16 September 2019
Joining Paras Anand, Head of Asset Management in Asia, to take a closer look at China's equity market are Jing Ning, a senior portfolio manager at Fidelity with some 20 years experience investing in the country, and Casey McLean, an investment analyst with a focus on China's technology stocks. With additional contributions from portfolio manager Hyomi Jie and Fidelity's head of Asia trading, Kelly Clark.
Ways to listen
Listen to Episode 1 here:
Paras Anand Hello and welcome to The Investor’s Guide to China from Fidelity International. I'm Paras Anand, Head of Asset Management in Asia-Pacific, and each episode I'll be taking you deep into China's economy to find out what's driving the country, where the exciting opportunities are and perhaps areas where we should be a little bit more wary. Today: stock picking - the art and science of researching and understanding which companies to invest in, whether those be SOEs - state owned enterprises - or POEs - privately owned enterprises - acronyms you'll be getting very familiar with.
China is in many ways still an emerging market and it comes with its own idiosyncrasies. But as markets continue to open up - and there's been big news just as we record this episode - China offers significant rewards if you have the right tools. And bringing their toolboxes with them today to join me in Hong Kong are two of Fidelity's China experts. First we have Jing Ning, one of our senior China equity portfolio managers. Jing you've been looking at this market for some 20 years. What's the biggest misconception that you tend to come across when people think about investing in China?
Jing Ning Every year I meet probably dozens of investors, they’re very interested in investing in China and they want to know what's going on from the policy and consumption story and new technology in China. But with that being said I can't feel there’s always a wall of worry with China. Everyone is asking about: China has been growing their credit very rapidly in the past decade and when is it going to stop. They've been building the bridges and railways and infrastructure investment - when is it going to be stopped? And I think the more pessimistic question is always asking, when is the reckoning moment that's going to come? So there hasn't been a year - I can be very honest with you - there hasn't been a year, if I visit my investors globally in Europe and Asia, that they I haven't asked this question, right. So there’s always been this wall of worry on China.
Paras With Jing is Casey McClean. Casey, you’re an investment analyst who's covered Asia Pac for almost two decades. The last 13 years you've been really focused on China. You've covered almost every sector during your career in the region. From an analyst’s perspective, what are the big changes that you've observed?
Casey McLean I think the biggest changes specifically with China really is the composition of the market. I think if you look back 10, 15, 20 years ago it was dominated by industrials, materials, financials, property. China was back then really the outsourcing factory for the rest of the world. But if you look at the market composition now it's changed a lot. You’ve had the emergence of internet. There's a lot of consumer brands with their own genuine brand value in China. And there's more and more services being delivered in the market every day. I think what's changed is China's gone from a an industrial manufacturing centre to a place of genuine innovation. And that innovation is being rewarded in the market as well.
Paras So let's dive into the topic of today's podcast which is stock picking. Jing, how do you go about stock picking and what makes your investment approach unique?
Jing You know China's an emerging market. The market is quite chaotic. Everyday we're dealing with policy changes, new competition, and there's always new changes to business models. I think for investors in the China market you really have to know your company well and it takes years, sometimes it takes ages to know the company, especially [because] you know your company better in a downturn than in the good times. Sometimes I tell my investors, although there are so many noises flowing around in the China market every day the key is to build conviction and what comes with the conviction is to know your company really well. And that takes time.
Paras And Casey, how do you distinguish a good company from a from a bad company in a market like China?
Casey For me, the first point of my process when I'm looking at a company will be to screen out any bad actors by looking for stocks that are potentially accounting manipulators or have some bankruptcy risk or what not. But I try and look for companies that have a minimum level of quality. I'm not saying high quality, I'm saying a minimum level of quality - one that's able to earn a return on invested capital above its cost of capital across a full cycle. There's a lot of cyclical companies in China, especially within the tech sector which I'm looking at. So I don't worry about what they earned last year, I worry about what they're going to earn next year. And if you pick a stock at the right point of the earnings cycle you can be rewarded for that.
