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Investing in ‘New China’

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on Jan 23-29, 2017.
Published on The Edge Markets on Jan 23, 2017

Following the launch of the Shenzhen-Hong Kong Stock Connect last month, retail investors can now trade China A-shares listed on the Shenzhen Stock Exchange. This has opened up new investment opportunities in one of the world’s fastest growing economies.

Prior to this, retail investors had no direct access to Shenzhen A-shares, which are renminbi-denominated shares of companies incorporated in China, as they could only be traded by Chinese citizens and foreign institutional investors. There are more than 800 companies listed on the Shenzhen Stock Exchange.

The Shenzhen market gives investors the opportunity to invest directly in some quality companies, such as those in the manufacturing sector, says Teh Chi-cheun, CEO and executive director of Pacific Mutual Fund Bhd.

The reason is simple, he says. China’s economy is still growing at more than 6% per year and Shenzhen, which has been the country’s manufacturing hub since the 1980s, offers good exposure for those looking to invest in quality companies to ride China’s economic growth.

“The Shenzhen A-share market has quite a few good manufacturing companies due to the city’s history as China’s gateway to the world in the 1980s. It was the country’s first special economic zone and many international car manufacturers that entered the China market in the early days came to Shenzhen,” says Teh.

In fact, one of the investment themes that Chenye Yannan is looking at is companies involved in what she calls a “manufacturing upgrade”. The head of China equity research and portfolio manager at Harvest Global Investment Ltd, one of the biggest fund houses in China, says there are good manufacturing companies listed on the Shenzhen Stock Exchange that provide key components and equipment to the industrial, automotive and electronic sectors.

These companies are expected to perform well going forward, she adds. “It is a trend happening in Shenzhen, which made China the manufacturer of the world. Key components and equipment, which were previously distributed by Japanese and German companies, are expected to be gradually replaced by local products. The upgrading trend is a big thing and we are seeing more acquisitions in the market.”

According to The Wall Street Journal, the upgrade is taking place at a time when China’s manufacturing sector can no longer rely on low labour cost as wages are rising. Many manufacturing firms have been relocated by the government to cities in western and central China where labour costs are lower, while others are moving their factories to Southeast Asian countries such as Vietnam.

All this comes at a time when Shenzhen manufacturing companies are moving up the value chain to remain competitive. “Some of them are already gaining market share,” says Chenye.

Both she and Teh say another theme investors can look at for the longer term is the growing wealth of the Chinese middle class, which is expected to benefit sectors such as healthcare, insurance, education and tourism.

These sectors have some quality companies listed on the Shenzhen Stock Exchange, says Teh. “The population is getting wealthier and are willing to spend more. The evolution of spending habits will be similar to the more advanced economies in Asia and this will benefit these sectors.”

Anthony Ho, deputy CEO and chief investment officer for Asia ex-Japan equities at Amundi Hong Kong, says China’s economy has shifted from a reliance on exports to local consumption following the rise in middle-class consumer spending. Also, disposable incomes are rising and this is giving domestic demand a boost.

Ho expects the economy to continue growing, albeit at a slower pace. This will contribute to an increase in the wealth of the middle class.

“After achieving an official rate of about 6.7% [GDP growth] last year, we expect a gradual slowdown to 6.3% to 6.5% this year. We think China’s Producer Price Index and private investments will peak later than the market expects. Property investments are also expected to peak later, which will have a limited drag on the overall economy. These statistics remaining positive is more important than forecasting when they will peak,” he says.

The valuations of Shenzhen A-shares remain attractive, says Teh. The market currently has an average price-earnings ratio of 22 times compared with its peak of 45 times in mid-2015.

“While it may seem high on an absolute basis, the growth of China and potential higher corporate earnings justify such valuations. The number is still compelling,” he says.

Chenye says the volatility of the Shenzhen A-shares has subsided since the bubble burst in mid-2015. More importantly, China’s A-shares are expected to be included on MSCI’s indices in the near future. This will spark buying interest from global institutional investors that want to include these shares in their portfolios, which in turn will boost the prices and liquidity of the A-shares. MSCI Inc is one of the world’s largest research-based index providers.

Ho says the demand for commodities, which the markets are seeing now, will continue to improve in the light of the positive statistics and economic stabilisation. This will lead to a recovery in China A-shares.

The Shenzhen Composite Index had fallen 7.84% to 1,851.41 points as at Jan 16, from 2,008.79 points on Jan 6, according to Bloomberg. At the time of writing, the market had slightly recovered to 1,868.65 points. The index was up 2.09% year on year as at Jan 17.

China’s Nasdaq?

The Shenzhen Stock Exchange is the third largest bourse in Asia and among the top 10 in the world. It is known as China’s Nasdaq as it boasts a number of technology companies. The Shanghai Stock Exchange, meanwhile, has many state-owned and financial companies listed on it.

“Nearly 20% of Shenzhen’s stocks are tech companies. This a much bigger proportion than the 4% of [these companies] in the Shanghai market,” says Shen Kai Wen, global markets manager at Phillip Securities in Singapore.

Among the better-known tech names listed on the Shenzhen Stock Exchange is ZTE Corp, a global telecommunications and IT player, which is one of the largest smartphone manufacturers and vendors in the world.

Others include Hangzhou Hikvision Digital Technology Co and Gree Electric Appliances Inc. The former is a supplier of video surveillance products and solutions while the latter is the world’s largest home air-conditioner manufacturer. Hikvision had a market capitalisation of about RMB148 billion as at Jan 16 while Gree’s market cap was about RMB145.34 billion.

However, most of the tech companies on the Shenzhen bourse are mid and small-cap stocks, says Aaron Yew, co-founder and deputy chief investment officer at Malayan Traders Capital. Most of these companies focus on hardware rather than software, he adds. Malayan Traders Capital, which manages a hedge fund, invests in blue-chip tech companies around the world.

