Argument in favour of investing in China

Asian Investment Market Series 1/3

By Willem le Roux, Principal Investment Consultant and Actuary

According to Forbes.com, in the decade of the 2010s (just after the Global Financial Crisis), worldwide growth led to the number of US dollar billionaires around the globe nearly tripling to 2 095 on the 2020 Forbes World’s Billionaires list. Although there were reportedly 61 countries and territories which saw new billionaires, China gained the most – up from 64 in 2010 to 389 in 2020 (that is about 6 times as many in 10 years), plus an additional 66 in Hong Kong, so 455 between the two. This is about three-quarters of the US’s 614, implying a much smaller gap between the two than a decade before.

As the saying goes, “Where there’s smoke, there’s fire.” If there are so many Chinese nationals becoming billionaires (more new billionaires than anywhere else in the world, including the US), there must be some money to be made in China. Any traveller to China in recent years will tell you that the scale of things simply boggles the mind. China has a population of approximately 1.4 billion, which represents just under 20% of the approximate 7.8 billion people on the face of the planet. The size of the buildings, the amount of construction, the scale of online connection and the quality of the Chinese infrastructure serving the sheer number of people living in China are all impressive, to say the least.

Think about this: a super successful product in South Africa may be able to attract half of our 59 million (that’s 0.059 billion) population, or about 30 million customers. Tencent (the Chinese business in which Naspers/Prosus holds a meaningful stake) has about 1.2 billion customers. Success in South African terms simply cannot reach anything near success in Chinese terms. Even the United States of America, the greatest consumption engine the world has ever seen, only has a population of about 330 million (or 0.33 billion).

What does China have going for it?

Clearly, it has the demographic dividend to reap from the massive population. The population includes a strong, young middle class even after the one-child policy.
Foreign direct investment stands to increase following the lifting of restrictions on foreign ownership over the last number of years, with more concessions expected.
Nowhere in the world has an economy as large as China continued to grow consistently at high single digits for such a protracted time as China has done and expects to prolong.
Although much of the past growth was funded by the government’s infrastructure programmes, there is still much scope for growth in the policy of Xi Jinping’s government, seeking to transition from an infrastructure-led economy to a consumer-led economy.
More than half of the Chinese GDP is now made up of services sector businesses, which are also an important driver of employment.
China’s manufacturing is being transitioned from high volume/low technology to high technology and innovation, in a similar fashion to what Japan did very successfully a few decades ago.
China has seen substantial productivity growth due to innovation and technology.
China is explicitly targeting urbanisation as a further tailwind to economic growth, alongside a growing middle class with an increasing disposable income.
Mobile take-up is at least as high as anywhere else in the world, implying engaged consumers.

As if all those changes are not enough to build an investment case, even what China already has, is under-represented in global investment markets. Taking full account of H-shares listed in Hong Kong and the A-shares listed in mainland China, Chinese listed equities make up less than 4% of the MSCI All Countries World Index. This is compared to its GDP contribution of between 15% and 20% of global GDP. Conversely, companies listed in the United States make up over 50% of the MSCI All Countries World Index, while contributing a very similar proportion to global GDP compared to China.

To make an even more scary comparison, the market capitalisation of all of “China Inc” is only slightly more than Apple’s approximate 3.3% weight. This is notwithstanding the fact that China has competitors for the likes of Apple, Facebook, Alphabet (Google) and Amazon, with substantial customer numbers, not lagging the US companies by as much as you may have thought. All of them together, along with all the rest of listed China, can be bought for just more than the value of the market capitalisation of Apple. Now that’s an interesting investment idea, rather than the recent speculative acquisition of certain cryptocurrencies…

There is another reason for institutional investors, in particular, to consider investing in China. Besides the fact that the higher growth rate and potential upside may look mouthwatering, investing in China also comes at a reasonably low correlation to most of the big global markets. More pertinently, it provides the benefit of substantial diversification from the South African listed equity market (see the chart below sourced through Prescient). The CSI 300 is a mainland (A-shares) China listed equity index and it shows a lower correlation to South African shares than emerging markets, European markets, Japan, the United States or the entire MSCI World Index.

Source: Prescient, Bloomberg, February 2021

China’s low correlation with other markets may be partly thanks to:

A lack of global investors, and therefore constrained trade, in the past; and
Many capital-intensive businesses and Chinese state-owned enterprises, which tend to be less volatile by nature and make up about 40% of the A-share market capitalisation.

Challenges relating to investing in China are also plentiful, including but certainly not limited to:

The language barrier;
Much lower governance and information-sharing requirements;
Non-financial goals and priorities held by executives, often relating to national interest; and
The active role of the State in society, business and investment markets.

These risks would obviously seem best mitigated by active asset managers with regional expertise in the area. Such asset manager firms should have access to better information, knowing which businesses are more focused on national interest than returns etc., possessing governance insight and understanding the risk of disruption through politics, global polarisation etc. They should also be better able to construct optimal allocations between the typical growth companies and the Chinese state-owned enterprises. The latter tend to be more capital-intensive and yielding lower returns, but also more stable and government-protected in terms of their area of service or product delivery. Some asset managers highlight that many investors have a one-sided (negative) view of political risk in China – good active managers should be able to exploit such inefficiencies.

The recent crackdown of the Chinese government on businesses with a perceived negative social impact or detracting from the Chinese national interest, should stand as a stark warning to investors to understand the businesses they are buying, and to consider the sustainability of the business models, in the Chinese context.

There seem to be many merits for institutional investors to investigate a meaningful exposure to the Chinese equity market within their global equity allocations.

However, implementation is complex. If an investor makes a strategic allocation to one country, arguably, this sets a precedent for “manually” considering the investment case for more countries, potentially leading to a complex regional strategy in the long term. The alternative would be to find asset managers who are experienced in emerging markets, and particularly Asian markets, and allow them to allocate dynamically to access good investment opportunities within that space. Read more about this in the next article.

Disclaimer.