The investment opportunity you can’t ignore

China’s economy has grown at above 6.5% per annum every year since 1991. It has become the primary driver of global economic growth since the financial crisis.

In nominal US dollar terms, the Chinese economy is now the second largest in the world. By 2020 the International Monetary Fund predicts that it will account for 19% of global GDP, not far short of the 22% contributed by the US.

Breakdown of global GDP by nominal value in USD

What this shows is that, in economic terms, China has become extremely important. Yet this is hardly matched by its significance for most investors. For a number of reasons, exposure to China makes up a relatively small part of global portfolios.

Until recently, direct access to the Chinese market was limited for foreign investors, which meant that generally the only way to gain exposure to Chinese companies was through those listed in Hong Kong. In addition, state-controlled companies make up a large part of the domestic market, which has made it less appealing. Government influence on the performance of the stock exchange has also been a regular feature.

The potential 

Due to these and other factors, the Chinese stock market has shown little relationship to the performance of the economy. Yet it’s fairly obvious that there must be an opportunity for investors to get access to the Chinese growth story.

“If you look at the demographics of China, there is immense potential in the growth of the sheer number of people in what one would call the middle class,” says Chris Potgieter, head of Old Mutual Wealth Private Client Securities. “The government is effectively trying to pull people out of poverty on a proactive basis.”

This is most obviously manifested in the current initiatives to transition China from an export-driven economy to a consumption-led economy. This is creating an opportunity for companies that serve this immense consumer base.

Yet for most South African investors China remains both mysterious and daunting as an investment destination. On top of which, local investors are already in an emerging market, so there is a reasonable reluctance to invest too much in another one.

“The usual thought process would be that because we are in an emerging market, we have a lot of emerging market risk inside our portfolios already,” says Andrew Finlayson, co-founder of Maven Wealth. “The tendency is therefore to look at developed markets to find alternatives.”

Growth and more growth

However, while China is categorised as an emerging market, it is substantially different to most of those considered its peers.

“The more that we engage with investment professionals who have a deeper understanding of the markets, the more we realise that China is not a pure emerging market,” Finlayson says. “It’s already a behemoth economy. The scale and rate of change taking place in China makes it difficult to ignore as an investment opportunity in the long run.”

In a sense, China represents the most obvious area of growth in the world over the next few decades.

“You have strong economic growth in China relative to developed markets, which offers an attractive backdrop as it provides a strong tailwind for earnings growth at a company level,” says Stephen Kam, co-head of product management for Asia ex-Japan equities at Schroders. “It’s helpful to have that tailwind, but just because the economy is growing quickly doesn’t mean that you’re guaranteed to make money by any means.”

That requires identifying good quality companies in sectors that are particularly exposed to those areas of the economy that are most attractive.

“We believe these are sectors such as technology, healthcare, and consumer discretionary,” says Kam. “We are very much investing along the theme that economic growth will lead to rising prosperity, household incomes will continue to rise, and the trends we are seeing and expect to continue to see are consumers upgrading their purchases and upgrading their lifestyles.”

Getting exposure

One way of accessing this story is not necessarily within China itself.

“A big part of the growth story for all true multinationals actually relates to China,” Potgieter says. “So you don’t necessarily have to invest directly in China. You can get exposure to the Chinese consumer and Chinese development through multinationals listed in the US, the UK or Europe.”

If however an investor does want to buy specifically into the Chinese stock market, what is the best way to do it? There are exchange-traded products listed on the JSE that track a Chinese index, and while these may provide simple and broad access, they may not be the most efficient approach.

“Our concern would be that more than 40% of the Chinese index is made up of state-owned companies,” says Finlayson. “That’s not what you want to buy. If the thesis is that there is an explosion of brain power in this country opening up new technologies and markets, that’s where you want to participate. We think that you have to find active mangers who have people on the ground, and who understand the market.”

Kam agrees, particularly in light of the inefficiencies that still exist in Chinese equities.

“Over 80% of trading volume in China is driven by retail investors,” he points out. “As a result of that, the market is very momentum driven and the potential for undervaluation and overvaluation of companies is very high.”

The information provided to the market by listed companies in China is also not as comprehensive as in other parts of the world. This means that those investors with the ability to meet management teams and scrutinise their operations are at a distinct advantage.

“Because a lot of these companies are not as accustomed as those in developed markets to providing information to investors in general, that information inefficiency creates a lot of opportunities for active managers,” Kam says.

Originally appeared on Moneyweb