Even as the broader geopolitical environment and global economic uncertainty continue to impact the headlines on China, strong growth prospects underpin several sectors and companies in this vast market. China is forecast to become the world’s largest economy by the end of the decade. To explain the current challenges and opportunities, Pensions & Investments spoke with Dan Chace, portfolio manager at Wasatch Global Investors; Ronald Chan, chief investment officer, equities, Asia (ex-Japan) at Manulife Investment Management; and Jin Zhang, portfolio manager and senior research analyst at Vontobel Asset Management.
Pensions & Investments: Covid-19 has arguably accelerated deglobalization, yet China seems to have emerged, if anything, stronger from the pandemic. What are China’s prospects for growth post-pandemic?
RONALD CHAN: In terms of Covid-19, China has been first in, first out. As the manufacturing hub of the world, China has been able to take advantage of work from home, the demand for [information technology], computer gadgets and related trends. From here on, we expect the momentum will continue, but it will be of a slightly different nature. The demand in China for leisure, domestic travel, gaming and cinemas will all improve. Another ingredient is the demand from the U.S. for Chinese goods, given America’s stimulative monetary and fiscal policies. China, as the manufacturer of the world, should benefit.
A number of sectors have been able to do well due to domestic demand within China but have yet to build additional capacity to cater to the increase in demand from overseas. As interest rates are low, these sectors will likely spend more on [capital expenditure] to respond to this demand. Corporate capex will help China continue with its strong investment and growth cycle, as opposed to just relying on infrastructure spending from the government.
DAN CHACE: One of the things that China has that many emerging markets countries don’t have is that it is self-sustaining. We think the prospects for growth are very strong. You can’t put that genie back in the bottle. We’re positive that from China’s dual-circulation strategy, there will be growth from a domestic demand component and also from an export component.
JIN ZHANG: I agree with Dan. The Chinese economy is large and diverse. It has a number of different sectors and different drivers. China’s middle class is quite sizable and still growing, which contributes to several positive domestic consumption stories.
One area within domestic consumption that’s an interesting growth theme is snack food. As people are getting busier, the younger generation is actually snacking a lot more than the previous, older generation. This food sector has several good, high-quality companies that are tapping into this trend in domestic consumption and growing well.
P&I: What changes in the Biden Administration’s policies toward China should investors be paying attention to?
ZHANG: We are bottom-up investors, but we are watching these changes carefully. U.S. policies are more coordinated than before. We are very aware of the potential risks and disruptions to previous Chinese business models, and we are watching how these changes will affect industry dynamics. One example is the distrust [between the U.S. and China] that is growing in the technology sector. There could be domestic champions in China that will emerge from this trend, for example in software, and we are watching that side of the situation too.
CHACE: One of the few bipartisan mindsets in the U.S. right now is in the efforts to contain China. I agree with Jin that [the Biden administration’s] policy will be more coordinated. But, as I said before, you can’t put China back in the bottle.
CHAN: America and China are linked economically in several ways, and they rely on each other. So when you talk about the trade tariffs, we don’t see them as being that successful because there are a lot of American companies operating in China. Europe also has a lot of interests in China. The only way that the U.S. can come out ahead in its strategic competition with China is with the help of its allies. Yet none of its allies in Europe or Asia is interested in a cold war (alia Soviet Union in 1970s), since their economies depend heavily on engagement with China, and few of them see China as an existential security threat.
CURRENT PERSPECTIVES ON CHINA
P&I: What are the implications for investors of the technology bifurcation between the U.S. and China, as well as China’s dual-circulation economic strategy?
CHAN: This strategy is really about China gaining more control over long-term domestic growth without losing its role as a manufacturing hub of the world. The reasons behind this policy are rising protectionism around the world and a global economic cycle on the decline. On the domestic part of that equation, it’s about modernizing domestic industry and upgrading consumer necessities so that China is less reliant on foreign products and is self-sufficient, especially in technology.
ZHANG: We want to look outside of this technology bifurcation that you mentioned to the other countries that are in the middle. It could be an investment opportunity if [those country’s companies] do the right thing. For example, Samsung Electronics is a very strong player in semiconductors and technology in general. They supply to both sides of the Pacific, and they are also increasing their production capacity in Texas. If companies like Samsung play their cards right, we will see more investment opportunities.
CHACE: This [technology bifurcation] is really significant, and the nexus of that is in semiconductors specifically. The semiconductor sector is likely to be a flashpoint in trade and diplomatic relations. China is going to invest heavily in its own semiconductor manufacturing capability, and Intel, with some pressure from the [American] government, is going to invest in the U.S.
