Chinese consumers are the next big thing - this fund can help you ride the trend

China has evolved remarkably over the past thirty years. Gone were the days that it relied on manufacturing goods for the world or infrastructure development to fuel its economic miracle. The fact is that its producer and investment-led model was powerful in propelling its economic development forward, but it was certainly not a sustainable one.

The new China we are seeing today was borne out of the government’s ambitious economic reform plan unveiled back in 2010, which aims to result in an eventual shift to a consumer and services-led economy. We believe there is a need to have a different approach to investing within onshore China especially when the nation is at the home stretch of its economic transition.

Aberdeen sees opportunities stemming from structural changes in China’s economy

Moving to a consumption-led economy is not some magic the Chinese government can conjure up overnight, although we must say the country’s economic make-up has changed by leaps and bounds since then. China’s tertiary industry – the part of its economy concerned with the provision of services – is now taking a lion’s share of the responsibility in driving economic growth.

Chart 1: Tertiary services growing in prominence as the main contributor to GDP growth.

Government policy aside, there are other structural tailwinds in China. Millennials (assumed to be born between 1981 and 1996) have often been touted as the group that will reshape the world. In our opinion, millennials in China will have a greater impact on China’s future economy than anywhere else.

The beneficiaries of the yester year’s producer-led economic reforms are 350 million Chinese young adults who grew up knowing little about the hardships of older generations. Being the only child in the family, millennials often got their way when it comes to their material desires. As they come of age and enter the workforce, these millennials therefore have a higher propensity to spend.

For instance, Chinese millennials on aggregate do not have to service a mountain of student debt, which is often the biggest component holding back consumption for young adults. Barring any major economic or cultural shock, it is unlikely that their established habit of wanting to experience the finer things in life will go away anytime soon.

Chart 2: Reducing the consumption gap will be led mostly by a rising Chinese middle class in which millennials will form a large part of.

One Chinese onshore equity fund that we think has a clear understanding of these underlying tectonic shifts is the Aberdeen Standard SICAV I – China A Share Equity Fund. The fund’s top ten holdings captures the spirit of China’s new consumer-based economy – a significant point given that they constitute more than half of the fund’s total AUM.

A high amount of conviction is placed by the investment team on single names like Ping An Insurance, China International Travel Service, Kweichow Moutai and Midea Group which they believe will become leaders in their respective fields as internal demand for discretionary goods and services expand. Rising consumerism will inevitably push demand for insurance, travel, liquor and electric appliances to new highs.

Table 1: Fund’s top ten holdings.

A thematic play on the future of Chinese consumption would mean that the portfolio will be skewed towards related sectors and sub-industries. Evidently, consumer discretionary, consumer staples and health care are among the fund’s heaviest over-weights – but that only scratches the surface of the fund’s investment process.

Chart 3: Aberdeen China A Share Equity is an indirect play on Chinese consumption

Corporate governance the key to investing in onshore China

One reason why investing in onshore companies is fraught with risks is largely due to corporate governance issues. How can we understand if the companies are legitimate and separate the good apples from the bad?

Aberdeen’s answer to that would be a focus on Environmental, Social and Governance (ESG) practises of shortlisted onshore companies. On the ground, they are assisted by third party local research firms to assist the investment team in their company due diligence process.

What the team is focused on ensuring that the companies’ senior management are transparent in their business activities and has adequate protection for minority shareholders. Besides, the fund would take on an activist shareholder role to instil best governance and shareholder-friendly practises.

One example of such is encouraging capital discipline in invested firms – many of which are strong cash generators and have negative debt balances – such as issuing dividends when the company has excess cash in their balance sheet (net of working and capital expenditure requirements).

Share performance of companies with stronger corporate governance outperform the market

In upturns, well-managed and high quality companies have better odds of providing more stable returns to investors, and will likely hold up much better when things turn south. Looking at the chart below, Aberdeen Standard SICAV I – China A Share Equity Fund’s one-year rolling performance since inception has outperformed its other peers and its benchmark consistently across different market conditions.

Chart 4: Aberdeen outshines its peers and the index on a one-year rolling return basis.

To understand the downside risks involved with investing in Aberdeen Standard SICAV I – China A Share Equity Fund, let us look at the most recent major drawdown of onshore markets as a point of reference. In 2015, the fund’s maximum drawdown was ~840bps lower than the MSCI China A Index.

From a bigger picture perspective, these savings compounded over a long period of time has the potential to grow investors’ capital at a faster and greater rate than simply buying into an index.

Chart 5: An actively managed strategy can help investors achieve lower drawdowns

Bottom-up stock picking is still the fund’s primary tool for returns

Where does the fund’s outperformance come from? While it has quite a bit of overweight on consumption-centric sectors, asset allocation on the contrary does not form a significant part of its alpha generation.

Using the MSCI China ETF as a proxy for the onshore market benchmark, we estimated the fund’s ability to allocate to sectors (allocation effect) and ability to stock-pick within a sector (selection effect) relative to a benchmark.

The results conclusively point to stock picking being the main driver of alpha generation. These are, however, alpha generated over a three year period. Given its long-term perspective of holding its investments for at least three years, investors need not be alarmed if the fund undergoes periodic underperformance in the shorter term as structural trends, and consequently its stock picks, may take a longer time to play out.

Table 2: Alpha generated via Aberdeen’s stock picking^

Go active or go home!

Less transparent markets allow for opportunistic actions. While there has been steps taken to improve on the onshore market’s corporate behaviour and harmonisation towards international financial reporting standards, the market as a whole still has quite a long way to go in terms of transparency and accountability. It is because of this high information asymmetry we believe an indexing strategy simply will not cut it.

In China, there is a saying that goes “muddy waters make it easy to catch fish” – from a short seller’s perspective such opaque environments present alpha opportunities from shorting fradulent companies. As long-only investors, alpha opportunities are also available if we do the inverse of avoiding companies that do not pass our due diligence requirements.

It is therefore paramount for investors to be actively involved when investing in onshore China, either directly through your own research, or indirectly via delegation of duties to an active manager, to improve one’s odds in the market. 

[All returns in SGD terms unless otherwise stated as of end March 2019]

The Research Team is part of iFAST Financial Pte Ltd.