Wednesday, 24 June 2015 - 20:00
Seed Weekly - Why China?
We invested a portion of Seed’s multi asset unit trusts into a Chinese fund 8 months ago. At the time we received many questions about our decision. Some concerns included, “the Chinese economy is slowing down, surely this will result in poor returns?” and “China is also an Emerging Market (EM), why ‘waste’ your global exposure in another EM?” While, on the face of it, these are valid concerns I will discuss some of the thinking behind our decision.
Naturally there were (and continue to be) concerns about a slowing economy, but study after study has shown that there is no link between economic growth and stock market returns. Even if economic growth was a good predictor of returns, Chinese economic growth (despite slowing) is still far in excess of most other economies. As China moves from being a production lead to a consumption lead economy, there will be many bumps in the road, but that doesn’t diminish the opportunities to investors.
Further, the global research that we subscribe to from well renowned BCA Research had indicated for some time that Chinese equities were offering good value. The chart below comes from BCA’s quarterly Global Asset Allocation report at the end of Q3 2014. A similar picture had been painted a quarter earlier. Ultimately, starting valuation and growth in earnings are the biggest drivers of returns to investors.
With regards to the argument of not getting diversification benefits by investing into another EM may seem valid at face value, when digging deeper one can understand why this observation is, in fact, not true. There are a few factors that need to be taken into account.
Firstly, South African listed companies generate the majority of their returns outside of the country. While some of this is in other EMs, simple geographic listings no longer suffice when looking to classify market exposure.
Secondly, Chinese (Mainland listings) retail investors dominate trade (over 80%) compared to the local market that is dominated by institutional investors (probably close to 90%). These different types of investors invest in vastly different ways and therefore offer a level of diversification. As a result of this anomaly, there is also good opportunity for an investor with a well-defined process to outperform the market over time.
Finally, China is a net importer of resources, while South Africa is a net exporter of resources. Changes in resource prices therefore affect each economy in the opposite direction. Falling resource prices help to spur Chinese consumption, while in South Africa they negatively affect profitability, and put a dampener on growth.
With the arguments given above, it is no surprise that Chinese equities have a low correlation with South African equities. The chart below shows the correlation of South African equities versus a range of other markets (including China – CSI 300 Index). China is clearly the least correlated market with South Africa
Source: Prescient Investment Management
Make no mistake, Chinese equities are volatile and that is why position sizing is important when constructing a Fund. With a return in excess of 100% over this 8 month period, the position size (4% of Fund value) was, with hindsight, too low. We console ourselves that any position is better than no position though!
Such a large return over such a short period naturally brings questions of whether the Chinese market will still be able to generate acceptable returns going forward. It is interesting that this performance has only brought the market’s valuation in line with South Africa and US markets. The chart below shows the forward PEs of the three markets. While we have taken some profits to return the allocation to its target weighting, we continue to expect acceptable, uncorrelated, returns from this investment.
Source: Prescient Investment Management
There are other arguments in favour of this investment, such as the liberalisation of the market bringing a host of new market participants, and we therefore expect (subject to valuations not moving to high) that this allocation will form part of our Funds for some time to come.
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