Chinese equities showed high gains since the beginning of this year. However, it will be difficult to repeat the good figures of the first quarter of 2018. We spoke to Greg Kuhnert, Portfolio Manager at Investec Asset Management about the outlook.
AsiaFundManagers.com: Where do you see the main reasons for the high gains in Chinese equities since the beginning of the year? What do you expect for 2019?
Greg Kuhnert: They were mainly due to the economy and global politics, but also to the latest announced changes in the index structure. However, the current reporting season has so far shown that Chinese equities have not yet overcome the recent trend towards negative earnings revisions; it will be difficult to repeat the good figures of the first quarter of 2018. This could lead to more volatility in the coming weeks. Nevertheless, we believe that there are still good long-term reasons for investing in China, which is moving towards a more sustainable consumption-oriented economy. In addition, Chinese equities are attractively valued compared to the past and compared to other markets, especially against the background of the profit potential of Chinese companies. International investors are still underinvested in China, but we believe that they will increase their weighting in the near future.
AsiaFundManagers.com: What role do these short-term considerations play for your portfolio?
Greg Kuhnert: It’s easy to get carried away by this mood-driven rally and bet too much on price momentum. We will therefore continue to ensure that our investment strategy is implemented in a disciplined manner. We believe that it pays off in the long term to focus on inexpensive, high-quality stocks with rising corporate earnings and positive market technology. In our opinion, this is the best way to exploit the long-term opportunities on the Chinese market.
Volatility in Chinese equities
AsiaFundManagers.com: The Investec GSF All China Equity Fund focusses on equities or equity-related securities issued by Chinese Companies. It heavily invests in A Shares. Do investors have to expect higher volatility?
Greg Kuhnert: The fund has delivered strong results, outperforming the MSCI All China Equity Index in 10 out of the past 14 quarters. The fund performed best in trending and relatively stable market conditions. The process will typically struggle in two circumstances: The first is where fundamental stock picking is not rewarded and stock correlations are high (e.g. event-driven markets, risk-on risk-off markets). A period of volatility, such as was seen in China from the second half of 2014 to the first half of 2015 when the Shanghai composite jumped 150% within 12 months and lost half of its value in three months, would fall into this category.
AsiaFundManagers.com: Which China A Share are your favourite stocks at the moment?
Greg Kuhnert: Currently, we are overweight information technology, consumer discretionary and consumer staples, as these are areas of the market that are outgrowing the rest of corporate China. Our stocks are currently from sectors such as consumer staples, consumer discretionary, technology and financials. Some companies are leveraging the massive home market to become a global leader in their specific categories (e.g. Hikvision, Fuyao Glass, Gree). Some are moving their products higher up the value chain by repositioning their brands (e.g. Midea). Some have strong brands and product ranges, well positioned to benefit from the ongoing long-term trend of consumers upgrading their lifestyles and tastes (e.g. Moutai, Geely). This is a result of our bottom-up stock-picking based on our 4Factor screen process.
New economy sectors offer long-term growth potential
AsiaFundManagers.com: The fund has a high proportion of tech stocks (Alibaba, Tencent, Baidoo). Does that follow your preference or the index?
Greg Kuhnert: We believe that thanks to increasing penetration and high barriers to entry new economy sectors, such as consumer, technology, internet and healthcare, are generating interesting long-term growth opportunities for equity investors. The new economy has been growing at a much faster rate than the old economy. Reflecting this superior expected growth rate, valuations of new economy stocks, such as IT stocks, tend to be at a premium to those in the old economy. But given the higher long-term expected growth rate, better cashflow generation, and stronger return on invested capital, we think that the valuation premium is justified.
