This article first appeared in Personal Wealth, The Edge Malaysia Weekly on July 6, 2020 - July 12, 2020

The Hong Kong and China A-share markets are beginning to see positive sentiment as investors price in the country’s “first in, first out” Covid-19 experience.

While this is good news for Malaysian investors, recent economic data out of China indicates that the recovery will not be as robust as expected. Nevertheless, the prospect of a weaker-than-expected upturn could mean a longer window to buy into quality Chinese stocks at lower valuations.

China was the first country to impose strict lockdown measures in the effort to contain the outbreak of Covid-19. Its economy effectively ground to a halt as much of the country came under some form of movement restriction.

The sweeping lockdown measures, particularly in the ground zero city of Wuhan — as well as the wider Hubei province — were initially criticised as draconian. But these drastic steps have arguably prevented the coronavirus from ravaging the entire country.

With China’s economy recovering ahead of the rest of the world, the experts who spoke to Personal Wealth had constructive things to say about its domestic and offshore investment landscapes. “As the country first hit by Covid-19, China is now making the fastest recovery. What this means is that investors should be putting their money to work in economies that are recovering the fastest,” says Patrick Chang, chief investment officer at Principal Asset Management Bhd.

There had been some initial concern about a second wave in China, with a number of clusters appearing in Beijing over the last few weeks. However, the government ­— having learnt from earlier experiences in Wuhan — is moving quickly to quell the spread, he adds. “[The Beijing experience so far] will only have a noticeable impact if the lockdowns go nationwide and become a deterrent to consumption.”

Andrew Gillan, head of Asia ex-Japan equities at Janus Henderson, says more than 40% of the firm’s Asian equity funds are committed to China. “From the perspective of Malaysian investors, China is a very large market, with a number of exciting new economy sectors to look at. I also think the country’s billion-plus consumers make a strong investment case for itself.

“We are broadly positive on China. But, of course, there will be negative headlines, with any number of short-sellers or naysayers pointing to factors like the debt in its economy, as well as recent scandals such as the Luckin Coffee fraud. But given the sheer size of the market, there are bound to be pockets of negativity. A key positive for investors to consider is that the outlook for China has stabilised.”

On April 2, Chinese coffee chain Luckin Coffee disclosed that an internal probe had found that its chief operating officer had fabricated 2019 sales by about US$310 million.

Bin Shi, head of China equities at UBS Asset Management, is positive on the country’s investment outlook despite the fact that for the first time in decades, Beijing has decided not to set a GDP target for the year. This was a prudent response in a post-Covid-19 environment, he says.

“Setting a GDP target would mean that the central government has to give growth targets to local governments. This runs the risk of local officials rushing to enact policies to achieve their goals in a way that may not benefit the economy in the long run,” says Bin, who runs a number of China-focused equity funds that are available as target funds via local asset manager Affin Hwang Asset Management Bhd.

However, the improving sentiment should be balanced against recent economic data, Nomura chief China economist Dr Ting Lu said during a recent webinar. Although the country enjoyed a remarkable V-shaped recovery in 2Q (on the back of a very low base in 1Q), he believes markets are a little too optimistic about an economic upturn in the second half of the year.

The recovery in the services sector remains weak, according to data compiled by Lu. “The services sector, as characterised by restaurant openings in 2Q, is still down roughly 10% year on year (y-o-y). Restaurant revenue is down 40% to 50%, so we are still well below normal levels,” he said.

“Meanwhile, intercity travel is down 50% y-o-y. Travel within cities is improving but even so, subway travel is still down anywhere from 5% to 40% y-o-y, depending on which city one looks at.”

However, there are some bright spots. Lu has noted pent-up demand in passenger car sales. “In March, vehicle sales were down 40% y-o-y. But in the weeks since, sales have registered strong positive growth. Broader retail sales numbers are also showing similar patterns of recovery,” he said.

Lu expects pent-up consumer demand to gradually lose steam going into 3Q, with social distancing measures expected to persist well into the second half of the year. Additionally, while China has enjoyed some export-related upside, thanks to increased demand for its medical products and refrigerators, this could drop as exports peak and a lack of new orders finally dent production, he warns.

Also, the already frosty US-China relations have deteriorated further in recent weeks. This could impact China’s export performance as well as export-related manufacturing activity.

