China’s paypackets are key to healthy returns

Investors in emerging markets who are enticed towards China, now the world’s second-largest economy, but who do not know where to start, should think about the companies and sectors that will profit most from the rising incomes of the Chinese, say fund managers .

As Douglas Turnbull, co-manager of Neptune’s two China funds, sees it: “The future of the Chinese economy is about harnessing the spending potential the emerging middle class in China can unleash . Even if its export market slows up, China has another option.”

For managers like him, the debate is whether to buy shares in western companies with operations in Beijing and Shanghai, or in Chinese companies themselves. Opinions differ.

In one camp are those managers who claim that Chinese companies such as China Mobile – which trades at 12.6 times 2010 earnings – are capable of fending off competition from foreign companies.

“Chinese companies are stepping up and raising their game,” says Philip Ehrmann, manager of Jupiter’s China Fund. “It’s a myth that China is just about exports. The reality is they have a huge trade
surplus.”

He points out that a number of Chinese companies trade at a discount to their rivals in both the West and the East. He cites the market for disposable healthcare products. Becton Dickinson, a US manufacturer of syringes, needles and other medical products, still controls three quarters of sales in China, but Beijing is looking to encourage local companies to compete against it.

“If Chinese companies can begin to grow their market share, it bodes well, not just for foreign companies but also domestic players,” Ehrmann says.

Rupert Foster, manager of Matrix’s Asia fund, meanwhile, claims that a second advantage Chinese companies have over their US, Japanese and Korean rivals is their ability to distribute products more widely. Chinese cola makers “annihilate” Coca-Cola when it comes to finding ways to sell drinks around the country, he says. And Samsung and Sharp televisions are not sold in smaller cities in China, he notes. According to Foster: “A number of Japanese and Korean companies are thought to be great China plays – but they’re really not. They get attacked by Chinese competitors.” Chinese companies’ returns on equity and operating margins are also “surprisingly” high, according to Foster. Ausnutria, the Chinese babyfood manufacturer, has operating margins of 30 per cent, for example.

Ehrmann discourages investors from taking direct stakes in the mid and small-cap companies listed in Hong Kong, as he believes the fund route is safer. “Some of the more interesting areas and opportunities are quite illiquid,” he says. “People shouldn’t go out and buy into them themselves.”

Two holdings he has bought are Shandong Weigao, a medical device group attempting to go toe-to-
toe with Becton Dickinson, and China Automation, which makes signal systems for China’s railways.

The possibility that growth in western economies will remain sluggish for some time has also encouraged Tristan Hanson, manager of asset allocation and strategy with the investment house Ashburton, to increase equity weightings in China and reduce exposure to Japan and the US.

“Structural economic problems are far more severe in the developed world than in China,” says Hanson. “The Chinese authorities are unlikely to tighten policy much further and therefore fears of a major slowdown in China are overdone. Following a long period of under-
performance, Chinese equities are not expensive on 13 times forward earnings given long-term growth prospects.”

At present, the MSCI China Index, which tracks stocks listed in mainland China and Hong Kong, trades on 12.3 times 12-month forward earnings. So, it is more expensive than the S&P 500, the US index, which trades at 11.9 times forward earnings and the FTSE 250, which is at 11.5 times forward earnings.

“While we remain strategically positive on equities, we acknowledge risks remain and that volatility is likely to remain high,” Hanson says. “We therefore added downside protection on the back of strength in the form of equity put options. This insurance
policy provides protection against downside risk while maintaining long exposure should the rally continue.”

But suggestions that the Chinese property market is in “bubble” territory are exaggerated, says David Livingston, a portfolio manager with Thurleigh Investment Managers who recently returned from a visit there. “Most mortgages use significant cash and those based on credit borrowing have a 25 to 50 per cent down payment rate,” he says.

“The real challenge for China is to see whether it can successfully transition from an export, east-coast dominated country to a more balanced domestic consumer-orientated nation.”

Returns from China funds, focused only on the mainland and neighbouring markets, have been strong.

Tim Cockerill, head of research with the advisory firm Ashcourt Rowan, favours First State’s £478m Greater China fund, which has 72 holdings spread across Hong Kong, mainland China and Taiwain and returned close to 160 per cent over five years.