Investing in China – Be Selective and Stick With Quality

China now makes up over 40% of MSCI Emerging Markets Index and getting the country right is crucial to investing successfully in emerging markets (EM). However, owing to heightened tensions between the United States (US) and China in recent years over trade, technology and geopolitics, many investors have concerns about being exposed to China.

It should be noted that compared with the total return of the MSCI EM ex China Index, MSCI China Index has outperformed dramatically (Figure 1). From 1 January 2017 through 29 May 2020 MSCI China was up 46.6% – a whopping 41.9 percentage points ahead of MSCI EM ex China (cumulative).

Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Past performance is not a reliable indicator of future performance.

Obviously, China has been a bright spot within EM and is also unique in many ways, but there are many important nuances about investing in China and our approach is to be selective and stick with quality. We are fundamental bottom-up stock investors and aim to build a portfolio of quality companies that we expect will deliver attractive returns over the long run. Our quality focused approach has served our clients well and we want to share some of our thoughts on China and their implications for investing in the country.

Distinct Characteristics of the Chinese Market

First of all, China’s large domestic market is the most important factor as it makes the market special to both global businesses and investors alike. From an active investor’s perspective, China’s sheer size brings significant advantages. For many products and services, China already represents the largest market in the world, providing enormous room for growth for high-quality competitive companies we seek to invest in. It can also support domestic industry leaders with significant economies of scale, enabling them to be highly competitive as they expand beyond China. Tencent is a good example of what a big winner in China could be like. In addition, the huge domestic market helps China’s economy to be more resilient against external shocks such as trade wars.

Second, we see rapid changes in China’s economy, mostly for the better, enabled by the government’s continued push for reforms and driven by factors such as industrialization, urbanization and technological advancements. The rapid pace of adoption of the latest information technologies is particularly notable. For example, penetration rates of mobile payment and ecommerce in China are already significantly ahead of those in the US. Often, adoption of new technologies can lead to significant transformation of existing competitive landscapes, creating new winners in the process. As active stock pickers, we see plenty of investment opportunities created by the rapid proliferation of new technologies.

Third, while we see opportunities in China, we must also point out that China remains a developing country with many associated short-comings and risks. Being a reformed communist country, familiar free market economy characteristics such as for-profit private enterprises, stock exchanges, IPOs, among others, are recent phenomena in the country. Many listed companies have relatively short operating histories, and their competitive position and long-term sustainability vary widely, with most yet to be time-tested. In addition, the quality of management at listed companies is uneven compared with those in more developed markets. One direct manifestation of this is that there have been, and we believe will continue to be, great divergences in business performance among the listed companies in China (Figure 2).

Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Past performance is not a reliable indicator of future performance.

This in turn has led to a much greater dispersion in stock market returns of listed companies on the MSCI China Index compared with those on S&P 500 (Figure 3), and there is evidence that the market is less efficient in creating opportunities for active stock-pickers.

Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Past performance is not a reliable indicator of future performance.

Be Selective and Stick With Quality

Recent events surrounding Luckin Coffee may have heightened investors’ concerns around the risks of fraud and the quality of accounting among Chinese companies. We would point out that financial frauds are rare events in China, and they can and do happen across the world. Wirecard in Germany is presently the best example. In our view, accounting irregularities are more likely to happen at companies where the business is not performing well, management have significant character flaws and there are gaps in oversight. We believe our approach to investing with a long horizon and a focus on quality companies with attractive businesses run by trustworthy management teams can, by design, go a long way in terms of mitigating this risk.

In our approach, we use a proprietary framework called Confidence Quotient (CQ) to evaluate the quality of a company. The CQ framework is backed up by a detailed scorecard, which considers management, transparency, governance and financial conditions of a company. The inputs from the CQ framework is key to our stock selection process.

One source of potential risk, however, is the rising tension between the US and China. We see increased uncertainties for companies exposed to global trade and certain sensitive technologies. However, as mentioned earlier, China’s large size could potentially limit the scope of any damage as net exports are no longer a driver of growth and the country’s domestic sectors will likely continue to do well. It is in domestic consumption and services that we find the most attractive opportunities today. This highlights the clear advantage of an active approach – one can be very selective in what to invest in.

Conversely, the simplistic buy-the-whole basket approach of index investing that works well in the highly developed and mature markets has its downsides when it comes to China or for that matter EM economies in general. The way we see it, why buy the whole basket when one could cherry pick the best ones. We believe it pays to be selective and stick with quality.