Although infrastructure-related construction is a major stimulus measure for now, government stimulus has been conspicuously absent in the property sector. “Beijing is likely to exclude the property sector in its demand stimulus package. As the economy continues to deal with the dual challenges of plummeting exports and the remnants of Covid-19, the economic recovery could be much weaker than markets expect,” said Lu.

Nonetheless, he takes the view that China’s recovery will take place ahead of other countries. Thus, the country could lead the world in turning things around, albeit at a slower rate than the market presently expects.

The case for consumption

Although the markets initially reacted strongly to the pandemic, this was not entirely unexpected, says Bin. “We counteracted this by keeping cash at higher levels than normal. We will put more cash to work when we feel the time is right.”

Recent valuations in China’s offshore and A-share markets are reasonably priced relative to their regional peers and historical averages, he says. As at May, these markets were trading at an average price-earnings ratio (PER) of between 12.5 and 12.8 times (on a 12-month forward basis). This is lower than the 13.4 times of the Asia-Pacific ex-Japan market.

Amid the cheaper investment environment, Bin is invested in sectors that are expected to benefit from China’s structural change to become a consumption-driven economy. Despite the disruptions caused by Covid-19, themes such as urbanisation, “premiumisation” (lifestyle upgrading), innovation and the ageing population continue to gain traction. “Our China equity portfolios are focused on selecting winners within these themes,” he says.

The Chinese consumer growth story is also shared by Principal’s Chang, who sees a strong case in the short to medium term. There are opportunities in the consumer staples and discretionary sub-sectors.

One discretionary sub-sector he likes is local tourism. While conventional wisdom in most other markets point to a broadly negative outlook, early indications in China are encouraging. “The Chinese are the biggest tourists globally and with robust controls on travel for the foreseeable future, they will be touring their own country in numbers,” says Chang.

Indeed, there was a wave of reports out of China in early and mid-April, detailing packed tourist destinations as citizens emerged from months of strict lockdown measures. “While there is still a lot of caution around travelling right now, our teams on the ground in China are reporting that travel is gradually getting back to pre-Covid-19 capacity,” he says.

“Hotel occupancies are also on the rise, and not just in the lower to mid-tier hotels. Five- and six-star hotels in tier-one cities are starting to book out.”

Local tourism aside, Chang believes that consumers will be engaged in what he calls “revenge spending” post-lockdown. To illustrate, he points to a record day of sales at the Guangzhou branch of French luxury brand Hermès. The store reportedly made US$2.7 million (RM11.5 million) in sales on its first day of reopening in mid-April. “My guess is that there is a huge amount of pent-up consumer demand and we want to position ourselves ahead of that trend,” he adds.

However, given the elevated levels of caution around spending since January, Chang does not rule out an eventual pullback in discretionary spending. Even so, consumption would still be a significant driver in the consumer staples as well as online retail and delivery sub-sectors.

“For example, a large noodle manufacturer or a major dairy producer that has outperformed over the last few months would continue to do well in this environment. And a related play would be companies that specialise in online delivery. This is a sub-sector that has really benefited from the months of movement restrictions in China,” he says.

One online-to-offline delivery counter that has outperformed this year is Meituan Dianping. It is a group-buying portal that offers local food delivery services, consumer products and retail services. The Beijing-headquartered and Hong Kong-listed Meituan, which was trading at HK$171.60 (RM94.87) per share on June 29, is up about 70% this year.

The company went public in September 2018 and turned a surprise quarterly profit for the three months ended September 2019. Profit increased to US$123 million from a US$1.1 billion loss in the previous corresponding quarter. According to company announcements, the results were driven by its food delivery business, which accounted for more than half its revenue.

Earnings understandably have taken a hit this year and the stock was not spared at the depths of the Covid-19 sell-offs in March. The company reported in late May that quarterly revenue for the first three months of 2020 came in at RMB16.75 billion (RM10.1 billion), down from RMB19.17 billion in the previous corresponding quarter. An operating loss for the quarter increased y-o-y to RMB1.7 billion from RMB1.3 billion.

However, these losses have not hindered the stock, which had surged about 130% from its late-March low (as at June 29). According to Bloomberg data, the counter had a whopping PER of 541 times.

According to Brendan Ahern, chief investment officer at China-focused asset manager KraneShares, this outperformance is at least partly due to the company’s first quarter results beating analyst expectations, which were broadly more bearish than the eventual financial reports. “But also, Meituan is benefiting from being in Hong Kong and therefore being accessible to global investors. The company has gained far more visibility than it otherwise would have,” he says.

