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Thinking of investing in China?

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In this article, Riscura attempt to dispell myths about Chinese investing.

We’ve heard mainland China is a difficult place to allocate to…
This used to be the case, but things have changed and will keep getting easier. Historically, access was limited to large Chinese companies listed on ‘global’ stock markets (like Hong Kong), or cumbersome through capital-controlled investment programmes (like the Qualified Foreign Institutional Investor programmes). The Stock Connect programme, launched in 2014, links the Shanghai and Shenzhen markets to Hong Kong and opens access to over 3,000 listed companies and a combined mainland market capitalisation of USD 8 trillion. Stock Connect very recently linked Shanghai to London as well, further opening the Chinese markets.

Even so, China is a small weight in the index – what’s the point?
USD 8 trillion makes mainland China the world’s second largest equity market after the USA. Index providers, like MSCI, know this and have been tracking the mainland market by progressively increasing its weighting in their indices. Currently only around 230 large cap stocks are included, and limited to 5% of their actual size. They make up less than 1% of the MSCI Emerging Markets index. But MSCI has already published a roadmap for increasing the 5% limit to 20% and increasing the number of eligible stocks.
What does that mean for me?
It would raise the weight of mainland China to almost 4% by year end. Early movers into China will have a constant tailwind of demand supporting prices, as global portfolios follow the index allocation. In addition, retail investors – not generally known for their investment acumen – dominate trading in China; we consequently see outperformance of over 5% p.a. from good institutional managers.

That’s a compelling argument, but what sort of companies would we be investing into? Isn’t China mainly a low-cost production site for global manufacturers?
Many people are not aware of how the Chinese economy is maturing, and underestimate the resulting potential. Urbanisation is bringing demand for items including white goods, branded clothing and cars (China is already the world’s largest car market). Even more interesting is that the service sector – like banking and transportation – is now the biggest proportion of Chinese GDP, creating tremendous opportunities for local players. An investment in China today gives exposure to a wide range of return drivers, well beyond factories for cheap components.

Do Chinese companies create their own products or simply copy someone else’s?
Transfer of intellectual property has been a testy subject between China and the rest of the world, particularly the US. Forcing foreign companies to partner with local ones when setting up factories is unpopular but allows the local partner to fast-track assimilating new technology. We are now seeing Chinese companies building on that platform to innovate and extend their product capabilities - leadership in 5G networking is a good example.
With the current tension between China and the US, is now really a good time to get involved with Chinese stocks?
The extent and direction of the trade tension has surprised many observers, and correspondingly the real impact is likely to be misunderstood. Indeed, China is much better prepared than the market may be expecting. For example, consider that exports to the US represent less than 5% of Chinese GBP. Additionally, China has policy tools at its disposal to counteract the economic cost; not least one of the largest tax cuts in recent history (bigger than the 2017 US tax cut) which will boost domestic consumption and benefit a portfolio of well-chosen local companies serving local consumers.

The state controls large parts of Chinese society and the economy. What does that mean for investors?
State involvement is greater in China than in many other places. Chinese policy changes can be substantial in a short time so must be fully understood to find opportunities and avoid traps. A recent example is the significant improvement in air quality by closing polluting industries and becoming the world’s largest renewable electricity producer – with opportunities for investors in those industries. But the opposite is true where policies cause business models or sectors to become unviable overnight.
We get Chinese exposure through our global emerging markets manager. Why would we need local Chinese managers? Is there a credible asset management industry in China?
China is underrepresented in most emerging market equity portfolios. Additionally, the global manager would need to overcome language barriers when doing their own research, or a lack of English broker coverage when relying on third party input. The Chinese equity universe is very large – probably too large to cover immediately for a foreign manager who is more likely to focus on well-known Chinese companies (like Alibaba or PingAn) at the expense of local companies (where the opportunities lie).
The Chinese asset management industry is becoming sizeable with strong track records emerging. That said, the industry is relatively new, staff turnover remains high, mistakes will be made. Diversification of managers and specialist advice are essential.

What about frauds and regulatory issues. How careful should we be?
Frauds are possible anywhere – some of the largest have occurred in the US and Europe (not least Enron, Madoff Securities or the diesel emissions scandal). Chinese accounting standards are comparable to IFRS so the issue would be compliance more than unfamiliarity. Fraud by Chinese companies listed on local markets is comparatively rare, possibly because local investors have a better understanding of what is reasonable and what not, how contracts work, plus a fear of regulatory retribution (i.e. prison) if the fraud is discovered.
China is working towards being a global player in the capital markets. The astute investor will be ahead of this wind.