China: my super-sized contrarian bet for 2014

It’s been a long time coming, but Chinese equities might finally be on the move. Although I’d still be a little cautious on the risks, as we enter 2014, I’d contend that China is now the super-sized contrarian bet for next year. Valuations remain very low in terms of local share prices, with Chinese shares generally trading at eight times 2013 earnings estimates, and yielding about 4% on 2014 numbers. But investors are starting to pay attention, and that could send prices a lot higher. People have already stopped yanking money out of China exchange-traded funds (ETFs) – $1.2bn has been poured into the sector in just a few months.

A large chunk of this (mainly Western) money comes in the wake of local stockmarket advances. The Shanghai Composite Index of local shares rose 3.7% in November, the biggest monthly gain since August. This upsurge is due in part to growing domestic business confidence – just a few days ago the November Chinese Manufacturing Purchasing Managers’ Index (PMI) came in at 51.4, suggesting fairly robust expansion. But what’s really helped is a shift in sentiment among Western investors. Suddenly China is no longer the dog everyone thought it was. As we discussed in last week’s cover story, this change of heart has a lot to do with the recent Communist Party plenum, which outlined an incremental but extensive series of reforms, and stamped President Xi Jinping’s authority over the party.

As Anthony Bolton over at Fidelity pointed out, the reforms may seem modest individually, but “they will streamline government, abolish forced labour for offenders, increase the independence of the judiciary, accelerate new business approvals and capital projects [and] create new success measures for government officials beyond simple GDP growth”, among other things. Bolton also reminds us that the really important thing is that the plenum makes clear that Xi is firmly in charge – Western investors prefer a leadership that knows who’s boss. According to Bolton, “perhaps the most daring move is the establishment of a new Central Reform Group to oversee all aspects of reform. It is rumoured that [the president] himself may lead this organisation, underlining the seriousness with which the latest reforms are being taken in Beijing.”

How to play a Chinese revival

We suggested some ways to play China last week, and I’d like to expand on that here. Soon after the plenum announced its reforms, Western banks rushed out their views on how to profit from the changes. Most were fairly hackneyed, held back by lack of administrative detail. But niche bank NSBO sums it up brilliantly. According to its China strategy team, the key sector ‘buys’ from the plenum were insurance, water, telecoms equipment, and gas distribution. The key ‘sell’ was copper.

For NSBO there were two big positives: “the shift to a market mechanism to control the economy” and the opening up of the economy to private sector firms and “financial sector liberalisation”. The big negative was the “lack of consensus on land reform and the property market, which is still under discussion”. Looking at the market reforms, NSBO focuses on resource pricing. Natural gas and water and electricity pricing are set to be freed up. Control of the interest rates banks can charge and pay on savings is also being liberalised. “We therefore remain cautious on the banks, but think insurance will benefit, particularly after Premier Xi also highlighted serious illness insurance as a key focus.” Overall these reforms could “remove some of the worst inefficiencies in the state-owned or state-directed sectors through imposing higher costs on major enterprises and promoting more rational use of resources”.

Fund managers at EFG focused on the financial sector, and especially local banks. “Without a healthy banking sector, the rest of China’s reform plans would be much more difficult to achieve. The Chinese government is expected to accelerate interest-rate deregulation and facilitate the development of the fixed-income market.” In practical terms this means more municipal bonds (where cities and regions can borrow money by issuing bonds, as in the US), plus greater freedom of manoeuvre for local financial brokerage houses, and a general liberalisation of financial and asset markets. If NSBO and EFG are right, now might be the time to bet on specific sectors in local Chinese equities – financial services and utilities in particular. You might want to consider the sector ETFs range from Deutsche’s db x-trackers business – the banking ETF is db x-trackers CSI300 Banks Index UCITS ETF (HK: 3061).

