BlackRock has reduced its weighting to China equities considerably since six to nine months ago on uncertainty about what will drive the country's economic growth in the coming years. This follows a 30% rally on the CSI 300 index between the fourth quarter and its peak in February.
The world’s second largest economy needs to find a new growth driver to sustain its momentum after benefiting from several years of double-digit growth thanks to its demographic advantages, argues Ning Jing, portfolio manager of the firm’s China Fund.
“Since 2007, [China] has been in what I call the ‘muddling through’ stage,” she says. “That is, we haven’t identified the new growth driver yet, so we are still heavily reliant on investments [and] to a certain degree the property market and consumption.”
However, optimism sparked by China’s once-in-a-decade leadership transition, concluded last week, may help spur reforms that are badly needed if the economy is to alight on a growth driver and create attractive investment opportunities.
Ning is somewhat confident that the necessary reforms in China will be pushed through, citing the break-up of the country’s Ministry of Railways – once viewed as one of the most bureaucratic government divisions in China – as one of the first actions taken by the change in leadership.
The hope is also that financial sector reform can help inject efficiency and capital into an economy dominated by state-owned enterprises at the expense of the private sector, for which capital-raising costs are relatively high.
“If you talk to state-owned steel mills, historically even if their returns have been very poor, they have been able to get very low-cost financing from the banks,” Ning notes. “But if we are talking about the private business owner – the guy who opens a restaurant or the guy who needs help setting up factories – his cost of capital is so much higher.”
China has been a very bank-dominated financing market, with Ning suggesting that around 80% of all the corporate financing is done via banks. While some asset allocation is determined on the basis of return, most lending decisions are based on what is considered strategically important for the government.
Despite policy reform rhetoric, BlackRock says it is toning down its macro approach and relying more on stock selection. “In this kind of muddling-through stage, it is very hard to make money out of macro [strategies],” Ning says.
For instance, financial reforms will create investment opportunities in specific segments. Ning says she is overweighting brokerages because of their ability to improve on return on equity without the need for additional capital, while reforms will allow for more products to be sold on their shelves.
Similarly, BlackRock is positive on China’s healthcare sector, which Ning argues will benefit, with the industry suffering from a lack of private and public investment in past years, combined with a ‘silver tsunami’ that will see an increasing number of retirees.
“Historically, if you talk to drug companies in China, they didn’t focus on R&D [research & development], and everyone competed with each other based on their relationship with hospitals,” Ning says. “But we see that changing. R&D is becoming a more and more critical element of competitiveness amongst healthcare companies in China.”
Finally, BlackRock favours industrials in the belief that the sector is facing greater consolidation opportunities due to higher costs of labour, land and environmental maintenance, a trend that will particularly benefit industrial leaders with strong balance sheets.
Over the next couple of years, it’s not demand that will provide opportunities, but consolidation in this sector, argues Ning. “This is an industry ignored by the market that is not as exciting as e-commerce and consumption, but from our stock selection perspective, we see a lot of very good companies that could take advantage of consolidation.”
BlackRock's China Fund returned 23% last year, meeting its MSCI China 10/40 benchmark target (also 23%), but it lost -21.1% in 2011, underperforming the benchmark by 2.7 percentage points.