“Further, it is likely that the stock will be added to the Hang Seng Index sometime in August. This means even more investors will be able to access the stock via exchange-traded funds (ETFs) and futures contract trading. Quite simply, there will soon be more money flowing into the stock.”

KraneShares is the asset manager of the KraneShares CSI China Internet ETF, which is now part of StashAway Malaysia’s investable universe.

Optimism notwithstanding, Meituan’s earnings report cites a number of factors that could potentially impact the business in the second half of the year. These include ongoing pandemic precautions, consumers’ insufficient confidence in offline consumption activities and the risk of merchants going out of business.

Technology still a major theme

The pandemic appears to have accelerated the adoption of technology, already a proven growth play even before the outbreak, throughout the Chinese economy. Experts have long been bullish about Chinese technology and remain so in the post-Covid-19 investment climate.

UBS’ Bin has seen a lot of non-technology companies ramp up their technology investments and innovation efforts. This has been especially true for the consumer discretionary sub-sector as well as communications-related service sectors.

“Online businesses such as gaming, education and retail are all doing well this year, largely because the pandemic has accelerated the shift from offline to online. Leading companies in these sectors will likely take market share from offline competitors this year,” he says.

Bin remains positive on leading companies in these spaces such as Alibaba Group Holding Ltd and Tencent Holdings Ltd because they continue to place an emphasis on innovation while their core business models remain robust. His various China equity strategies have relatively large positions in both companies.

Alibaba and Tencent have been instrumental in the structural shift of China’s economy from manufacturing to consumption, with its more than one billion citizens as an invaluable target market. Bin points out that China leads the world in e-commerce and this has been illustrated by the recent record sales volume achieved on a major Chinese shopping event, dubbed “618” because the event falls on June 18 every year. It was conceptualised by Chinese retail giant JD.com (partly owned by Tencent).

Rival Alibaba also has its own special shopping event, dubbed “Singles Day”, which falls on Nov 11. Due to increased competition, however, both retailers have taken to ramping up sales efforts even on each other’s special sales days. This year, on 618, amid the worst pandemic since World War I, Alibaba and JD.com handled a record US$136.51 billion in sales through their respective platforms.

Bin says Tencent’s super-app WeChat has become indispensable to the Chinese consumer. It has successfully integrated everything from social media to ride hailing, e-payment and even medical services, all of which are available on consumers’ smartphones.

“Tencent’s ability to remain intertwined with daily life in China will help ensure long-term revenue streams for the company. In fact, both Tencent and Alibaba have diversified sources of revenue that can help them through difficult periods,” he says.

China’s three big technology, gaming and e-commerce players — Alibaba, Baidu Inc and Tencent — all beat expectations in their May earnings reports, with each citing a boost to their gaming and advertising revenues. They did, however, take hits to their payments and enterprise cloud businesses as people stayed home and reined in spending in the first quarter.

For Principal’s Chang, any short-term weakness is an opportunity to add to his China positions. The business segments in which these companies continue to operate are competitive and warrant close monitoring, he says.

In fact, the emergence of new technology players will make this broad cloud computing space even more competitive. “However, we are very constructive on these incumbents over the long term. These companies have massive balance sheets and the ability to go out into the market and acquire companies in their verticals,” says Chang.  

The emergence of new and smaller Chinese technology players over the last few years has made the investment climate that much more growth-oriented and, therefore, even more attractive to retail investors. However, Chang cautions against going for smaller companies.

“The Chinese technology investment dynamic is gradually evolving and sectors such as data centres, cloud computing and 5G-related plays are areas that we think will be new growth drivers. But we are also conscious about the relative valuations that these segments entail,” he says.

While finding value is important, Chang urges investors to also look at the quality of earnings. In the current climate, people tend to think that Alibaba, which is trading at a PER of well over 20 times, is expensive. However, the company has a very strong balance sheet characterised by diversified, profitable and sustainable business units.  

“Sure, an investor could simply buy into a very cheap, high-growth tech company, but how sustainable and diversified would its earnings be? Its quality of earnings is unlikely to match the incumbents,” he says.

Interestingly, one sector that all the experts are wary of for now is the Chinese semiconductor space. Having long been reliant on US-made semiconductors, Beijing is determined to remove this multitrillion-dollar bargaining chip from the trade war table.