Jing Yeah, I think another thing is that most people coming to China are looking for growth. They're looking for the next Alibaba, the next Tencent, and people are constantly looking for the next growth story. But Paras, as you know, I’m probably one of the very, very, few value investors in China and actually I think that value plays a very interesting angle in China. The value story in China is not dull at all, it’s quite interesting. For example, Casey and I, we looked at a company called Lenovo. It was two years back and at that time Lenovo didn’t fit into any definition of a growth company. But when we looked at it, it used to have a great company history and it got into temporary trouble and we believed that the company still had a decent chance to turn around and to be a growth company sometime, a couple of years later. Would you say Lenovo was a value stock or growth stock? I would say it’s a very interesting growth stock but with an extremely attractive valuation at that time we looked at it.
Paras Was it hard to get excited about Lenovo, Casey, as a technology investor?
Casey Lenovo is probably not quite at the leading edge of some of the technology companies that you can look at out there. But I agree with Jing, it was very attractive value. It was spinning off a lot of cash flow from its main division which was PCs and if you could get confidence in their mobile division - which has been loss making for a long time - if you got confidence in that turnaround story there was a lot of money to be made. And so you do need to have very high conviction in those turnaround situations. But doing a lot of work and sitting down with management - we had a full day with management and every head of every division - we were able to gain that conviction. And fortunately that division did turnaround quicker than the market was expecting and they've gone on to do better things.
Paras Turning to Jing, you talked at the beginning about this ‘wall of worry’ that investors often climb and one of the things that's often reflected to me is that corporate governance is a huge area of concern. People worry about protection for minority shareholders being different to what you might see in other parts of the world, balance sheets, ownership structures can often be sort of convoluted. So how do we consider those risks. What do you consider when it comes to corporate governance?
Jing You cannot invest in China without thinking about corporate governance risks, that’s for sure. But for me, I think about the issue as many different layers of grey rather than straight black and white. Because when I talk to many companies, and sometimes they do things I wouldn't like them to do like related party transactions and they do irrational acquisitions. We you ask them, ‘Why you are doing that? You’re destroying minority shareholder value. As a result, your market value has been going downhill. And the usual answer I get from them, amazingly, is, ‘We don't think it’s a big deal. Why do you think it’s a big deal?’ It’s all about corporate culture and the way they think about what is a right form of governance for the minority shareholders. I think Casey, you probably agree with me, that the active manager plays a role here?
Casey Yeah, definitely I agree. I think there is perhaps a perception and a reality that the level of corporate governance in China is lower than in some of the developed markets. But what I try and focus on is the delta in that corporate governance. It's the improvements which drive better quality in the companies and potentially the re-ratings in stocks. And you've seen evidence of that over the last few years particularly among some of the bigger SOEs who have really improved their capital allocation and doing a lot less national interest investing.
Paras And you've talked a lot about this idea of trust and building trust in companies. How do we do that? How, Jing, in your process do you go and build trust in companies and the management teams that run them?
Jing For me, people are the number one top priority in any business you look at. So usually when we meet a new company, identify a new interesting investment idea, the first step is you go to meet with senior management - CEO and CFO - but I don't think the research work usually stops here. Usually we'll try to meet further staff to try to meet the middle layer of the management - we want to meet the head of sales, the head of marketing, the head of PR and to understand the culture. But that takes time.
Casey That's right. I think increasingly over the last few years we've been engaging, collaborating with companies a lot more and they're a lot more open to these discussions, dialogues, two-way streets here. We're not an activist investor in any way but we're trying to work together to generate better shareholder value.
Paras So you actually feel your voice is being heard. When you go and see these companies and you engage with them, you feel that even as a minority shareholder your voice is heard and listened to.
