China shares will impress again in three years, says JF

The China A-share market, reserved for domestic investors and those with QFII quotas, has suffered huge losses so far this year. AsianInvestor spoke with fund managers and analysts about their views on the market. This is part three of a four-part series.
Shumin Huang is an investment manager for the Pacific regional group of JF Asset Management in Hong Kong. Huang co-manages the $700 million JF China Pioneer A-Share Fund, which was launched in June 2006 and was the first, and thus far only, authorised retail fund in Hong Kong that invests in the ChinaÆs domestic stock market.

It could be said that Huang is under tremendous pressure to find good value amid the weak China A-share market this year after her fund posted a return of 158% in 2007, outperforming all retail portfolios in Hong Kong last year. The fund was down 14.1 in February, largely in line with the performance of its benchmark. Huang spoke to AsianInvestor about her outlook for the China A-share market.

What is your outlook for the China A-share market?

Huang: In the longer-term, we believe corporate earnings will represent ChinaÆs economic strength. There certainly are a lot of opportunities in China.

The outlook for the medium-term of three to five years, in our view, is even better. The wealth effect created by the rising middle class and urbanization, having an undervalued currency, increasing listings, and improving corporate governance and limited investment alternatives for local residents, make for an even better medium-term outlook.

The short-term, or this year, is more challenging given that we have a history of a few years of strong growth already. Bear in mind that there is always a cycle even in a developed economy. China, to a certain extent, is more open now and more available to the global economy, so it will definitely be affected by the developments worldwide.

What can we expect for the rest of this year?

Near-term, this is a transition stage in terms of challenging the senior leadership in terms of their policy setting, which will affect all the challenges they are facing such as how to balance inflation and growth, which is not really unique to China. Globally, most economies are facing the challenge of how to balance inflation and growth.

I think China, in a way, is less lucky in the sense that it has had an internal food problem to deal with since last year and the latest problem, which was the snowstorm.

I think this has challenged the senior leadership. But they are better positioned than before to tackle the issues, given the strength of ChinaÆs balance sheet, capital accounts, and trade position. They are well equipped to deal with the issue. However, there is always a potential for policy to lag and, in a way that could put the market at risk in the short-term.

Is the government addressing ChinaÆs economic problems appropriately?

If you look at ChinaÆs growth over the past few years, surely the competitive advantage of the exporters, the upgrade of the value-chain for the export industries, and the urbanisation have all contributed to the positive growth in the mainland. However, the side effect is you have huge trade surplus and that translated to excess liquidity.

China has been appreciating its currency. However, in our view, the pace is not fast enough. So excess liquidity was building up over the past year-and-a-half. And just when China started to tighten liquidity, it bumped into the global economic problems and the US dollar depreciating against all currencies. If you look at the trade weighted basket, the renminbi is not really appreciating against other currencies, just the US dollar. And then there are other problems to deal with now such as the snow storm, the food supply, everything seems to have piled up.

What should they do to unclog all that?

If you look at previous cycles, the consistent approach of the senior leadership either during the Asian financial crisis in 1997 and during the Sars period has been fiscal expansion. When they are faced with external pressure, they turn to fiscal expansion, and they have a stronger balance sheet now to be able to support that.

Inflation-wise, they have come up with monetary tightening, product price controls, renminbi asset appreciation, and continued liquidity stabilisation. I think this would all continue.

For the food supply, it will really take time because we will have to let nature take care of it. And I donÆt think they would like to import a lot and push up global prices either. They are doing certain things like giving incentives to farmers, for example. It will just take time. And if we have bad weather or flooding, these things just happen.

What is the best way to get exposure to ChinaÆs growth amid all the short-term concerns?

We basically hold stocks that have lower multiples if there is dual listing involved. If the premium is not too much, we believe that liquidity in China is safer and is less affected by the global developments. If the valuation is similar, maybe a 3% to 5% difference, then A-shares should be better supported in terms of liquidity given that there is more foreign capital involved in the Hong Kong market.

What about in terms of choices of listed companies?

