- There are considerable opportunities in China for disciplined, fundamentally driven investors.
- Because the rally in China’s A-share market (shares that are primarily owned by mainland investors) was too quick and too strong, a pull-back in the market was not unexpected.
- The magnitude of the correction, coupled with the inability of policy to restore investor confidence, has been a surprise.
- Investor behavior is reminiscent of U.S. markets in 2008 and 2009, when liquidity dried up and many investors were forced to sell liquid blue chip companies over less-liquid smaller-cap securities. This created a significant opportunity for us then, and we believe this could set up a similar opportunity now.
- China’s medium- and longer-term secular tailwinds remain intact. Global geopolitical aspirations will drive China’s government to transition the Chinese economy from investment-led growth to consumption-led growth, and from the public sector to the private sector. The Chinese government is committed to expanding its economic and military influence in Asia and globally. Over the medium term, we’ve seen an opening of capital markets and a bid to internationalize the renminbi. (For more on our perspectives of China, read our recent blog “A Long-Term View for China”.)
Margin financing fueled much of the rally in Chinese stocks, particularly in less-liquid smaller-cap Chinese A-shares. As the market began to correct and many of these securities were locked down for multiple days, the sell-off spread to more liquid holdings. This week, the panic has spread to the China H-share, Taiwan, and ADR markets, as forced sellers with illiquid assets have sold anything liquid to meet margin requirements, including many high-quality H-share blue chip companies. As in the U.S. sell-off in 2008, many of the Chinese blue chips that have been caught up in the selling frenzy had not rallied to dizzying valuations nor have their fundamentals deteriorated, in our view.
A Closer Look at Valuations
During recent months, news coverage has focused on high valuations in Chinese equities. Less well known is that many of the most pronounced valuation dislocations were in the Chinese A-share market, with the media often quoting backward-looking P/E ratios or focusing on specific segments of the market. In our view, the valuations of many other Chinese stocks have remained at much more reasonable levels.
For example, as of July 8, 2015 the CSI 300 Index, a benchmark of the top 300 A-share stocks by market cap, traded at 13.6x forward earnings, which is 5-10% below historical averages. In contrast, the MSCI China Index (H-shares) trades at 7.4x forward earnings, more than 20% below its 10-year average, nearly 20% below the MSCI Emerging Markets Index and nearly 40% below the S&P 500 Index.
Our Approach in the Current Environment
Over recent months, we had been monitoring valuations and fundamentals, leading us to reduce exposure to several positions that became more fully valued. In some cases, we reallocated capital into more defensive convertible securities (see our recent post, “Investing in China’s Expanding Universe of Opportunity While Maintaining a Risk-Managed Approach” for more) as well as into more attractively valued equities. With the pullback we’ve seen in the H-Share listed market, we continue to focus on individual company fundamentals, valuations and secular trends where we can selectively allocate capital.
Our team continues to encourage investors to look past the short-term noise and remain focused on the longer-term potential. The economic transition that China is attempting is incredibly challenging. Right now, Chinese regulators have taken a kitchen-sink approach. While it hasn’t achieved the desired effect, it affirms the depth of China’s commitment to stabilize its markets. As always, our process and approach to investing in China focuses on understanding downside risks, and despite the market dislocations we’ve seen, we believe our approach positions us well for the eventual recovery.