Jing Yes, sometimes. Every year we try to identify some companies and we send angry letters, we call them angry letters - just basically complaining about something that they have done, not taking care of the interests of minority shareholders. Sometimes they don't pay us dividend and sometimes we think they should do more. In the beginning most of our letters get ignored and we get no consequence whatsoever but gradually, very interestingly, and I think Casey would agree with me in the case of Sinopec, we sent a letter to them, to the board, asking for a sustainable dividend payout policy and they actually responded to us and said they would seriously take a look at our proposal. I'm not anticipating any fireworks coming at the end of the day, they're going to change their behaviour overnight, but that's a very encouraging development I would say.
Paras And looking at the composition of the market, they're obviously state-owned enterprises as well as private companies. Casey, should investors approach those differently?
Casey Not necessarily. At the end of the day you're just trying to find a company that's going to deliver a good return. But I think there's different risks that you need to be aware of when you're looking at those two different groups of companies. In private companies the potential for fraud, accounting manipulation, those things are probably higher. And they're also smaller, more nimble companies. They can move fast - they can break things though at the same time. Whereas you look at some of the SOEs, they're larger companies, they move more slowly. And I guess the biggest risk with those is that they have to undertake national interests and support the Chinese economy and other companies.
Jing I think that basically what Casey is saying is there's always two sides of the same coin. SOEs - they’re taking the state support but on the other hand they will of course take on social responsibility, and private companies, they’re very nimble and very flexible but on the other hand they have a very strong incentive to do well and of course they will have incentive to cheat you to maximise their shareholder value.
Casey But there can also be a valuation disconnect. Often the SOEs trade at a big discount to the private companies. And like we say, if you see this delta, the improvement in corporate governance or their earnings profile, that can be a great opportunity especially for a value investor like Jing.
Paras So it really seems that it's all about making sure that you understand the individual company and doing the on-the-ground research.
Casey Yeah, that’s right.
Paras Well, on the subject of on-the-ground research we spoke earlier to another one of our portfolio managers, Hyomi Jie. Our Asia Editor, Neil Gough, caught up with her for some window shopping in Shanghai to hear about her approach to consumer stocks and in particular how the trend of premiumisation is playing into her investment thinking.
Neil Gough I'm standing here at a sprawling hypermarket in Shanghai with the Hyomi Jie, a portfolio manager at Fidelity International who focuses on China's consumer sector. We're at RT Mart in Yangpu, a mainly residential district a few kilometres north of Shanghai's historic riverfront Bund. It's a typical weekday morning in the summer and the store is busy with all kinds of shoppers from across generations. They're picking over produce, looking for bargains, stocking up on bulk items like rice. And this is a retail supercentre. They sell everything from leather shoes to air conditioners to live lobsters. Hyomi, you actively stock pick within China's retail sector and I'd mentioned to you previously that I was interested in seeing how you carry out research on the ground and I assume that's why you brought me here today? Is that right?
Hyomi Jie Yes. Yes exactly. You come to this store and you see what kind of consumers are coming to the store and what kind of things they're buying, in which aisles they're spending more time. So that helps me to gain a bit more insight into what kind of brands are gaining traction and what kind of products are gaining interest from the everyday consumer.
Neil One of the trends across the consumer space that we talked about before was premiumisation and how customers are upgrading their purchases across a whole bunch of different categories. How does that play out in an environment like this, in a supermarket?
Hyomi Premiumisation is a trend that's going on across all the sectors in consumer, I should say. It's really driven by the growing income of Chinese consumers and expanding middle class and their desire to want and aim for higher quality products. And in a supermarket environment you can see that people will choose higher quality, higher price items within the same brands, or they might move up to the perceived higher-end brands. But also within the fresh produce that is happening as well. If you see that in the traditional supermarkets you can see the piles of meat products in the very typical Chinese supermarkets.
Neil And some in front of us here today. I see the butcher swinging his cleaver here in the background.
Hyomi That’s right, that's very normal and that's still the majority. But you can see in a small section, which is expanding, you can see that there’s branded pork, branded beef, and it is packaging in a small format that's suitable for a single households and younger generation who don't want to spend too much time cutting and cooking.