In A-shares, we try to focus on the sectors or companies that we cannot buy in Hong Kong or those that make up only a small portion of the market in Hong Kong. In China, we have more choices in consumer products and machinery. While these are very small sectors in the MSCI China index, these provide a different kind of exposure to ChinaÆs growth. Our JF China Fund also holds a little bit of our JF China Pioneer A-Share Fund to provide a different kind of exposure.

How much of the JF China Pioneer A-Share Fund is in China A-shares?

95%. The rest is in cash. We tend to keep cash steady for investors who will want to come in the market. Our mandate is to have at least 75% in China A-shares, but we are trying to utilise our entire QFII (qualified foreign institutional investors) quota in China. We received a total QFII quota of $190 million, but we are allowed to keep the market gains as long as the principal capital is not remitted. We have applied for a new quota, but that has been pending.

Do you think that the QFII rules will be relaxed so that more investors can easily invest in China A-shares?

It was planned that the total quota will be raised from $10 billion to $30 billion, but they are still trying to define the quota because. If they go with the market cap definition, then the value of the $10 billion granted three years ago could be close to $30 billion already and so the room to issue more quotas is limited. We are still waiting to get a clearer definition.

However, I think they will gradually increase the QFII quota. I believe thatÆs the direction they are taking, but the pace is uncertain. I think the Chinese leadership would always like to think about things twice before they do anything.

What sectors do you like at the moment?

We like consumer stocks. For the A-shares, we try and focus with companies that are less accessible and difficult to replicate in the overseas markets. For example, we like the notable brand names in China like wine liquor maker Kweichow Moutai. It has strong brand name and pricing power. It has over 90% alcohol and is generally perceived to be the favoured by the Chinese people. We also like department stores, which are mainly accessible only through mainland listings.

We also like manufacturing, particularly construction machinery and shipbuilding. These are where China has stepped up in the value chain and has been gradually taking over the market share globally. On the demand side, we think these have very good dynamics going forward. However, they will be subject to the global cycles and raw materials cost so we are quite selective in terms of companies we invest in. Management has to be very good in execution. They should have competitive strength to take market share and deliver growth, especially on the volume side. Because raw material costs are increasing, those stocks have been sold down so we are very selectively adding.

The third sector we like is domestic cyclicals, namely banks, financials and property. There has been a huge correction in either A- or H-shares, triggered by the policy tightening. I think in the longer term you will see that insurance companies still have longer-term protection and banks have strong potential growth. We hold shares of banks where we are comfortable with management, such as China Merchants Bank and Shanghai Pudong.

China Merchants Bank, this is one of the large banks that didnÆt get recapitalisation form the government, so they went through the cycle. The fact that the senior leadership of this bank has been through various cycles is positive. The management now is more cautious and mindful about risk. For this bank, having a senior leadership that has been through the cycle is a positive. Their risk approach and their product innovation in terms of exposure to credit cards and private wealth management, ahead of its peers.

Property is controversial now, but we like some companies. China Vanke has a very fast asset turnover so itÆs not holding land reserves. China is not in the stage of Hong Kong in terms of the property market. We think China Vanke is in the right position to benefit from the growth and capitalise on the urbanisation process in the mainland

What is your investment universe in the China A-share market? WhatÆs the average number of stocks that you hold in your portfolio?

Our benchmark is the Shanghai Shenzhen 300, or the CSI 300 (top 300 shares in the domestic market in terms of market cap). There are over 1,500 shares listed on the China A-share market, many are quite small.

We have the China International Fund Management joint venture in Shanghai, which has more than one dozen analysts who screen the market. They cover more than 500 companies in the mainland. To compete in the domestic market, the style there is to have higher turnover. When the index is going up or down, they all rotate in different industries.

For my investment style, I tend to stick with longer term winners. My portfolio turnover is lower than most who invest in China A-shares, especially among those who manage funds from China. I invest in a range of 50 to 60 stocks.

For an in-depth look at China's fund management industry and domestic stock market, see the April 2008 edition of AsianInvestor magazine.
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