Like in Malaysia, many of the tech companies on the Shenzhen Stock Exchange are manufacturers of electronic chips and automobile parts. US tech firms, meanwhile, are on the frontlines of global innovation and producing cutting-edge technologies such as virtual reality devices, electric cars and Internet of Things solutions.

Yew says while many of these companies are called tech firms, they are also manufacturing companies, and they are expected to benefit from the growing wealth of the middle class. However, their growth is not expected to be as good as companies that focus on software and online services.

“The companies in China are still at an early stage in terms of innovation compared with US firms, with a few exceptions like Alibaba.com, which is also listed on the New York Stock Exchange,” he says.

Many of the Chinese tech companies do not have a solid track record of stable earnings and performance. “The revenue and earnings are still unpredictable. Hence, investing in these types of companies can be highly speculative,” says Yew.

Instead of the tech companies listed on the Shenzhen Stock Exchange, Yew favours the more established blue-chip China tech stocks. They include Alibaba.com, the e-commerce business that is tapping the growing consumer spending of the Chinese middle class. “We look into tech companies with the ability to replicate its already successful business model in the different provinces in China and that can push it globally,” he says.

To invest in such companies, investors do not have to access them via the Shenzhen bourse as they are also listed on the Hong Kong Stock Exchange, says Yew. Some of them are listed on the New York Stock Exchange as well.

He says this is a better option as China’s stock markets are highly speculative in nature, with more instances of stock prices not reflecting the fundamentals of the companies. “As active investors, we monitor all the markets daily to get a sense of the market movements and the short-term noise. As a result, we were able to see how increasingly volatile China’s stock markets were in 2015. The Shanghai Composite Index increased 17% in April 2015, followed by a 7% decline in just one day on May 28.”

Pacific Mutual’s Teh says the stock market’s roller-coaster ride is an inherent risk of emerging markets and investors should not shun the Shenzhen market, provided they know the risks. “The same thing [referring to stock market fluctuations] happened in Brazil during the impeachment of Dilma Rousseff (Brazil’s previous president) and Russia when oil prices plunged. Investors should be aware that it is an inherent risk in emerging markets.

“Every new investment opportunity should be explored, especially when it provides exposure to the local equity market of the largest economy in Asia and should be included in most equity portfolios that permit offshore exposure.”

Main risk: Trump vs China

However, there is a major risk when it comes to investing in China’s stock markets, say fund managers. US President Donald Trump is widely expected to impose tariffs on Chinese imports to protect US interests.

“China could be negatively impacted. Trump has made it clear that he intends to strike better deals for the US, including imposing tariffs of up to 45% on Chinese imports. With the US being the top destination for China’s exports, such levies could reduce China’s export revenue by more than 10%,” says Yew.

Chenye and Teh express the same concerns. Teh says Trump is likely to adopt a confrontational approach on China in terms of US trade policy.

“Trump’s presidency will be one that the current generation has not seen, although historically there have been other leaders with a similar personality. Specifically on China, it is likely to be a confrontational approach to which China can and will respond in a similar manner. The situation will likely get worse before it improves as brinkmanship and extremes are behavioural norms of Trump,” he says.

“Hence, I will not be surprised if anti-dumping duties are imposed on quite a few of the US’ imports from China. It will definitely dampen trade and economic growth.”

Amundi’s Ho, however, says it is too early to comment on Trump’s presidency. “There is pressure to be exerted on China to have it stop manipulating its currency. But Trump’s execution could differ from the campaign rhetoric.”

From a currency perspective, a foreign exchange trader at a local bank says the renminbi is expected to strengthen against the US dollar in the near term and slowly weaken over the next three months. The trader says the short-term strengthening of the renminbi is due to the liquidity cut by the People’s Bank of China (PBOC) at the end of last year.

“There was a spike in the US dollar against the renminbi at the end of last year. That is why the PBOC cut liquidity to strengthen its currency and avoid short-term volatility. However, it is most likely a short-term measure and the central bank will let the market determine the strength of the renminbi, which is expected to weaken again,” says the trader, who is expecting the renminbi to hit 6.85 against the US dollar in the next three months.

In the longer term, Ho expects the Chinese currency to slowly depreciate against the greenback and stand at 7.2 by the end of this year. “Since the PBOC is managing the renminbi against a basket of global currencies, we have no specific view of the currency against the ringgit,” he says.

Access for local investors

Some brokerage firms in Malaysia have started to provide services to facilitate trade via the Shenzhen-Hong Kong Stock Connect, says Remisiers Association of Malaysia president Sam Ng.

He says Phillip Securities Ptd Ltd, a Singapore-based firm with branches and clients in Malaysia, is among those that allow clients to trade A-shares listed on the Shenzhen bourse. The firm’s clients can place trade orders with their brokers and the trades are executed in Hong Kong.

Phillip Securities global markets manager Shen Kai Wen says the firm is also offering this service to some of the banks and brokerage firms in Malaysia.

The fees include a handling fee (0.000487%), security management fee (0.002%), transfer fee (0.004% on gross value or consideration) and stamp duty (0.1% when selling the securities). There is also a portfolio fee (0.008% of the daily stock portfolio value divided by 365 days), collected by the Hong Kong Securities Clearing Co Ltd and a brokerage commission of 0.18% to 0.25%, or a minimum of RMB80 to RMB88.

“It worth noting that the ability to do contra and intraday trading is different for China stock markets, where there is a restriction on intraday trading as shares have to be settled by T+1 before investors can liquidate. There is also an upper and lower limit of plus and minus 10% on China A-shares,” says Shen.

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