Downside is limited for China shares, says Invesco

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 whether the current setback is temporary. This is part two of a four-part series.
Joseph Tang has been investment director at Invesco Hong Kong Limited since August 2007.

Tang manages two institutional funds that invest in the yuan-denominated China A-share market, the Invesco China Opportunity Fund I and II, which have a combined size of around $450 million. Prior to that, he was based in Shenzhen as head of investments at Invesco Great Wall, the joint venture between US asset management company Invesco and the mainlandÆs Great Wall Securities. Tang spoke to AsianInvestor about his outlook for the China A-share market.

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

Tang: We are still a long-term bull on the China A-share market for a number of reasons. The longer-term growth for China is still intact despite the short-term headwinds, both domestic and external. We believe that a 10% GDP growth annually for the next few years is largely achievable. On the back of that, strong economic growth will translate to strong corporate profit growth.

Other than that there are other factors. We think that the market will be able to sustain the valuation premium on the China A-shares. The State-owned Assets Supervision and Administration Commission (SASAC) will speed up industry consolidation over the next few years, whereby there will be one or two industry leaders for every industry. The rationale behind that is for good companies to grow bigger, so that when the markets open up, they will be able to compete with Chinese overseas companies. That also makes sense economically because in the past there was over-confidence in all the industries, leading to a waste of resources. They will hand pick a few companies that are most efficient in each industry and those under the radar screen will either be merged or wound up.

Have you seen a marked increase in corporate governance in China?

We noticed that China has improved corporate governance, although there is still room for improvement. In the masterplan, capital markets are among the priorities.

On corporate efficiency, the trend is also improving. In the past, the managementsÆ interests were not tied up with the minority shareholders. But now, they have been given the incentive schemes if their interest lies with minority shareholders.

With the strong economic growth, excess domestic liquidity, very little investment alternatives within China, we remain very positive about investing in that market.

What are the issues that concern you at the moment?

In the near-term, there are a lot of headwinds such as inflation, growth slowing down, and whatÆs happening in the US.

In the short-term, we think that since the correction year-to-date, downside is limited. ThatÆs a rather contrarian call. But as history can tell, when everyone is so bearish, thatÆs an indication that we are near the market bottom.

How should investors play the China market?

We will stick with the big companies to ride the storm. There could be downside, but the downside will not be that substantial. It is quite apparent from the attitude of the regulators that they think the market has corrected enough. They are releasing bit by bit the reassuring signals to the market such as approving more new fund launches.

What are your main worries?

In terms of supply, there will be more available for sale. We have to look into it in greater detail. If you are talking about state-owned companies (SOE), whereby the minority are state board, they may not sell off depending on the performance of the market. The only concern would be minority shareholders who are private enterprises who got their stake as strategic investors. They may sell out if they think the market is trending down. It could be too early to tell if they are going to sell. Since the market is choppy, I donÆt see any rush for them to sell. That is something we have to watch. That issue is valid, but overplayed.

What are the key challenges in investing in China A-shares at this time?

Companies with H-share listing have high standards of corporate governance. We presume that they have full compliance with international standards. They have built up their investor relations and have been dealing with foreign investors for quite some time. In my experience with companies listed on the H-share market, they will tell you almost everything they can tell you. They will even put up some operational statistics on the web. On that front, I donÆt see any issue.

The biggest room for improvement is among A-share companies without an H-share listing. Since they are less experienced with foreign shareholders and institutional investors, they may be reluctant to disclose what the company has been doing and what they are planning. But we have seen some improvement. In the past, if we wanted to visit an A-share company, they simply didnÆt care, they may not entertain you. The mentality has changed a lot since the launch of the share reform in 2005. With the reform, companies were forced to talk to investors. Over the last few years, they have become more transparent and more forthcoming with minority shareholders.

How do you select stocks to include in your portfolios?

We have around 30 to 50 stocks in our A-share portfolios. We use the Shanghai Shenzhen 300, or CSI 300, index as our benchmark and then we add another 30 stocks at our discretion. My colleagues in our JV in Shenzhen and I do the company visits. The JV has 11 staff in their investment team. In Hong Kong, I am part of the Greater China team, which is made up of six investment professionals.

China A-shares have better exposure to ChinaÆs growth. There are not enough candidates among consumer stocks in Hong Kong. In A-shares, we can find department stores, electrical appliance companies, machinery and equipment, and others that provide a much fuller range. In the H-share market, those companies are underrepresented.

Local knowledge is essential. Knowing your competitors and knowing the way they behave is also essential. ItÆs like playing a corporate game.

The key to any successful portfolio management is discipline and looking deep enough into company fundamentals. ItÆs true that the China A-share market tends to be more volatile and more news-driven, but at the end of the day you are chasing profit growth.

What sectors do you favour now?

We like consumption. Wages are going up, wealth is picking up, the growth story is long-term and sustainable, disposable income is higher, people are consuming more. As things improve, we think consumption power will be released. If you look at the base of consumption compared with other Asian markets, China is still below average.

We also like infrastructure. There are people concerned about China because a lot of the economic growth has been driven by the high growth in investment and they think that cannot be sustained forever. But we tend to think the cycle will last longer than people think because of several factors: ChinaÆs 45% urbanization rate is still very low compared with 60% for developing economies; most affluent cities are along the coast; natural resources concentrated in the inland west and northern part of China; China now is facing semi-energy crisis as the economy develops. The government still has to invest a lot in infrastructure. We donÆt think that the fixed-asset investment will stop or slowdown substantially.

In line with that, construction materials and heavy equipment that are infrastructure related will also have a very robust business outlook in the foreseeable next few years.

We think financials is a very good value play. Earnings visibility will be good in the coming years. Net interest income and fee-based income will keep expanding.

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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