Neil So individually wrapped in plastic as opposed to a giant slab of ribs or something like that.
Hyomi Indeed. The per unit price should be higher by easily 20-30 per cent but from consumers’ perspective maybe you can actually save food by not buying too much at once. Also it's much easier for you to prepare your food.
Neil So you're paying more per unit but you're probably wasting less on the whole. What does it mean for a company at the bottom line level? Are you seeing that feed through in revenue and in sales?
Hyomi It's still a small portion of their revenue but the companies who can take advantage of this kind of trend with better marketing and better merchandise will obviously be able to attract more customers to lead to better revenue and at the product level, at the unit level, they should be able to generate better returns and better margins.
Neil Beyond supermarkets, when you look across retail, what other areas are you seeing premiumisation playing out? What are some of the other sectors?
Hyomi I should say that in services the premiumisation is also happening. The overseas travel has been growing faster than domestic travel in a very consistent way for the past few years. And that’s shown in the duty-free stores’ revenue growth trends in the past few years.
Neil And then when you're not running around the aisles of supermarkets like these what are some of the other things you're doing on the ground to carry out research when you're coming to China? Because I know you do travel here quite often.
Hyomi When I come to China I try to spend my time here as much as like locals. So, I take Didi and go to other department stores or I go to meet my friends and on the way I get to see many different things like what's happening, what's changing. Also, the payment pattern is definitely changing in China. So, it is indeed a cash free economy at the moment. You really need to pay for things with Alipay or Tenpay. Another thing that I have been doing for more in-depth research is to spend a couple weeks with a Chinese family doing homestays. So last year I spent two weeks in Shenzhen with a Chinese family of four members where I could learn about their consumption behaviour, their aspirations, what they care about for their children and their parents and their wealth creation, all these things. Soon I'm going to go to Chengdu and will spend another two weeks with a Chinese family over there.
Neil Thanks Hyomi. That's a really interesting look at how stock pickers are doing their research on the ground in China.
Paras So Jing, Hyomi paints a rich picture there. She's spending time in the new engine room of the Chinese economy as we can hear, in these shopping malls and spending time with families, really going in deep to help her understand the country's changing consumer trends. But stepping back a little bit, what about the equity markets more broadly. How have they been developing?
Jing I think there is a key element currently missing from the whole story which I think is very important going forward which is the income element in China. The income story globally has been a very popular strategy but very few people associate China with the income element because people come here looking for the growth story, they’re not looking for the dividend story. But China is actually changing into a very interesting income story. We're not growing 10 per cent every year, right? This year we're growing six, next year we’ll probably be growing at five or something. But for corporates they’re free cash flow is improving and with cash coming in they now have an opportunity to think about another capital allocation perspective which is paying dividends.
Paras I mean when I think back to some of the changes we saw in the European market, so going back 10, 15, 20 years ago, companies were prevented from paying dividends because boards would often think that you were taking money out of the out of the pockets of the employees and giving it to shareholders. But I've always thought that there's an association with companies paying dividends and treating minority shareholders well with a maturity of an investment market. So, Casey is this good news from an analyst’s perspective?
Casey Yeah, it definitely is Paras. I think the thought process for some of the Chinese companies in years gone by was that dividends were simply paying money out of the company away to foreigners. That's gradually changing and I think there's a recognition that the capital structure is more important. And they have made some significant progress. It's been helped by the government: SOEs are now mandated to pay out 30 per cent of their earnings. And I think if you look at the market as a whole I think it trades on about a 2.5 to 3 per cent dividend yield, which is actually higher than the US, the S&P 500. So, it's still got a long way to go but they've definitely made some significant progress.
Paras And of course it's such a strong signal of the continuing evolution of these markets. As I mentioned earlier in the introduction there's another significant development, which is that the Chinese regulators have dropped quotas for foreign institutional investors, or QFII. This is a really big deal, isn't it Jing?
