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James Carthew: has China’s transformation been overlooked?

James Carthew: has China’s transformation been overlooked?

There are only two investment companies that focus solely on China: the £1.2 billion Fidelity China Special Situations trust (FCSS) and the £180 million JPMorgan Chinese Investment Trust (JMC).

JMC has performed well over the past year, returning 56% in net asset value (NAV) terms and 65% in share price terms. By contrast, FCSS grew its NAV by 53% in and saw its share price rise by 58% over the same period. These impressive gains might cause investors to wonder how much longer the party can go on for.

The first thing to note is that both funds trade on fairly wide discounts to NAV, 13% in the case of FCSS and 14% in the case of JMC. Those discounts aren’t unusual, however. If anything, they have narrowed over the past few months. This might suggest that other investors aren’t feeling too nervous about China’s prospects.

A few weeks ago, Citywire + rated Dale Nicholls, manager of FCSS, said that Chinese equities continue to offer notable investment opportunities.

'Broader long-term trends, such as the development of the middle class remain in place, and this creates stock picking opportunities. There is also great variation in trends between different parts of the economy,’ he commented.

At the end of May, Nicholls’ trust had net gearing, or borrowing, of 21.1%. The equivalent figure for JMC was 6%, in a typical range of 20% gearing through to 10% net cash.

The JPMorgan team, comprising Howard Wang, Emerson Yip and Shumin Huang, do not appear to be overly worried about the state of the market either.

‘The valuations of both onshore and offshore listed Chinese companies are still at reasonable levels after the recent rally,’ they noted.

Evidence of further deep structural reform should provide further stimulus to any re-rating, the team added.

Performance drivers

Some of the recent performance from these funds has been driven by the weakness of sterling relative to the renminbi. The relationship between the two currencies has been volatile over the past year but, overall, sterling is down about 11% since the eve of the Brexit vote.

Private investors own a large proportion of the domestic China A-share market. The net result of this is that flows in and out of the market creates significant volatility in share prices: talented fund managers are able to exploit valuation anomalies when they arise.

While individual stocks trade at very high ratings, the overall Chinese market is not excessively expensive relative to developed market peers. The forward price-to-earnings (PE) ratio on the MSCI China Index at the end of May was 12.7 x, which compares with 12.2 x for the MSCI Emerging markets index, and 16.2 x for the MSCI All Countries World (ACWI) Index. The PE ratio measures share prices relative to per-share earnings.

Baby step forward

The make-up of the MSCI China Index is also poised to change. In a year’s time, the index will include domestic large cap Chinese A-shares. However, only 5% of the market cap of each stock in the A-share market will find its way into the index.

It is a baby step forward, especially as MSCI has not given any indication of when the 5% limit might be increased or when it will consider including mid cap stocks to the mix. However, all being well, over the medium term the Chinese market should come to dominate regional and emerging market indices even more so than it does today.

For the moment, a few large stocks have a significant influence on the MSCI China Index. Tencent, Alibaba, China Construction Bank and China Mobile collectively comprised 37% of the index at the end of May.

FCSS and JMC have no exposure to the latter two stocks, but both funds have reasonably large positions in Tencent and Alibaba.

In some ways, these two companies sum up the enormous change that is taking place in the Chinese economy, away from state-driven manufacturing and infrastructure investment to consumer-led retail and services.

Do we, in the West, underappreciate the pace and depth of this transformation? We obsess about Facebook, Amazon, Alphabet and Apple while their Chinese competitors match, or sometimes exceed them, in technology and reach.

It is a peculiarity of the investment companies market that there aren’t as many funds focused on the US market as there could be given the size and sophistication of that market. There appears to be a similar situation with China. It is possible that, barring political accidents, in a few years the Chinese market could match that of the US in terms of size.

There’s room for the two existing investment companies to expand but might there also be scope for new, more specialist launches focused on that country?

Equity markets everywhere are trading at or close to highs and you may think this is a good reason to feel cautious in the short-term. Over the long-term, however, it may become commonplace to have some exposure to the Chinese market and it could even prove to be a good long-term investment.

James Carthew is a director at Marten & Co. The views expressed in this article are his and do not constitute investment advice.

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