Sophie Earnshaw runs through three reasons why she believes the time is right for investors and their advisers to consider a material allocation to China
It increasingly makes sense to think of China as an asset class in its own right. China's share of the MSCI Emerging Markets index has more than doubled in the past decade. Even now, however, although it is the largest country by weighting, it represents a mere 26% of the index. That figure is still low.
At the moment, more than 3,000 Chinese listed companies are omitted from the index. Simply adding in their market value at the present time would increase China's MSCI weighting to around 41%. Clearly, given that most emerging markets managers have underweight positions, the potential for inflows into Chinese equities is huge. Many active managers are now addressing this situation, attracted by three key factors.
* Growth: China is likely to experience one of the biggest consumption booms in world history over the next decade. Indeed, China's e-commerce market is already larger than the US and the number of outbound Chinese tourists already exceeds that of the US. These trends are only going to accelerate.
There are roughly 100 million affluent households in China today. This is set nearly to double by 2025. To put this in context, there are only 125 million households in the US, in total. That is a huge number of people with a huge amount of disposable income. Industries with multi-billion dollar growth potential include healthcare, insurance, online retail, semiconductors, electric vehicles, tourism … the list goes on.
China households in each income group
Source: Gavekal Data/Macrobond
It is not just growth, but quality of growth that counts. China spends more on research and development (R&D) than any other country in the world, excluding the US - $370bn (£281bn) at the last count. At its current rate of spending, it could easily overtake the US in a couple of years.
Patent filing by Chinese entities at the US Patent Office has risen tenfold in the past 10 years - already surpassing the UK. In artificial intelligence, companies such as Baidu and iFlytek are rivalling US technology giants in Mandarin voice transcription and natural language processing while others are making remarkable progress in AI-powered facial recognition technology. China is no longer a copycat country. It produces its own world-class intellectual property.
Source: OECD, Main Science and Technology Indicators
* World-class companies: The quality of listed companies in China has improved dramatically over the past 10 years to the extent this is now one of the best investment universes in the world. Indeed, greater China contributes more ‘big winners' - stocks which have delivered 20% a year. in US dollar terms over 10 years - than any other region in the world, bar the US.
To properly capture China's remarkable rise, one must own world-class Chinese companies, rather than multinationals. Everything from healthcare, to online retail, to autos, to insurance is dominated by domestic Chinese companies. The value of goods traded on Alibaba's platform is larger than Amazon and eBay combined. Indeed, if one were to think of Alibaba's platform as an economy, by value, it would be bigger than Sweden!
But the opportunity extends well beyond this. Midea and Hikvision are both A-share names. Midea offers Buffett-esque quality at a knockdown price with a leading robotics business on the side. Hikvision meanwhile offers cutting-edge surveillance technology and an innovation-driven culture.
Gross market value
Source: Alibaba Group as at 31 March 2017. Amazon and Ebay are UBS estimates year ended 2016
10-year big winners by region
Source: Baillie Gifford/Factset/Worldscope. Information based on global equity universe of stocks where market cap is greater than $500m (historically adjusted)
* Inefficiency: The market - and particularly the A-share market - is exceptionally inefficient. In the A-share market, retail participation is around 80%. Valuations can swing from a price/earnings ratio of 100x to 10x in the space of a year. Mis-pricings are frequent. For the patient, bottom-up stockpicker, this is an excellent hunting ground for attractive, long-term investments.
More broadly, valuations in greater China remain very attractive as the market is still obsessed with headline GDP growth and headline leverage. We do not think either matter. An active Chinese allocation allows you to buy the good bits and avoid the bad. As the chart below shows, market selectivity is crucial. Since 2012, old economy, typically over-indebted, state-owned enterprise stocks have languished, while those geared into the new, consumer-oriented economy, have flourished.
MSCI Golden Dragon Constituents
Source: Bloomberg, Bernstein Analysis and relevant underlying index provider(s). Rebased to 100
The best way to exploit this Chinese opportunity in a meaningful way is to allocate directly to a greater China fund. Investing via a global or emerging markets fund does not give one enough bang for one's buck and risks diluting returns with exposure to less attractive geographical markets.
Sophie Earnshaw is an investment manager at Baillie Gifford
Closing in 2020
Second of five videos with Cazenove Capital’s DFM team
Why the flow to passives?
Our weekly heads-up for advisers