Big data as revenue potential for companies
Greg Kuhnert: Within information technology, we favour companies with a large wealth of data and the ability to monetize that data through innovation. Alibaba and Tencent are two such examples. Both companies have accumulated significant amounts of customer data on their platforms. There remains a lot still to be done to mine this data to increase the revenue potential of e-commerce and cloud users in the case of Alibaba, and the gaming and social network users in the case of Tencent. These are areas where penetration rates in China are low but growing rapidly. In spite of already being the world’s largest e-commerce market by some margin, e-commerce sales are still only 20% of total retail sales in China. Alibaba’s e-commerce business has grown more than 40% annually in the last three years. Cloud business at Alibaba has grown 115% annually in the last two years.
AsiaFundManagers.com: What is in favour for Chinese financial stocks, especially Ping An?
Greg Kuhnert: Many positions in the financial sector contributed to higher earnings, in particular the insurance giant Ping An. It benefited from the fact that many consumers switched to higher-margin insurance policies. China’s life insurance penetration rate is surprisingly lower than that of Thailand and Malaysia and is the same level as it was in the US back in 1945. The middle class in China is growing larger and wealthier. Historically, there has been a positive correlation of wealth and life insurance penetration: as disposable income increases, demand for life insurance rises. Chinese life insurer AIA is well positioned for this structural trend, being in our view best-in-class in terms of both strategy and execution. In the first half of 2017, its value of new business, an industry-specific way to measure the profits generated from selling insurance policies, grew by 65% year-on-year.
AsiaFundManagers.com: How do you position your portfolio with regard to the inclusion of A shares?
Greg Kuhnert: The Investec All China Equity Strategy splits between the various markets (A-share, H-share and US listed) by allocation and selection effects. There is a strong record of stock selection, where selection effects dominate the alpha generation. All markets had positive attribution, with China A-shares contributing the most alpha. Our investment team is well equipped to invest in Chinese equities, especially in the A-share market. The index inclusion to Bloomberg Barclays Global Aggregate starting 1 Apr will bring in about $150bn of passive index flows over 20mths. To FTSE Russell’s World Government Bond Index is another $150bn, but starting earliest next year. To JPM GBI EM Global Diversified (our EMD local benchmark) is potentially $30bn, possibly by Q4 in 2019.
Emphasizing China A-shares
AsiaFundManagers.com: How do you split your portfolio between H and A shares?
Greg Kuhnert: There are nearly 100 Chinese companies that have multiple classes of shares listed domestically (A-shares) and in Hong Kong (H share, Red chip, P chip). In theory, the share price on both markets should be the same, save for transaction costs, provided they represent the same class of ownership. In reality, the same company may have a price difference as large as 300%. This inefficiency is partly explained by the closed nature of China’s capital account. But even after the launch of the Stock Connect scheme by the Hong Kong Stock Exchange (allowing for greater capital flow between the mainland and Hong Kong exchanges), the premium expanded rather than contracted and remains in a range of 20-45%. Seven of ten stocks in our portfolio are A-shares.
AsiaFundManagers.com: In the first few months of 2019, performance of the fund lacked behind the index. What was the reason?
Greg Kuhnert: In the months under review, the strategy lagged behind the MSCI All China Index (gross). Real estate stocks accounted for the largest drop in earnings. The share of real estate developer China Resources Land suffered from doubts about its profit margin as a result of the recent fall in real estate prices in China. In China Vanke’s case, investors feared that the lower property portfolio compared to competitors could lead to competitive disadvantages. The individual value with the largest reduction in earnings in the month under review was the Baidu Internet portal. The title reacted with losses to disappointing figures from the core search engine business. In the energy sector, China Shenhua recorded lower earnings; part of the recent increase was lost again.
AsiaFundManagers.com: Thank you very much for the interview.
Investec Asset Management
Greg is the portfolio manager for the Asia Pacific ex Japan and Asia ex Japan Equity strategies and also co-portfolio manager of the China Equity Strategy in the 4Factor Equity Team at Investec Asset Management.
Greg joined Investec Asset Management in 1999 working as an analyst researching Asian and global equities. Prior to this, Greg spent five years at Ernst & Young in Johannesburg, South Africa, within auditing and consulting, where he specialised in mining and financial companies. He qualified as a Chartered Accountant in 1997 and is a CFA Charterholder.