Reasons to tell your clients about China

Agnes Deng, investment manager of the Baring Hong Kong China fund, looks at the prospects for the global powerhouse.

China’s economy enjoyed a vigorous expansion in 2009 and growth remains robust. According to its July 2010 World Economic Outlook Update, the International Monetary Fund (IMF) expects China’s economy to grow by 10.5% in 2010 and 9.6% in 2011. In contrast, the IMF predicts that leading Western economies will experience comparatively sluggish growth this year and next. According to the IMF, the US economy will expand by 3.3% in 2010 and 2.9% in 2011, while the UK economy is expected to grow by just 1.2% and 2.1%.

Despite its superior economic growth prospects, China’s equity market has been a disappointing performer year to date. Concern about the authorities’ action to cool the economy has been a factor. In early spring, in response to clear evidence of a strong rebound in manufacturing, a revival in export industries, rising commodity prices and a significant recovery in asset prices, central banks started to consider stepping back from super easy monetary policies.

With China’s economy having experienced one of the sharpest “V” shaped recoveries, the authorities acted to cool growth via a number of strategies including allowing a currency revaluation, bank reserve adjustments and regulatory measures to address the housing boom.

As 2010 progressed, apprehension that the global economy could be facing a double-dip recession has grown. At the time of writing, these concerns persist, exacerbated by weak US economic data releases and recurrent concern about the health of Europe’s banking sector. The net effect of this has been that investors have preferred to hold safe-haven assets like US Treasuries and gold at the expense of both equities in general and emerging market equities, in particular.

Authorities in control

Looking ahead, there are grounds for optimism. We believe concerns about a hard landing in China are overdone and that the authorities are likely to successfully engineer a soft landing. Furthermore, China is in the midst of transitioning its economy to one that is more consumption focused.

In this regard, the decision to move away from the peg to the US dollar in favour of a “managed float” against a basket of currencies, is a step in the right direction. The benefits of a stronger currency will support domestic consumption by boosting the international purchasing power of Chinese consumers. In addition, it should also help contain inflationary pressures arising from imported goods, thereby reducing the probability of aggressive monetary tightening.

Appealing opportunities

So which areas of the market look attractive? Our bottom-up research suggests some of the stocks with the strongest earnings growth prospects can be found in the consumer discretionary sector. The healthcare sector also scores highly.

We are relatively cautious on the more defensive areas of the market such as telecoms, utilities and energy, where a combination of increasing competition and capped tariffs do not make for particularly attractive investments, in our view.

The healthcare sector fits with our growth at a reasonable price philosophy, with potential for strong long-term growth as demand for new products and services expands. Among our favoured positions is pharmaceutical distribution company Sinopharm, which has the resources to continue to grow through acquisition.

In the consumer discretionary sector, CTrip, which dominates China’s online travel sector with a market share of around 70%, compared to around 3% for its closest competitor, is a key holding. It is cash-rich, with high profit margins, and able to fund its own expansion. In recent years it has grown aggressively, at an average annual rate of around 35%. CTrip’s ability to deliver strong value-for-money travel options to China’s growing middle classes has tremendous growth potential, in our view. Already, leisure travel is extending beyond provincial capitals and the national ‘first cities’ and spreading to Hong Kong, Taiwan and further afield.

At the other end of the spectrum, we hold a position in China Shanshui Cement. Despite its short-term underperformance, as investors have eschewed economically-sensitive cyclical stocks in favour of more defensive areas of the market, we believe China Shanshui has good long-term growth prospects. It is a company with pricing power and a unique business model which allows it to impose stringent cost controls. The majority of its business is in public sector, providing a relatively secure long-term revenue stream.

Our key message is that, whilst the performance of China’s equity market has been disappointing so far this year, we think it has created some genuinely interesting buying opportunities. We are using periods of market weakness as an opportunity to build positions in attractively valued stocks which we expect to deliver strong earnings growth in future.

Agnes Deng, investment manager of Baring Hong Kong China fund