China Reforms: Painful Now, May Pay Off Later

When it comes to assessing Chinese equities, it may help to take a sector-by-sector view.



It’s clear. From both a top-down, big-picture view and a bottom-up, company-by-company perspective, China’s economy is in transition from one based on infrastructure to one centered on services. This change has come with plenty of growing pains, as markets in China have gotten off to a very shaky start in 2016.

After five years of underperformance, investor sentiment toward Asian markets remains subdued. With a price-earnings ratio of 11 for 2015, Asian equities are trading near their cheapest levels in the past 20 years relative to the global investment universe. By contrast, the MSCI World index has a P/E of 15, according to Bloomberg. This represents a discount for Asian equities of 26 percent. Part of the reason is that returns on capital have deteriorated much more rapidly in Asia than in other regions, driven by falling margins — a lack of pricing power and increased commoditization of products — and declining asset turnovers, which stem mainly from overcapacity and declining growth. A risk to further underperformance of the asset class is a hard landing in China caused by a transition in its growth model, with negative consequences for the financial sector.

Nevertheless, there are bright spots. We at Investec Asset Management saw early signs last year that Asian returns on assets and equity are showing improvement relative to global peers. Profit margins started recovering in 2014, thanks in part to falling raw material prices as well as to companies moving their products up the value chain and streamlining efficiency. We believe more can be done on this front. It is encouraging that the Chinese government has introduced supply-side reform — that is, efforts to deal with excess capacity, one of the key focus areas at the Chinese Communist Party’s annual Central Economic Work Conference, held in December. The devil is in the details, and execution is key, but if these positive trends persist, they will be an important catalyst for relative outperformance.

Some consumer-facing sectors of the economy are doing well, such as automobiles, health care, retail and travel. The property market is also staging a recovery. So-called old-economy sectors such as materials and industrials are struggling because of excess capacity and slowing investment. Markets find it difficult to understand these nuances and instead focus on macroeconomic variables that are often too generic to make real sense of the transition. This disconnect can create volatility but also presents opportunities for disciplined, bottom-up investors to buy good-quality companies with decent growth at cheap prices.

The good news for potential investors is twofold. First, expectations for 8 percent profit growth in 2016 look reasonable compared with the past five years — when expectations for profit growth in the subsequent year have been around 14 percent on average, only to deliver half that growth. At flat growth, 2015 might turn out to be one of the poorest years for profit growth, which would potentially form a low base for 2016.

Second, as mentioned above, the good news for potential investors is that the in-price for Asian equities looks attractive. Asia in general — and China in particular — has fallen out of favor in global portfolios, as the market has overreacted to these negative trends. We believe that the patient investor should be rewarded.

Greg Kuhnert is the 4Factor strategy leader of Asian equities at Investec Asset Management in London.

See Investec’s disclaimer.

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