Active versus passive funds

If that’s too specific, you could bet on the local markets via either a China ETF or an actively managed fund. If you’re using an ETF, pick your index carefully. The box on page 30 shows the top company and sector holdings for each of the four major benchmark indices for local Chinese shares. The HSCEI index tracks Hong Kong-listed Chinese companies, for example. Or there’s the newest entrant to the Chinese equity index world, the CSI 300 Index – this might benefit from the growing Western interest in buying locally held A-shares. These shares are usually reserved for mainland residents, but new ETFs in the US and the UK allow access – as these multiply, we could see prices begin to rise. I’ve listed year-to-date returns for the main London-listed Chinese ETFs in the box on the left.

As for actively managed funds, there’s a huge range of choice, although charges tend to be a great deal higher than for index funds. A lot of retail money has flooded into Bolton’s fund, but it saddens me to say that he would be far from my first choice. In the box above, I’ve given details of the top UK funds in terms of recent returns. My own preference is for the specialists at Matthews (a US-based firm), as well as GAM, although I also rate the teams at Ignis, Henderson and Neptune.

Last, but by no means least, if you’re looking for a more general bet on Asia, I’d also suggest that London investment trust Asian Total Return Investment Company (LSE: ATR) is still an interesting fund. It currently trades on a discount to net asset value of around 3%.

MSCI China Index FTSE China 25 Index HSCEI Index CSI 300 Index

Top five company holdings

China Mobile (9.8%) China Mobile (10.6%) Bank of China (10%) China Minsheng Bank (4%)
China Construction Bank (8%) China Construction Bank (8.9%) ICBC (Bank) (10%) China Merchants Bank (3.5%)
ICBC (Bank) (7.2%) ICBC (Bank) (7.6%) China Construction Bank (10%) Industrial Bank (2.7%)
Tencent (6.2%) Tencent (7%) PetroChina (7.8%) Ping An Insurance (2.4%)
Bank of China (4.8%) Bank of China (6%) Sinopec (6.8%) Shanghai Pudong Development Bank (2.3%)

Top five sector holdings

Financial services (35%) Financial services (52%) Financials (61%) Banks (28%)
Energy (13%) Communication services (16%) Energy (21%) Construction (7%)
Communication services (12%) Energy (11%) Consumer discretionary (4%) Pharmaceuticals (5.9%)
Technology (7.7%) Technology (7%) Mining (3.6%) Real estate (4%)
Consumer cyclicals (6%) Mining (5%) Industrials (3.4%) Insurance (3%)
(As of 25 November 2013)

Returns for main UK-listed China ETFs

Ticker 2013 return TER* Currency
Amundi ETF MSCI China UCITS ETF LSE: CC1 2.83% 0.55% GBP
db x-trackers CSI300 Index UCITS ETF LSE: XCHA -3.54% 0.5% USD
db x-trackers FTSE China 25 UCITS ETF LSE: XX25 -7.06% 0.6% GBP
db x-trackers MSCI China TRN Index UCITS ETF LSE: XCX6 5.69% 0.35% GBP
iShares China Large Cap UCITS ETF LSE: FXC -8.48% 0.74% GBP
Lyxor UCITS ETF China Enterprise LSE: ASIL 1.93% 0.65% GBP
Source MSCI China ETF LSE: MXC5 6.2% 0.95% USD
*Total expense ratio (annual management and other fees). Source: Morningstar, 25/11/13

Returns from main China unit trusts

2013 return Currency
Matthews Asia Funds China Small Companies 29.24% USD
Invesco Perpetual Hong Kong & China 28.33% GBX
Fidelity China Consumer 26.26% GBX
Threadneedle China Opp Ret Net 23.34% GBX
GAM Star China Equity 23.15% USD
Ignis Intl China A 21.21% GBP
Jupiter China 20.31% GBX
Invesco PRC Equity C 19.95% USD
Henderson China Opportunities 18.73% GBX
Neptune China Special Situations 18.21% GBP
(Source: Morningstar, 25/11/13)

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