The massive investment potential of China’s burgeoning healthcare market is set to be unlocked by ongoing reforms, and investors are encouraged to adopt a diversified and prudent approach to identify the best opportunities.

China’s population is ageing rapidly. The demographic change means the country needs to develop a more robust healthcare system and improve access to affordable and quality drugs, said Frank Tsui, senior fund manager for equities and head of ESG investment at Value Partners.

“Reform is much required to address healthcare needs in China. It has become a key factor in driving investment opportunities in the sector,” Tsui said.

The Chinese elderly population is expected to more than double in size from 2020 to reach 366 million in 2050. To cope with this, healthcare expenditure in the country is estimated to more than double to Rmb17.61 trillion between 2020 and 2030, according to Frost & Sullivan and Goldman Sachs research.

As part of the efforts to reform the industry, a centralised bulk procurement programme that helps to eliminate substandard pharmaceutical companies was launched in 2018. The programme, known as the Group Purchasing Organization (GPO), helps vendors consolidate bargaining power and obtain the best prices for selected generic drugs and medical devices.

 “This led to sector consolidation, favouring quality pharmaceutical leaders that are in a better position to absorb the drop in margins. This creates investment opportunities,” Tsui said.

Meanwhile, a string of measures has also been rolled out to facilitate the registration of innovative drugs and fast-track approval process of novel drugs. Innovative drugs are a key growth area for pharmaceutical companies, as they are expected to generate over 20% of their annual revenue growth in the next few years.

Investment opportunities can also be found in other sub-sectors. Medical device companies are increasing their global market share due to technology advancement and price advantage, Tsui said.

Demand for quality healthcare products and services, such as private specialty hospitals, is also expected to climb thanks to the growing middle-class in China. Ophthalmic hospital services and artificial reproductive services, which are both underpenetrated in the country, will also be in greater demand, he added.

Sector diversification of Value Partners' healthcare strategy
Source: Value Partners, as of May 2021
 
VOLATILITY

The medical industry in China is relatively nascent compared with developed countries. China’s healthcare expenditure only accounts for 6.6% of its GDP as of end-2019, compared with 17% in the US and 12% in Japan, data from Statista and Organisation for Economic Co-operation and Development (OECD) shows.

With China’s healthcare industry still being at its early stages of development relative to the rest of the world, the sector continues to provide long-term growth opportunities, according to Tsui.

“China’s healthcare sector has attracted a lot of investor attention in recent years, and we believe its development will remain exciting in the years to come,” Tsui said. Indeed, Chinese healthcare equities have returned positively in the past few years and consistently outperformed their global industry peers.

Source: MSCI, 31 May 2021

However, the healthcare sector also exhibits a different risk-return profile.  Returns are volatile, and reforms or policy announcements are among the factors underpinning the volatility. For instance, after several rounds of the GPO programme, profit margins of lower value-added generic drugs have been squeezed, resulting in share price volatility among mass generic makers.

Source: MSCI, 31 May 2021
 
VALUE INVESTING
 
To navigate the volatile market, it is important to invest in a diversified way and adopt an active bottom-up picking approach to identify quality companies that are expected to benefit from structural changes in the country, including demographics and reform, Tsui said.
 
One way to diversify a China-focused healthcare portfolio is having an 'all-China' approach. Investment opportunities in China’s healthcare sector can be found in both A-shares and Hong Kong-listed securities, according to Tsui.
 
While there are more Chinese healthcare companies listing onshore than offshore, investors may miss out investment opportunities if they were to focus on either one of the markets, as some Chinese healthcare leaders are only offshore-listed, he said.
 
A consistent approach to value investing is also encouraged to better manage volatility and generate higher risk-adjusted returns for the strategy in the long term.
 
Investors are encouraged to invest in quality medical businesses with earnings that are trading below their intrinsic value. They should also be cautious of companies whose share prices are driven by momentum. High valuations in medical companies are warning signs too, especially when one-off events are already reflected in their share prices, Tsui said.
 
Value Partners has been managing a $428.3 million China-focused healthcare strategy on behalf of institutions, high-net-worth individuals and retail investors since 2015. The strategy outperforms its benchmark when its performance is analysed using different metrics.
 
Source: Value Partners, as of May 2021
The healthcare strategy, holding around 40 names, is diversified across sectors but employs a high-conviction approach to investing. As of end-May, the China healthcare strategy had nearly 50% of its assets in China A-shares and 45% in Hong Kong-listed stocks, including H-shares and red chips. The strategy has a dynamic allocation when it comes to listing exposure, depending on where the firm finds the best risk-adjusted opportunities.

To understand about China’s healthcare sector in a nutshell, please check out the video below.