China was one of the best performing emerging markets last year as the stockmarket soared. This result probably surprised many investors who are more familiar with gloomy warnings about the country’s slowing economy, overheating property market and rising debt levels.
The rally arguably reflected growing confidence about the country’s prospects: the economy performed better than expected while company earnings and cashflow also recovered.
However, the main driver of the China’s outperformance last year was undoubtedly the impressive performance of technology stocks. The MSCI China IT sector returned over 90% (in US dollars). And most of these gains can be attributed to just two stocks, Alibaba and Tencent.
Alibaba, an e-commerce firm, has benefited from the rapid increase of online shopping in China, while Tencent owns a very popular messaging application and sells smartphone games. The two large index constituents rallied amid considerable optimism about their growth prospects.
In our view, this is a clear illustration of recent investor behaviour in China. For the past few years, many investors in China have focused on companies related to the so-called ‘new economy’. With China seeking to rebalance the economy away from investment towards consumption, consumer-related stocks have been much in demand.
But this has driven the valuations of many stocks related to popular themes such as the internet, social media and consumer spending to elevated levels. As contrarian, value-oriented investors, we think there are currently attractive opportunities in the mainly state-owned manufacturing and industrial companies associated with ‘Old China’.
These stocks have arguably been overlooked recently as investors have concentrated on the consumer theme. However, profitability in sectors such as energy and industrials has risen recently, but valuations have not. We believe this is an interesting situation that could well reveal undervalued opportunities.
New look for Old China
Our optimism about Old China is supported by some encouraging government measures. Supply-side reforms are taking effect whereby the government are looking to increase utilisation rates by cutting excess, unproductive, capacity. We have seen material capex cuts and capacity reduction in industries such as cement, coal and steel being permanently cut.
Tackling pollution is another of the government’s priorities and as part of its environmental protection campaign, many of the most polluting projects have been closed. As a result of this reduction in capacity, we are seeing consolidation in several industries leading to fewer, larger and more efficient operators.
This reduction in capacity and increase in efficiency is importantly increasing profitability with companies now more focused on profitability and cashflows rather than just revenues.
Cleaning up the banking system
The improvement in these industries seems to be happening at the same time as we are experiencing an inflection in the Chinese banking industry.
Driven by the goal of financial stability the government has sought to reduce the amount of leverage in the financial system. In addition, policymakers have tightened regulations around shadow banking and clamped down on certain savings products.
These efforts appear to be having a positive effect. The level of bad debts in the system appears to be falling, partly because of the improving economic environment, but also as a result of the banks writing off or selling bad loans.
Encouragingly, there is now greater discipline around bank lending with the ability to lend dependent on a bank’s financial strength. In this environment, the better-run, more disciplined banks with the strongest balance sheets should benefit from greater pricing power.
For arguably the first time ever, in our opinion, there will be real differentiation amongst the banks. Furthermore, there is a general shift in the sector towards more profitable, less risky retail lending.
Given these changes, we believe that the leading Chinese banks could potentially sustain decent levels of returns over the longer run. However, the stocks continue to trade at attractive valuations.
Considering these developments, and after a recent trip to China where we met several companies, including banks, we are more optimistic about China than we have been for a long while. In general, the Chinese firms we spoke to were upbeat about their prospects, both in terms of robust demand and profit growth.
In our view, the potential improvement in performance of these companies does not appear to be fully appreciated by the market.
Big year for China
The government’s initiatives are very timely. 2018 is a big year for China as local stocks, so-called A shares, will be included in MSCI’s global emerging index for the first time. Although they will only be a small representation initially, this development means China is destined to become an increasingly important focus for global investors in the coming years.
Many investors remain pessimistic about China’s prospects. The government faces a huge challenge managing the transition to consumer-driven growth, while keeping the economy on track. However, we are optimistic that the considerable reform agenda underway is likely to have a positive impact on the country’s fortunes, while creating attractive investment opportunities.
China’s stockmarket remains attractively valued in our view. While the MSCI China Index trades on a price-to-book ratio of 2.1x, valuations in areas like financials are much more promising. The MSCI China financials sector trades on a valuation of 1.1x. (data as at end of February 2018).
In our view, the steps taken by the government in the Year of the Dog to tackle the current problems could create an environment that brings investors good fortune in the years to come.