[The dual-circulation strategy] is keeping China’s historical strength in exports but also fostering domestic consumption which, if you look at the data, has done quite well. Domestic consumption has grown considerably, as Jin mentioned.
P&I: What are the most common questions you hear about China from existing or potential institutional clients, and what solutions do you present?
ZHANG: There is definitely a sense of opportunity in China among investors but it is mixed with fear and confusion. We approach investing in China the same way that we approach any other market. We do bottom-up research, a deep dive [into the companies we identify], and we want to own the best, highest-quality businesses. If we do our jobs right, we can buy and hold [these stocks] and bring that benefit of growth to our investors.
One concern we hear is that China’s market itself is relatively new and many companies in it are new to the market. We believe the advantage we have is a very experienced research team with diverse backgrounds, located in the U.S. and Hong Kong. We also have three former journalists on our team. They have become our internal investigative analysts and bring resources and insights that are not accessible to Wall Street research methods. Applied with our team approach, that goes a long way in helping us overcome [the uncertainties] associated with this newness.
CHACE: We hear similar concerns. China has led the world in terms of [initial public offering] activity by number of companies, though not necessarily in terms of capital raised. The market is hugely dynamic. For Wasatch, with our historical legacy in small-cap stocks, that’s something that we like to see. It represents innovation and change, and that brings opportunity for investors. But you need to have the resources to address that as well as an experienced team that can filter through all of that change.
Many potential institutional investors are still trying to figure out how to approach China. Do you pursue China exposure through an emerging markets strategy or, ultimately, will clients want to have a separate China allocation and an EM ex-China allocation? And a separate question within that is, ‘Do you have a greater-China strategy or an Asia strategy or a Hong Kong H-share strategy [Chinese companies listed on the Hong Kong Stock Exchange]?’
Part of the reason that we launched a greater-China strategy has been that the exchange is irrelevant for us. It can be Taiwan with mainland China exposure, ADRs [American depositary receipts, foreign company stocks that trade on U.S. exchanges] with mainland China exposure, Hong Kong companies that are mainland China companies, and then A-shares as well. So the venue to us is irrelevant, relative to the opportunity that we’re trying to access.
CHAN: Everyone wants to come to China for the growth, but they don’t want the volatility. Clients say, ‘Give me the stuff that’s not in the benchmark.’ They want high-alpha products, off-benchmark products, high-active-shares products.
The Chinese stock market has over 4,500 names, and that number is growing because of the number of [initial public offerings]. The U.S. has 3,500 names, and that number is shrinking because of [merger and acquisition] activity. There are a lot more opportunities in China than in the U.S., especially when the U.S. market is already at the very expensive end of the spectrum.
We offer solutions for investors with different risk appetites. We have a product that is high active shares; another that is All-China so that clients don’t have to decide between onshore China and offshore China or ADR and Hong Kong; and the Greater Bay Area Balanced product, which focuses on the highest-growth elements of China in the Pearl River Delta while managing volatility through fixed-income exposure.
P&I: Which investment themes within China do you see as most compelling right now?
CHACE: The growth opportunity in China that we get excited about is in innovation. China has had a lot of students come to the U.S. and Europe, and they return as entrepreneurs to start businesses in sectors that historically weren’t significant in emerging markets. Healthcare technology is a big one, and we are overweight in the sector. It is seeing massive amounts of change and innovation, to link back to that capital formation that I described earlier in terms of the number of IPOs.
CHAN: Investors come to China for growth and for yield because of the ultra-low interest rates in the U.S. So China will give you the positive carry, that’s number one. The second theme is the wider technological innovation and adoption of 5G technology, and how that can be transmitted onto the Internet of Things. The third element we are focusing on this year is climate change. [President] Xi Jinping has been talking about achieving carbon neutrality by 2060. That will bring opportunities in climate-friendly and sustainable projects like energy storage, battery charging stations, energy efficient semiconductor chips and recyclable materials. The fourth area is in consumer upgrades — to look for opportunities in Chinese products with brands that are on a par with, or better than, international products.
ZHANG: As bottom-up investors, by picking what we see as the right stocks with exciting [growth opportunities], we see several themes that come up. I mentioned the consumer sector earlier on. Others are technology and healthcare.
Some investors have a misconception about China benefiting from the ‘demographic dividend’, which refers to cheap labor. But, in fact, this is no longer the case. At the current stage, what’s paying off is actually the ‘engineer dividend’, meaning that the sheer numbers of engineers being trained by the education system is breathtaking, and that’s driving a lot of this innovation.
