Mandarin identifies winners and losers as China reforms old economy

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Lan Wang Simond (LWS), head of Greater China long/short equity strategy (Mandarin) at Pictet Asset Management explains how investors can benefit from China’s reform drive.

China is accelerating the pace of its financial market reforms. How will this open up opportunity for foreign investors?

LWS. We think overseas investors will be a great beneficiary of Beijing’s recent moves. The launch of the Stock Connect, a new trading scheme which enables investors in both Hong Kong and Shanghai to buy shares in each other’s markets directly for the first time, is a small but important step in the process.

Under this scheme, overseas investors can directly buy Chinese equities worth up to USD2 billion a day without the need for a special license. The new programme is likely to help make the renminbi (RMB) more convertible, reinforcing its long-term appreciation against the USD.

The cross-border programme will also help bring a wider variety of participants into the marketplace, which is currently dominated by retail investors who tend to trade much more frequently than their institutional counterparts. This is evident in share turnover velocity in China1, which is seven times higher than that of US markets.

The Chinese market is indeed prone to erratic price moves. This volatility was most recently evidenced in early December, when the Shanghai Composite index rallied to a 3-1/2 year high only to sharply reverse course later in the day to post the biggest daily percentage decline in five years.

In a way, China’s stock market is at the same stage in its development as Taiwan’s was in the early 2000s, when share turnover velocity was as high as 8 times the market’s capitalisation, in a market dominated by domestic retail investors. The velocity has since fallen as more institutional investors participate in trading.

In our view, diversifying the investor base represents a key phase in the evolution of the Chinese market. This is because it would lead to a more sophisticated market where prices are driven less by momentum and more by data and value-based analysis. We believe this would make it more attractive for foreign institutional investors.

Why would investors want to buy Chinese stocks at a time when the economy is slowing down further?
LWS. In my view, economic fundamentals do not always translate into stock market performance. As equity investors, we don’t particularly want runaway economic growth. Unsustainable growth is just that – unsustainable. We like a benign economic climate where companies can grow their bottom line – or net profit.

China has never been short of top-line growth – witness the double-digit GDP expansion over the past decade or so. Yet, in order to sustain that growth, companies had been under constant pressure to raise capital, in the form of equity or fund share placements.
This is not an environment that tends to reward existing shareholders. Moreover, because of falling margins, companies had little pricing power and many industries suffered from overcapacity; as a result there was no single dominant player who could grab a lion’s share of the markets.

Now that the economy is gradually slowing, we will see increasing consolidation in industries – helping sector or regional champions to emerge. Beijing’s reform drive is fanning M&A activity in China. For example, Sinopec, China’s second-largest oil company, sold a 30 per cent stake in its retail unit for USD17.4 billion in September, which was the country’s biggest M&A deal in 2014. M&A activity involving onshore Chinese companies totalled USD147 billion in 2014, up 24 per cent from the previous year.3

We believe we are only at the very beginning of this consolidation process, that could take five years. This is a great long-term opportunity for investors.

There is no strong correlation between growth and equity market returns. During the late 1980s to early 1990s, Europe – deeply in recession – experienced a decade-long bull market in equities. Industrial consolidation played a key role – at the end only the fittest survived. For example, Switzerland has seen the number of pharmaceutical giants fall to just two – Roche and Novartis – from more than a dozen.

The government is trying to shift China’s main source of growth from exports to domestic consumption. Does this mean investors should only focus on New Economy companies?
LWS. Not necessarily. The New Economy sectors – such as Internet – are indeed booming, and we can easily find both top line and bottom line growth. But it is in the Old Economy sectors where we see unique investment opportunities. Because of environmental concerns, the government wants to streamline heavy industries, such as cement and steel, and reduce the number of companies. We think companies such as Anhui Conch Cement will emerge as a strong Old Economy winner in the next few years.

You have been bearish on Chinese financials for some time. Is this still the case? And what are other interesting trades do you currently have?
LWS. We have turned neutral on the banks, having been short over the past year. In our view, the bad news are already priced in while the opportunities to short financial stocks are becoming rarer. We are overweight the utility sector where we can find a number of high dividend stocks at an attractive price.

We also do some company-specific pair trades that mix both long and short positions. We have a few pair trades in the housing sector, whose slowdown brings a number of event risks, in our view. These risks include financial difficulties and bankruptcies at certain companies. The property sector also has some policy risks, as the People’s Bank of China has been implementing targeted measures to support the market.

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