Jing It is. It is indeed a very big deal. That means that the market will in some way become open access for everyone. You don't need a quota to buy China A shares. That actually brings a sweet memory for me. I remember back in 2004 I was at the door of CSRC [China Securities Regulation Commission] applying for the QFII license and applying for the QFII quota and we got thrilled when the regulator awarded us $50 million QFII quota. And we thought that was quite an achievement back in 2004. And now, 15 years later on you don't need a quota to buy China A shares - very exciting as well. So, I think that with the years it’s moved along, and without a quota or any kind of restriction tacked on to it that just means that the market becomes a very friendly, even playing field everybody.
Casey Yeah, I remember I had a similar circumstance about 10 years ago, as well. I remember applying for an additional QFII quota and the process was very laborious, very bureaucratic. It was almost government-to-government-style negotiations and removing that sort of hindrance to foreign investors is a huge plus for the opening up of the China markets.
Paras And obviously when we think as investors we're always thinking about investing for the long term and there's a difference that often people think about between long term investing and and then thinking about the market in China which they see as being very volatile and retail driven. Do you think that there is an opportunity to reframe the investing proposition for those domestic savers?
Casey Yeah, I think it's a gradual process. But all of these measures that the government’s instituted to get foreign investors, foreign institutions investing into China means that they're less driven by speculation, they become less short term, the market becomes much more fundamental-based. And I think if you have a long history of following those fundamentals you’ll have a big advantage in the A share market as it develops.
Paras So what exactly do recalibrations like these mean on a practical level in terms of trading with and inside the country? Investment director Catherine Yeung spoke to Fidelity's head of trading in Asia, Kelly Clark, to find out. And a short caveat before we hear the interview: this conversation was recorded before the latest announcements around the scrapping of the QFII quotas.
Catherine Yeung We've seen a whirlwind of changes relating to access and regulation for trading when it comes to the Chinese markets. Volumes have skyrocketed but there's still a number of hurdles to navigate. I'm with Kelly Clark, Fidelity's head of Asian equity trading, based here in Hong Kong. Kelly, you've been in the market now for eight years. Can you share some of the biggest changes you've seen over this period?
Kelly Clark Sure. For starters, when I first started trading the only way to access China was through QFII. And I was actually at a hedge fund at the time so the only way we could do that was synthetically, which made it very difficult and very expensive to actually access the market. So, I would say the biggest change in my tenure has been Stock Connect, which went live in 2014 and that was far more affordable to reach. You didn't have the issues with putting cash upfront or with repatriating cash back out of China. So it made it much more palatable to invest in. That also piqued the interest of the MSCI and FTSE and why you have the interest I think you have in it now.
Catherine So, in layman's terms, Kel, what's the key differences between QFII and Stock Connect, especially from a trading perspective?
Kelly You've got the ability to trade with different counter parties, again you can move cash more freely, it's a lot more familiar and the counter parties that you’re trading with as well. It was just a lot easier to access and open accounts.
Catherine With QFII?
Kelly So QFII still has its advantages. You can trade during Hong Kong holidays, which you can't do through Connect. You can also invest in the full universe of stocks versus the limited amount that you have in Connect, which is about 1200. The bigger one being now that it's the only way that foreigners can access the Star IPO Board.
Catherine Yes, the Star IPO Board, I'm glad you mentioned this - so this is a science and technology exchange similar to Nasdaq?
Kelly Correct. So I think the driver of this, as you mentioned, was for the Nasdaq. So for new sort of unicorn tech type companies to come to market within China.
Catherine So we are seeing more foreigners - whether it's institutional money, retail money - going into the market. This is obviously being driven a lot by the Chinese government's policies to open up the capital markets, both equities and fixed income. So when we have the second largest economy in the world, a government who's very pro opening up the capital markets, can you please put into perspective just how big China is?
Kelly So China actually represents 70 per cent of all of the turnover in equity in Asia.