P&I: What are your thoughts on the active/passive debate when it comes to investing in China?
CHACE: We think it’s important to be active. The structure of the benchmark if you wanted to go passive in China is so highly tilted towards mega-cap companies like Alibaba or Tencent that there’s really no value to be had unless you’re active. Given Wasatch’s history as a small-cap investor, we strongly believe that with an all-cap strategy, we can find small companies that really don’t fit the benchmark. We’re strong believers in active versus passive around the world, but especially in China. Given the breadth and depth of that market, if you’re not looking for undiscovered companies, you’re not doing your job.
ZHANG: If you want to invest in China, you want to be an active investor in order to find the right opportunities. The trading volume in domestic equity markets in China is fairly high. The market is moving to mutual funds, but they churn their holdings rather quickly, which produces opportunities for active investors like us. Stocks of good companies can get penalized because of this short-term orientation. We feel this is a very good market to be active in and to add value.
CHAN: We think the current China equity index reflects the past but not the future of China. As previously mentioned, our high active-share approach would best capture what we think could be beneficiaries from China’s dual-circulation strategy, tech self-sufficiency and the shift in consumer behavior post-pandemic.
P&I: How do you incorporate environmental, social and governance investing into your considerations regarding China?
CHAN: We have a team of ESG analysts in Asia and globally. We do a negative screen from our ESG analysts to sift out any candidates that have high ESG risk. We do ESG rankings and engage with companies to think about how they can improve their ESG score. Typically, our ESG analysts join the conversations with a company and talk about potential improvement and what peers are doing.
ZHANG: ESG is incorporated into our investment research process, and it’s been that way for years, given the quality characteristics we look for in businesses in our portfolio. We have to be aware of the social impact of the businesses we own as well as the potential regulatory pressures and the environmental implications. We engage with managements of the companies in which we invest. We have thoughtful questions related to the sustainability of their earnings growth. If the earnings are not sustainable or issues emerge on the regulatory front, then our focus on ESG definitely will have helped us to avoid potential traps.
We also discover opportunities with our ESG focus. There’s a strong push in China for companies to become more environmentally friendly. One area that we find interesting is solar energy.
CHACE: We have followed ESG practices for years. If you want to have a sustainable business, you have to follow ESG principles. But one thing in particular in emerging markets, and in China too, is that the governance aspect is key. To address that, you can’t be an income-statement investor in China. You have to be a balance-sheet and cash flow investor as well. Companies that have great business models also have a lot of other operating income and other assets on the balance sheet that don’t really reflect what the operating business is, and you really have to analyze that.
P&I: What is your currency perspective on the renminbi versus the dollar?
CHACE: China is a hard currency country. You don’t really think about depreciation as a significant factor as you might for Brazil, India and Turkey. It’s a positive factor if you’re looking to allocate to China. China is one of the largest countries in the world economy, and it is realistic to think that the renminbi also becomes a reserve currency over the long term.
CHAN: The renminbi will play an increasing role in the world currency system, but it will not replace the dollar as a reserve currency. The general adoption of RMB in international transactions will rise over time, starting off with the One Belt One Road countries. With China’s economy running strong versus the stimulus package in the U.S., there will be a relative bias toward the renminbi versus the dollar.
ZHANG: We don’t hedge our currencies. We let the earnings of companies we hold take care of the currency impact. If China continues to deepen financial reforms, it will be able to gain some currency market share. The gain will not come at the expense of a core currency like the U.S. dollar due to the network effect of global currencies. It will come from smaller, more peripheral currencies like the British pound.
P&I: Do you feel it’s important to have an on-the-ground presence in China?
CHACE: The answer is no. We’re based out of Salt Lake City, so part of our DNA is that you don’t need to be in the news flow. However, prior to this pandemic, we traveled extensively to China. And since the start of the pandemic, we’ve done extensive calls [with the companies in our portfolio].
Hong Kong Connect makes it a lot easier to transact in the A-share market in particular. We’re not looking to make 10% on a trade and move on. We’re looking to own something for as long as we can, which makes the research process very different and much more insightful rather than a transactional process. So a lot of the topics that are brought up by the local sell-side culture are not interesting to us.
ZHANG: On this one I have to disagree with Dan. We do have an on-the-ground presence in China, with an office in Hong Kong. An on-the-ground presence allows you to be aware of the issues locally. You hear a lot through the grapevine. You want to be invested in companies that are led by executives that are trustworthy. You really need to tap into the grapevine and ask about their reputation and their shareholder orientation. You can’t really understand the [executive leadership] by just looking at the financial statement.
