At Heritage Wealth Partners, we are committed to being lifelong students of the markets. There’s always something to learn and there is nothing more enjoyable than an illuminating discussion with market experts.
A few weeks ago, we wrote on the topic of China. You can read the full article here. A quick summary is as follows:
- China offers high growth prospects but is a risky environment from a regulatory perspective.
- The Chinese Communist Party (CCP) has tolerated foreign ownership of companies in key sectors through a structure known as a Variable Interest Entity (VIE). The VIE structure has dubious legal standing but the government has turned a blind eye.
- Starting with Jack Ma last year (of Alibaba fame), the CCP has been cracking down on tech companies that are either too big, too noisy in their criticism of government or too much of a risk in terms of Chinese data landing in Western hands.
It’s been a bit of a mess. At the end of July, the MSCI China Index had dropped -12.19% year-to-date. It sits on an average Price/Earnings ratio of 15.8x which is arguably not expensive relative to the potential for growth. It isexpensive relative to historical multiples in China but could be considered cheap compared to the rest of the world, which is running at hot multiples.
The main reason for the lower structural multiples in China is that regulatory risk has driven a significant negative re-rating of Chinese stocks.
It’s genuinely difficult to figure out the inner workings of the Chinese economy when sitting in a Western country. For many investors, the China story consists of Tencent and Alibaba and goes no further. A brave few may venture into other well-known names like JD or Pinduoduo.
Still, the country is worth considering. The returns exhibit low correlation to South Africa and the rest of the world, which brings genuine diversification benefits to a portfolio.
To enhance our understanding of the Chinese market and to share those learnings with our clients, we engaged with a Chinese asset management team with whom we have a close relationship. They run a variety of funds with different strategies, ranging from balanced funds through to hedge funds.
A key learning was that momentum factors underperform in China over the long-term. In simple terms, this means that investor sentiment towards China is typically not as positive as it is in other economies. This is a direct result of the risks in the country, which at its heart is a communist state that tolerates capitalist behaviour (to a point).
This makes the Chinese market a stock-picker’s game, as broad exposure or chasing winners isn’t necessarily the answer. The key is to identify companies with sound balance sheets, modest valuations and great cash flows.
Speaking of “broad” exposure, the MSCI China Index (a favourite of traditional fund managers) is heavily weighted towards Tencent and Alibaba. The combined holding is over 25% of the index. Most South African investors are inevitably invested in Naspers, Prosus or both, so the last thing they need is more Tencent exposure. It gets worse as you look down the list of major exposures in the index, as there are several other companies that follow similar themes in terms of tech or eCommerce.
Importantly, our partner’s licence means that they do not invest through the VIE structure. This is a critical point. Buying Chinese stocks on the US market or via the MSCI China Index brings exposure to the VIE structure, which technically has the risk of being worthless if the government takes a hard stance on it.
Our partners believe that the VIE structure will be grandfathered rather than cancelled (i.e. no new VIEs will be allowed), but the risk shouldn’t be ignored. When something can go to zero, it demands a low allocation in any sensible portfolio. With our partners, the VIE risk is removed completely.
The approach taken by our Chinese asset management partner is to focus on the economic drivers in China beyond the tech industry. There are significant drawdowns on a regular basis in the Chinese market, but the impact can be lessened through robust risk management and ESG-screening processes.
We loved this quote from the call we had: “The only entity allowed to make monopoly profits in China is the government. Only buy the giants at cheap valuations.”
There’s another great quote from the call that is worth highlighting: “China doesn’t want a few giants. The country wants loads of small businesses. Be very careful where projections depend on monopolies.”
Our Chinese partner’s balanced fund has been in the top 2% of Chinese funds over the past 3 years and in the top 5% over 5 years. When you consider that there are 4,099 funds in the category, that’s extraordinary.
Our goal at Heritage Wealth Partners is to help our clients create wealth in the most risk-appropriate manner for their specific circumstances. Our international partnerships ensure that we can apply cutting-edge investment strategies in our asset allocation decisions.
Through our Unicorn and Altos products, complemented by relationships in other markets like China, we are able to structure the right exposures for our clients.