Catherine If we're seeing all this turnover, is it an easy market to trade?
Kelly It's a liquid market to trade. I wouldn't qualify it as easy because it's actually still very volatile considering you've got the retail investor base that you do. I think there's still a few hurdles in getting more foreign investment into China. One of them being access to hedging instruments, so futures would be the main one there that everybody's looking for as a way to hedge out their index risk. So, there are there steps that the government's taking there or that the exchanges are taking there too in sourcing solutions for that issue. There's also a number of nuances still around settlement cycles, funding, broker settlements, but again they're pretty small nuances and the government is focused on getting those looked at.
Catherine Kelly, thanks so much for your time. I mean it's a fascinating market to trade and to watch the developments in terms of the progress. Paras, that's all from us here on the trading floor in Hong Kong.
Paras So Casey, with your tech focus on China what do you make of the launch of the Star Board that Kelly just mentioned?
Casey Yeah, the Star Board is a really interesting development. It's another one of these baby steps to opening up and broadening the Chinese markets. But I think the fact that it's a registration rather than approval structure to list a company there is is quite important. It means that these loss-making companies, these high-tech companies which are innovating, can list and it gives them a new source of funding. I think from then from investor point of view it also opens up the opportunities to some of these smaller innovative companies that were probably only available to PE or VC type investors previously.
Paras And Jing, you’re a self-proclaimed value investor. Have you been looking at technology stocks at all recently?
Jing Of course. Actually, last year a very decent amount of my time was looking at the technology sector, in particular in the context of the trade war between the US and China. A lot of technology stocks were falling victim because of that and valuation for some of them looks really, really compelling even from the perspective of a value investor.
Paras Trade wars was one of those things that we talked about on the last episode and we made a call that it would be not a short-lived phenomenon and so it's proved. But for a stock picker such as yourself, Casey, how do you deal with a backdrop of trade wars when you're trying to find individual opportunities.
Casey Like Jing says, the tech sector really has been in the crosshairs of the trade war and the volatility that that's brought has made it quite difficult, especially when the sentiment of the market can turn on a dime after just a single tweet. But having said that, it did introduce some value into the sector and there have been buying opportunities. And if you focus more on the longer-term trends there is an opportunity for Chinese companies to become more self-sufficient in some of the tech areas, take some revenue, some business opportunities off the US companies. And so I am increasingly looking for those opportunities on a long term basis.
Jing I think like the Chinese always say, every crisis comes with an opportunity. So when we think about a trade war of course the relationship between these two countries - I think, in my personal view - is fundamentally changed going forward. But that actually leaves an opportunity for China to rethink its supply chain. They want to reduce their dependence of some of their key supply chain components to external parties and they want to rebuild some of the supply chain companies. And, of course, they want to build a domestic economy to fend off any uncertainty coming from global trade. And I'm hoping that this trade war will push policymakers to really seriously think about market reform because when one door is closed you want to open the other window.
Paras So it really sounds like when we come to think about China from a stock picking perspective that despite all of the development of the market, all of the maturity and some really key changes that we've talked about with respect to companies looking at returns to minority shareholders, actually there's no shortcut to doing your homework properly.
Jing Of course. For me, I have been investing in China for the past 15 years. That market for me today versus 15 years ago is equally challenging, equally new, and equally interesting. It’s just like a brand new market.
Casey Yeah, I don't I don't think there's any substitute for boots on the ground and kicking tyres.
Paras Great. Well that brings us to the end of our show today. Thank you to my studio guests Jing Ning and Casey McClean, and to our other contributors: Hyomi Jie and Kelly Clark with Catherine Yeung. And thank you for listening. If you like what you've heard then please rate and review us on your podcast app, we really appreciate it. And if you want to read more of what's been covered today then please go to our website. Our producers were Seb Morton-Clark and Neil Gough and our editor is Richard Edgar. Until next time, from Fidelity's Hong Kong studios, goodbye.
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