Such is the government’s commitment to semiconductor self-sufficiency that a March report by Nikkei Asia Review detailed how, at the height of the lockdown, the country’s sole NAND flash memory chip maker, Yangtze Memory, received special permission to shuttle workers in and out of its Wuhan fabrication plant. In fact, the report details how Yangtze Memory was actively hiring to fill key technical and business positions, most of which were based in Wuhan.

Meanwhile, another Chinese chipmaker, Semiconductor Manufacturing International Corp, is looking to raise about US$2.8 billion in a second initial public offering, on the Shanghai Stock Exchange, despite already being listed in Hong Kong.

For the moment, it appears that fund managers are sitting on the sidelines. “Our fund exposure to China tends to be in asset-light, online businesses, as opposed to the intensive technology industries in China. We are not specifically targeting semiconductor plays and the few counters that we do have tend to be based in Taiwan or South Korea,” says Gillan.

“We hold certain positions in the Taiwanese and South Korean chip industries. But even so, China is definitely beefing up its chip industry, especially in the light of the US effectively controlling Huawei’s supply chain,” says Chang.

“But it should be noted that it is still early days for the Chinese semiconductor space and we cannot really invest in the sector until we are sure that the earnings are there. It is definitely something we are watching out for though.”

Key risks and advice for investors

This being a particularly traumatic year for the global economy, China’s early emergence from Covid-19 shutdowns bodes well for investors. Concurrently, however, investors ought to be mindful that existing investment risks could be exacerbated by the local and global trajectory of the pandemic, as well as prospects of an effective vaccine.

According to Bin, one of the key risks of investing in the China A-share market is the volatility associated with it. “The market is dominated by retail investors, who generate 86% of the trading volume, according to our internal data from May 2018. This means the market is susceptible to those who rely primarily on headlines and invest based on speculation,” he says.

Meanwhile, US-China tensions have taken a turn for the worse in recent weeks. US President Donald Trump has railed against China’s role in the spread of the coronavirus — allegations that Chinese state media apparatus have vehemently pushed back on. “In addition, it is not unusual to expect that the current administration will continue its tough stance on China, especially in the run-up to the US presidential election this November,” says Bin.

A central theme of the escalation is related to the status of Chinese companies listed on US exchanges as well as China’s recent approval of a controversial national security law in Hong Kong. “However, on the issue of Chinese companies potentially delisting from US exchanges, we believe this is a manageable risk that, were it to materialise, would take a few years to be implemented. Companies would therefore have time to react,” says Bin.

As far as Hong Kong is concerned, he is confident that the city will remain an important financial centre for China, and perhaps even more so with recent news on the possibility of Chinese companies delisting in the US. “Hence, we continue to see more Chinese companies with American Depository Receipts exploring plans to list in Hong Kong,” he says.

“Further, the city’s Stock Connect programmes [which provide global investors access to the Shanghai and Shenzhen stock markets] are a very important component of China’s financial liberalisation as well as a source of foreign capital. We do not foresee these market access mechanisms being impacted.”

In the case of China’s national security law for Hong Kong, Bin says geopolitical risks are an ever-present reality when investing in emerging markets. “However, in the long run, most geopolitical events have not had any meaningful or lasting impact on markets. This is not to say that none do, however. The trade and tech-related conflict between the US and China is certainly a major risk factor that we will continue to monitor.”

Meanwhile, Chang is looking for signs that the present recovery may not be sustainable. “Obviously, the biggest risk to economic recovery is a second major outbreak, something like that could knock out China’s recovery,” he points out.

“We are also mindful of a second-order impact that could be building in this recovery phase. This has to do with China’s export demand. If developed markets across the globe fail to recover as quickly as anticipated, exports will take a hit and China’s already faltering export market could derail the broader economic recovery. This will eventually show up in company earnings.”

In the light of these risks, Chang advises investors to take a long-term view and with it, an ability to stomach volatility. He also says investors should not think of China as a developing market but as a country on the cusp of becoming fully developed.

“You want to be invested in the early days of this broad transition to developed market status. The government is transitioning the country’s entire corporate governance structure to be more in line with developed markets. It is very interesting to be invested in China during this time because there are plenty of great growth companies, cutting across all sectors of the economy rather than just in the technology sector, which tends to be the case in markets like the US.”  

Bin advises investors to take an active approach to their China strategy, as opposed to being invested in passive instruments. “It is important to be an active investor in the China A-share market because it remains dominated by retail investors. Active managers are better positioned to conduct on-the-ground research and buy into companies with long-term potential and sound fundamentals,” he says.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.