Uncovering quality in China through bottom-up stock picking

We are not new to investing in China. Our team has been visiting and researching companies in China for decades, and our portfolios have held Chinese equities as long as they have been running. Companies like Hong Kong & China Gas and Mindray Medical were core holdings for many years.

However, we have also been cognisant that China can be a risky place to invest, in part because of the way in which politics can intervene to upend business models. We are completely benchmark agnostic; we apply the same rigorous process to every potential investee company and seek the best investment ideas without recourse to index weightings. For much of the last decade, we have had lower exposure to Chinese equities than the relevant benchmarks.

New ideas and attractive valuations

The increase in the number of Chinese companies held in our Asia and Global Emerging Markets portfolios is a consequence of two changes.

Firstly, the Chinese market has got much deeper over time. The A-share markets in Shanghai and Shenzhen now contain over 5,000 listed companies and are being added to all the time through a robust pipeline of initial public offerings (IPOs) of new companies.

For the last few years, Shanghai and Shenzhen have been the number 1 and number 2 markets for new IPOs, and between them have raised 40% of all proceeds globally, twice as much as the United States.1

We have seen a steady increase in the number of high quality, privately-run companies in the healthcare, technology and industrial sectors. Investigating, watching and building up conviction in these A-share listed companies has been a strong research focus for quite some time and has allowed us to gradually generate a number of new ideas.

One example is Glodon. The Beijing-based company produces software used in the construction industry in China, to help operators to remove waste, cut costs, improve safety and save time. Its founder-operator management team have built a business with very high market shares, which stands to gain as labour shortages means digitalisation will be needed to improve productivity in sectors like construction.  It is exactly the kind of exciting, earlier stage company we see more and more of in Shenzhen and Shanghai.

This brings us to the second reason that we now have increased exposure to Chinese companies. That is that valuations have become very attractive, even for high quality companies.

It seems as though the attitudes of foreign investors towards China oscillate between two extremes: either China should be at the core of everyone’s asset allocation, or else is uninvestable.

During times of optimism, including much of the recent past, the best Chinese companies – those privately-owned, competitively advantaged businesses with solid growth prospects have often been expensively valued. Consequently, whilst we had got to the point of high conviction in a range of Chinese companies over the last few years, we have been sat on the sidelines in a number of them due to prohibitive valuations.

However, it seems we are now closer to ubiquitous revulsion, with sentiment towards China extremely negative. This near-universal aversion to Chinese assets on behalf of foreign investors has presented opportunities to long-term investors willing to look past China’s short-term economic difficulties to buy equity in some of the country’s best businesses at very reasonable valuations.

One of example is Yifeng Pharmacy Chain, the country’s largest drug distributor. Pharmacies are a business we know well, and tend over time towards consolidation around a few large players. The Chinese market is in a very early stage of evolution, and as the leading consolidator of a vast market, Yifeng’s earnings are growing at around 20% per year. Yet its shares now trade around 8x price-to-cash flow (P/CF), and we have had the opportunity to build up positions across portfolios.2

By any measure, we believe these are great businesses at very attractive entry points for the long-term owner.

Mitigating risks

China certainly remains a risky place to invest, given that policy changes are hard to predict and can have severe impacts. We believe this risk can be mitigated through both stock selection and portfolio construction.

Our starting point of seeking companies well-positioned to deliver sustainable development sets us off on the right foot; we are unlikely to own businesses that are, for instance, heavily polluting the environment, or causing public health problems, and thus obvious targets for government intervention.

We have always invested with the view that companies contributing solutions towards positive sustainable development are more likely to be able to grow more quickly, and with lower risk, and that is certainly true in China.

A good final example would be Centre Testing International, which is China’s leading provider of certification, testing and inspection services, guaranteeing compliance with quality standards and environmental regulations. The business will be driven by the inevitably greater focus placed on quality and safety in China over time, and in that sense is very well aligned with long-term sustainable development and Beijing’s goals. Centre Testing generates attractive returns and now trades on just 13x P/CF, and we have been adding throughout the last year.3

The cases described above are typical of the types of businesses we are most excited about in China. Common features include:

• run by credible former executives of multi-nationals, whose former employers give us some reference points in terms of their competence and integrity.
• partnerships with multi-national firms, evidencing technical capabilities as well as a willingness to deal fairly with foreign stakeholders.
• business models which have been proven to have fantastic economics in more mature markets.
• relatively niche businesses, hopefully below the radar of regulators.
• products and services that contribute positively to China’s continued development, and so should be aligned with Beijing.
• Business-to-business (B2B) franchises, which seems likely to be less politically sensitive and thus less vulnerable to policy intervention.

We believe these types of companies are likely to be lower risk than many others in China.

Nonetheless, cognisant that in any given case, we may be wrong, we have been adding increasing our exposure to these companies modestly and gradually. At the margin, we have been lengthening the number of companies in some portfolios in order to accommodate the current situation.

Every company that we own in China (and elsewhere) can be viewed on our Portfolio Explorer tool. We update the holdings on a quarterly basis.

As long-term investors, periods of economic turbulence and the associated market sell-offs can give us fantastic opportunities to buy quality companies for our clients. In that context, investing in a very select group of competitively advantaged, hopefully lower risk companies in China seems prudent. We believe these companies can deliver attractive returns to clients over the long term.