John Ventre, head of multi-manager at Old Mutual Global Investors and responsible for more than £3 billion of assets, is an active investor who backs other active funds. But in one market he has concluded that the only way is passive.
China first caught Ventre’s attention when he noted that it was ‘the cheapest market in the world’. The index in which Ventre (pictured) has invested – Hang Seng China Enterprises – has an average price-to-earnings ratio of 8.7. ‘It is pretty obviously attractively valued.’
The Hang Seng differs from the broader MSCI China index, which trades on a multiple of 10.1, in excluding mid-caps. It therefore has a stronger bias to the unloved China, with for example a 61% weighting to financials and 21% to energy compared with the MSCI’s equivalent exposures of 39% and 15% respectively. Hang Seng has nothing in information technology, a sector that accounts for 9% of the MSCI basket.
‘China is actually low risk, given the good margin of safety and the potential upside if the government gets things right,’ says Ventre. ‘The downside is the government has got things wrong for some time now.’
So what has persuaded Ventre that that is on the cusp of changing? A confluence of factors has, with Ventre taking confidence from both the recent third plenum and the ‘general tone’ emanating from Chinese policy makers. ‘It gave us some decent detail on whether they are thinking in the right way. We were bullish before, but we are more so now.’
Two developments stood out for Ventre. First, China intends to reform its state-owned enterprises. ‘There has been a lot of fear that some companies are not being run for the shareholder but according to another agenda.’ These giants like Bank of China and PetroChina comprise the bulk of large-cap indices, and they have now agreed to distribute more to investors through dividends as their target payout ratio has doubled from 15% to 30%. ‘That is much more important in China where investors do not trust that you are running the company for them.’
Second, Ventre has been encouraged by the proposed broader reform to China’s financial system. One element especially should break the toxic connection between banks and state-owned enterprises. Companies will now be pushed into tapping bond markets for finance rather than relying on cheap loans from state banks. This links to the liberalisation of interest rates in the country, which have been held artificially low to support indebted state-owned enterprises. As they are obliged are to seek money elsewhere, interest rates can rise, attracting bank deposits, which facilitates a more secure financial system and ultimately normalises capital markets. ‘These steps of reform are both intrinsically linked and positive.’
Ventre’s enthusiasm was further bolstered by a recent trip his team took to the country. ‘We went to China, knowing it was very cheap, to get a better understanding of the country.’ He had, like everyone else, heard plenty of anecdotal evidence about the economy’s weaknesses: ghost towns, property bubbles, shadow banking and so on. What he and his colleagues encountered reassured them that things weren’t quite so bad. ‘A lot of the local market does not talk to the global market very much, and so the risks are perhaps not as large as the global market is pricing in.’
Yet deciding where to invest is only half an outcome; Ventre then had to work out how best to gain access to China. He has allocated to some active China funds, but characterises that as a strategic position. To exploit what he expected to happen, he needed a different tactical solution. ‘It is just that this is more about a valuation mean reversion in the state-owned enterprises.’
However, active funds ‘avoid them like the plague’ because they afford neither access to management nor reliable accounts. ‘If you had been a value investor in China over the past few years, you would have been carried out. Those still in business have a quality approach. We couldn’t allocate to an active fund to express our view.’
This view is that the suite of reforms will prompt a ‘substantial’ mean reversion in state-owned enterprises’ currently depressed valuations, which Ventre feels will produce a bull market lasting between 18 months and two years in such stocks. ‘Active managers will struggle to keep up with that.’
Ventre emphasises that that is just a tactical trade, though. ‘Our general thesis is that the best way to build long-term shareholder value is not to invest alongside the state.’ He thus has no intention of embarking on a parallel move in Russia, where the government has proffered no such positive indications about the outlook for its similarly shunned national champions.