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China out of favour, time to reconsider?

Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.


It is another Macro article for me today as I look to add some quality trusts to my long term investment portfolio, so in this piece I take a look at China. Over a decade ago when I first started my career China was en vogue, if you didn’t have a large weighting to China in your portfolio then you must be quite simply bonkers, after all Chinese stocks had surged around 250% in little over 15 months from summer 2006. In those years the common thinking was that the business cycle was a thing of the past and the only way was up, that was until the 2008 financial crisis. Today though many investors are still steering well clear of China, with a trio of concerns, namely credit bubbles, doubts around the integrity of Chinese financial data and the slowing of official growth rates. But are these concerns overdone?

How is the recent performance of Chinese Stocks?

In Local and USD terms the MSCI China index is sitting at pretty much the same level it was at right before the 2008 financial crisis, at around 1,000. See Figure 1:

screen-shot-2017-02-05-at-12-17-21
Figure 1 – MSCI All China Performance – Source MSCI

There are two fairly extreme swings to comment on, during the 2008 financial crisis when the index declined by 50%, before quickly recovering. The second was almost an exact symmetry of the first, various actions by the government set the conditions to unintentionally allow fevered speculation in 2014/2015. During a matter of months from late 2014 and early 2015 shares were up around 100%, closer to 150% if you take the Shanghai Stock Exchange Index (SSE) in isolation. Again though the markets collapsed just as quickly. This incidentally remains somewhat of a risk factor of the Chinese markets in general, it is a common stereotype that the Chinese love to gamble, there is though some substance behind this. This behaviour has manifested itself in stocks but also many commodities over the last few years. That said intentional capital also contributed heavily and together they allowed massive disconnects between shares listed in between Shanghai, Shenzhen and Hong Kong, a clear sign that rational thinking went out of the door!

After the market correction referred to above though the current fundamental stock market value according to research by Star Capital for China is 7.2 on Price/Earnings, low by any comparison. CAPE is around 12.8, this measure divides current market capitalisation by the average annual earnings over typically the last ten years. It is therefore a measure which takes into account the booms and busts. You can compare China’s score of 12.8 and 7.2 to the USA which scores a CAPE of 26.4 and PE of 21.8. So the indicators of short term and long term value opportunities are present. However, we need to look forward to see if we really have value…

So, what are the future growth prospects?

China has been growing on an annualised rate at around 9%. Growth has though begun to steadily slow since 2012 and this trend is projected to continue through to 2020 as illustrated by Figure 2:

chinagdp
Figure 2 – Source: WorldBank, ShareInvestors

The point for much debate is whether you actually believe the figures put out by China, this is whether the earnings posted by the companies are materially correct but also whether the economy is really growing at 6-7%. Some commentators believe the growth on the ground could be as low as 1%. If you do believe the official figures then we can expect a total of 35% GDP growth from now until the end of 2021.

Exploring the headline figure a bit deeper, Economic growth and thus the fortunes of Chinese enterprise is driven by investment, domestic consumption and exports. China has had a solid recent history of infrastructure investments and there is little reason why this should slow on the demand side. China’s debt though has exploded since the financial crisis increasing by 2/3rds and now running at 2.5 times its GDP. This may limit the Infrastructure Investment activities and potentially also put a break on domestic consumption. The total ratio though is around the same as the USA ,so the total amount of debt in itself not necessarily an issue, especially given China is in growth phase. The speed of the development of this debt pile though is alarming and a large proportion of this borrowing is linked to real estate, sound familiar?

The debt is though largely locally funded through the large Chinese domestic deposits. Commentators when predicting the China bubble is about to burst fail to appreciate that China’s saving rate is around double the world average. This is not to deny that the debt growth needs steadying and that credit control needs focus. Further, In an apocalyptic scenario the government is likely to have the capacity to bale out a good proportion of the bank’s balance sheet too.

chinagds
Figure 3 – Source: WorldBank, ShareInvestors

Now to the final function of GDP growth, exports. China is starting to lose some of its comparative advantage in exports, wage growth is continuing which reduces the competitiveness and global demand continues to be tepid. There also continues to be the Trump factor, the US represents around half of China’s total trade surplus of $44.6bn. There remains a risk that Trump could bring China into his protectionist agenda, with some commentators suggesting a 3% slowing in growth levels at the extreme end. So far it is Mexico that has been his main target. My personal view that the comments Trump has made on the deficit with China are purely political and he knows that taking on China is a step too far, is likely to hurt too many US companies and consumers who benefit from cheap Chinese inputs. The analogy you can think of is one of a school bully picking on those he considers weak.