CHAN: We have a joint venture in Beijing where we have more than 25 equity professionals. We believe it gives us a strong proprietary research capability in terms of fundamental, bottom-up stock selection and also an ESG perspective. Investors come to China for alpha. Having people on the ground doing the tire kicking is very beneficial in finding the bottom-up opportunities in China and delivering that alpha.
P&I: What is distinctive about mainland China-based companies that trade on the Shanghai or Shenzhen exchanges — Chinese A-shares? And what are your thoughts on Stock Connect linking mainland markets to Hong Kong?
ZHANG: We view A-shares as an opportunity, as they provide exposure to a lot of different growth companies. But you need to be cautious to play in this market, as China is a relatively new growth market. We want to make sure that our interests are aligned and that we’re buying into companies whose earnings are sustainable. We look for good businesses that we feel we can hold for years, if not decades.
We view the Hong Kong market as similar to the domestic Chinese market in the sense that a lot of the businesses that are traded in Hong Kong mainly operate in China. Through Hong Kong Connect, we have access to practically all of the large liquid stocks in the domestic market now. China’s a large and diverse country with many different sectors and different business models, so it presents many very exciting opportunities.
CHAN: The U.S. is very good at innovation and research and development. But the Chinese have been able to use that R&D and monetize it into products. For instance, Chinese e-commerce companies have used big data and [artificial intelligence] in widening their customer base and product segments. That’s why investors need to look into investing in China A-shares as opposed to just considering the U.S. market. Currently, the Chinese market in certain sectors is already bigger than the U.S., such as in movies, autos, smartphones and online gaming. Hence, China equites offer growth and are a good diversifier for U.S. investors.
Stock Connect represents more than 80% by market cap of the China A-shares market. From a market-cap perspective, it is relatively well covered. But there are certain sectors it does not cover, especially non-benchmark names. So if you want small-cap or mid-cap exposure, Stock Connect has still got some way to go.
CHACE: Through Hong Kong Connect Northbound, the A-shares market has really opened up for institutional investors. Part of our enthusiasm for China has been the opening up of this market and the vast expansion of investable companies and IPOs.
Most other countries have been extensively covered [by research analysts] — China A-shares much less so. It’s clearly a place where, as active investors, we can add value. But you have to go into it with eyes wide open. In short, while A-shares have been the wild west for a long time, we believe it is one of the last areas of global alpha exploration.
P&I: What is your view of the world post pandemic? How does your view underpin your investment approach and strategy for investing in China?
ZHANG: China is a very big market, and it doesn’t matter where it shows up in the benchmark. There are very important changes that are occurring in its economy. A lot of companies are talking about having a one-plus-one strategy, meaning they have one manufacturing site in China and another one outside of China, maybe in the Southeast Asia region.
As bottom-up investors, we feel that if you own the right businesses, they tend to be able to navigate and take advantage of these kinds of ongoing changes. We mentioned the tech divide. Some companies are tapping into that change and becoming domestic champions. Other consumer-oriented companies that are not affected by these changes will just keep working in their niche, continue to strengthen their competitive position and deliver very good returns. We tell investors, when it comes to investing in China, or anywhere, know the businesses that you own.
CHACE: Institutional investors have to figure out how to approach China. Do you want an A-share dedicated greater China strategy, or a Hong Kong-focused one where the governance is arguably, but not necessarily, better?
In terms of the opportunity in China, its expansion is self-sustaining, its growth is real and it’s a strategic rival to the U.S. and Europe. That doesn’t have to be a bad thing. Wasatch doesn’t launch a strategy—as with China—because we think we can gain assets, we launch it because we think it’s an opportunity that we want to be invested in for our clients and personally, too.
CHAN: China’s growth rate might slow, but it will be sustained at 6% to 7% for an extended period. The rest of the world, especially the U.S., is talking about 2% growth on a normalized basis. If that continues, China will be the No. 1 economy in the world within the next decade or so. We are focused on long-term sectoral, secular growth in our strategy and incorporating a company-specific approach in our portfolio construction.
Given how each country has handled the pandemic differently, it may not be a surprise that China’s monetary policy and fiscal policy is not in sync with the U.S. The Fed is talking about dovish monetary policy, but China is already starting to tighten. With the world becoming less globalized, investors may need to look at China as a separate asset class and diversifier for their global investment. ■