The situation was pretty much business as usual, except for the restrictions on international travel.

My key conclusions were that China’s export sector is doing very well, despite previous concerns that their orders would fall after the easing of the COVID-19 pandemic. Secondly, I think China will continue to do a good job of controlling the COVID-19 virus, while vaccination rates of nearly 70% are way ahead of other countries. Finally, Chinese manufacturers are heavily investing in R&D, automation and digitalization and I believe that China will continue to be a global manufacturing powerhouse.