China though is nonetheless focusing on boosting domestic consumption to reduce its dependence on the export markets. China’s current consumption is around 38% of its gross domestic product, again significantly lower than average and it needs to get consumers to spend more. This is a challenge and careful policy choices to promote quality companies serving the domestic market as well as a sound fiscal policy are required. It will be interesting to see how this next stage of the economy transitions.

A lot of the above analysis is based on official figures, but can you trust them? I don’t doubt that China ‘smooths data’ but whether the largest country on the planet is able to consistently materially misstate its numbers to me is highly unlikely. Assuming I am correct then given the valuation then the investment case for China is compelling.

So how do I get Exposure to China?

There are hundreds of Unit Trusts, ETFs and Investment Trusts covering this sector. My favourite though is Fidelity China Special Situations (FCSS). This trust launched in 2010 dragging Anthony Bolton out of retirement in the process. The rockstar of the fund management world created a feeding frenzy at the time which saw the trust trade at a premium. I always avoid listed equity funds trading at a premium, you are already paying the fees of the asset manager and there is no need to pay a premium to the underlying assets too, even for a man that returned 19.5% per annum over a decade. The China Special Situations trust soon hit turbulence too and at one point was trading 30% lower than IPO price. Investors consequently left in droves which eventually created a reasonable discount to the underlying assets. This discount has stuck even during a period of outperformance, but more on this later.

Here are some quick facts as at 6th February 2017:

Current Share Price 179.3p
All Time High 195.3p, October 2016
52 Week Low/High Low 109.7p on 12th Feb 2016
High 195.3p on 21st October 2016
Market Capitalisation £990m
Enterprise Value £1.06bn
Net Assets and (Discount)/Premium £1.15bn / (13.7%) discount to Share Price
Dividend Yield 1%

Anthony Bolton eventually stood down from the trust and aussie Dale Nicholls took the helm. Dale has posted the best returns in his sector over the last 5 years according to CityWire, so you are in safe hands. No surprise then that the Fidelity China trust has beaten its benchmark comfortably, by 100% over a 5 year period as shown in figure 4. A stellar performance although the last year has been more disappointing, returning 17.5% growth in NAV compared to a 20.4% growth in benchmark MSCI China Index. However, I’m never one to dwell on short term performance.

Screen Shot 2017-02-06 at 12.31.28.png
Figure 4 – Source: Fidelity December Monthly Report

What is the latest investment strategy of the trust?

The relative weightings of the sectors vs. the benchmark are listed below. You will notice large overweight position in Consumer discretionary, thus trying to take advantage to the stated government policy of boosting domestic consumer spending. The largest underweight position is on the financial sector, again this seems sensible and reflects concerns around the explosion of credit, also discussed above.

Screen Shot 2017-02-07 at 11.12.24.png
Figure 5 – Source: Fidelity Monthly Report

Are there any other Risks to ponder?

As with all foreign currency investments there is a risk of Exchange Rate. The trust does not hedge the underlying holdings against GBP. The GBP exchange rate has weakened against the Yuan by over 20% since late 2014 and those who follow my posts will know I am a long term bull on Sterling. I therefore do expect moves in currency which will reduce potential gains on this investment, however the investment case still looks compelling.

Summary

BUY – Fidelity China Special Situations Trust. Remains a buy whilst discount remains >10% to NAV

I believe the Chinese markets currently have an attractive valuation and the fears about a Chinese crisis are overdone. In addition the Fidelity trust is already discounting in a 14% or so fall in prices, combine the two and there is a significant scope for outperformance.

There is a risk of volatility in this investment, some may be based on facts some may be based on excessive bullishness or bearishness, so pay close attention to movements and take action accordingly.

Disclaimer – I have long positions in Fidelity China Special Situations equal to 1.5% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.

This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.

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