We are seeing more green shoots appearing in China as Covid restrictions are easing with the reopening of Shanghai and other cities. Manufacturers have ramped up production while delivery times were shortened, supporting a re-acceleration in China’s exports.
As supply-chain constraints are resolved, this should help to temper global inflation. Other supportive policy actions in recent months include easing restrictions on Internet companies and plans to increase infrastructure spending. We expect this pro-growth stance to continue, albeit at a measured pace.
However, key challenges remain and any recovery could be fragile. The risks include further interest rate hikes from the US Federal Reserve leading to a stronger dollar, which is typically negative for emerging markets — it increases their USD funding costs, spurs capital outflows and limits the scope for interest rate decreases in China.
Domestic headwinds are still in place, such as high levels of debt to-gross domestic product (GDP), weakness in the property sector and uncertainty around regulations. Another risk, in our view, is renewed lockdowns in China amid the “dynamic Covid-Zero policy”.
While we cannot fully predict the short-term policy actions on the back of Covid cases, we think the government is shifting its priority towards boosting the economy, given the recent challenges and the reopening of the rest of the world.
In the longer term, we are more sanguine on China, as we believe that the structural growth drivers are intact — including growing wealth and rising incomes driving a consumption-led economy; increasing demand for better quality, higher-priced goods and services; and growing sophistication in technology and domestic import substitution.
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As bottom-up investors, our focus is on identifying high-quality companies with strong management teams and sustainable franchises; in other words, long-term earnings compounders.
Maintaining conviction in major holdings despite short-term headwinds
The pharmaceutical, medical equipment and industrial automation sectors are attractive for fundamental reasons — and they are less reliant on government policies, property measures, interest rates or GDP growth. Short-term market noise is less of a concern as we believe such companies have the potential for future growth.
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Treading carefully in energy and electric vehicles
Among the MSCI China sectors, only energy has a positive return year-to date as the Russia-Ukraine conflict escalates. We do not own companies with direct exposure to coal or oil production, but we are happy to sit out the rally and stay true to our investment philosophy rather than chase short-term outperformance.
We see many reasons for not owning such companies. Our process focuses first on quality, and it can be difficult to find suitable long-term investments in the energy sector. Commodities-driven companies tend to be cyclical and lack pricing power. We are also concerned about their demand potential in the long run given environmental concerns.
We are less enthused about electric vehicles. China accounts for 61% of the global electric vehicle (EV) market. Penetration has nearly doubled in the past year, while the US and European markets are also growing quickly. But as long-term investors, we have yet to see evidence that these companies are able to deliver on their promises — and whether they have the ability to build a strong economic moat.
After some consideration, we think valuations appear stretched, indicating high expectations on both profitability and volume. The sector is evolving quickly with competition increasing while visibility remains low. We are seeing a proliferation of models being built and rolled out, along with aggressive capacity expansion. Given the fast evolution among carmaker and battery companies, it is difficult to predict the long-term winners and we have minimal exposure for now.
We do hold some industrial companies in our China portfolios with growing EV-related businesses. To highlight a few examples, we own Hongfa Technology, Shenzhen Inovance and Nari Technology, which have growing exposure to the EV value chain along with dominant franchises in their core products.
Hongfa is the world’s biggest relaymaker with 17% market share, having overtaken Omron, Tyco and Panasonic to assume global leadership. A relay is an electrical switch which converts small electrical stimuli into larger currents. This function is critical for a wide range of standard appliances and vehicles, making relays indispensable in all kinds of electronic equipment. In vehicles, they can power gas valves, headlights, windshield wipers, interior lighting and alarm systems.
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New applications such as high-voltage, direct current (HVDC) relays are growing rapidly due to EV and renewables growth. Hongfa has around 36% of the global market share in EVs. It supplies to all major original equipment manufacturers including Tesla, Volkswagen and Chinese EV start-ups. Meanwhile shareholder alignment is strong, with senior management collectively owning 34% of the company.
Shenzhen Inovance is an industrial automation company with leading positions in inverters (which change direct-current power from a battery into conventional alternating-current power for operating devices), servo motors (which rotate machine parts with high precision) and new energy vehicle controllers (which coordinate the driver’s inputs into the vehicle’s subsystems, such as making the brakes smoother in a sudden stop). The company’s ownership and alignment are strong, with a dedicated team of founders who have grown Inovance from a small inverter maker into China’s most successful automation company over the past 20 years.
Nari is a leading power grid automation company with world-class technology and limited competition due to its close relationship with the State Grid. We think Nari will be a major beneficiary of the power grid reform and integration of renewable energies, with its expertise in grid automation, EV charging and HVDC transmission.
Given the rich valuations and recent run-ups, we have trimmed our positions, but these three companies remain high-conviction holdings for the long term.
In contrast, we do not own BYD, an integrated EV producer, which has gained market share because its highly integrated supply chain helped to source key components amid recent shortages. We have been following the company for some time, but it barely makes any profit and we are unsure if it can defend its market share after EV supply chains return to normal. We believe its high valuations may be unjustified and although the stock has performed well this year, we have not bought the shares.
When the market is fixated on a particular theme — this is what we call a thematic market — we believe it is best to be cautious and avoid the herd mentality. Sometimes that means missing out on the stocks that have performed well, but are yet to prove themselves as long-term earnings compounders.
Engaging with Chinese companies on ESG
Although Chinese companies are newer to ESG than those in the West, progress has accelerated alongside the country’s major policy initiatives, such as the goal to achieve carbon neutrality by 2060 and the structural opening-up of China’s onshore capital markets. The number of A-share companies issuing ESG reports has risen significantly this year. Companies are also conducting more buybacks and employee share option plans, showing better alignment with minority shareholders.
Rising number of listed A-share companies issuing ESG reports
As bottom-up investors, we hold regular meetings with the senior management of our portfolio companies, with ESG often being a key topic of discussion. We typically conduct more than 1,500 company meetings per year, and 2022 is no different. As of end-June, we have held around 800 meetings with management, including 200 at Chinese companies.
ESG is not only becoming a more frequent topic of discussion; we are also holding more meetings exclusively dedicated to ESG and related matters. We like to see a company’s leadership team being actively involved in its ESG committees, and we monitor progress over the long term towards stated targets.
We prefer to take a partnership approach with our investee companies, gradually nudging towards specific outcomes rather than being dogmatic or prescriptive.
When it comes to sustainability, we believe Chinese companies are shifting their mindset from an environment of “growing from zero/ a low base” to “don’t get left behind”. Perhaps the sense of urgency increased after President Xi Jinping announced China’s carbon neutrality goals in late 2020. We are encouraged by the steps taken and look forward to more green shoots in this space.
Winston Ke is a portfolio manager with FSSA Investment Managers
