China: A permanent revolution
To invest in an economy of over 1.3 billion people, a GDP of US$21 trillion and an all-powerful, all-seeing Communist government, you need to look at things a little differently.
China is a unique equity market with divergent features such as an immature investment climate; strong government presence across strategically important industries; high levels of domestic retail participation; hot money flows in both directions and frequent shifts in sentiment and volatility. Combined, these factors lead to frequent market dislocations
These events present challenges, but also create opportunities. The result is an extremely fertile environment for prospective equity market returns over the long term if - and it is a big IF - investors maintain a disciplined and rigorous risk-control process.
Different for a reason
Traditional long-only offerings found in the China universe do not use systematic, rules-based equity strategies. We look at China differently. We take a simple approach which involves:
Allocations at a country level when market conditions are most attractive, and
Investing in a concentrated portfolio of top-quality stocks.
Despite the country’s vast economic size and impact on global trade, China’s capital market environment remains relatively immature, even by emerging market standards, so we adopt a purely quantitative approach to help cut through the noise, the misinformation and the ever-present impact of state interference.
Two independent proprietary models govern our entire China investment process. A market timing indicator gauges the overall health of the market at the index level, which determines the China capital allocation. Once equity is committed, a screening model drives the stock selection. Once equity has been committed, our proprietary screening model cuts the investment universe from 1 500 actively-traded Hong Kong stocks down to the 150-200 stocks in the MSCI China Index, capturing more than 85% of the Chinese equity universe by market capitalisation. This screen looks to eliminate idiosyncratic stock risk, liquidity issues and prioritises superior data transparency.
Our proprietary composite screen then compares and contrasts each remaining company across a range of value, quality, growth and price momentum metrics. Each stock in the universe is graded using an absolute ranking - the aim is not to give a target valuation but to review a stock against the peer group universe.
Each company must meet a strict selection criteria to be included in the final portfolio. This creates what we believe are the top 20% most attractive stocks in the entire universe and culminates in a concentrated, high-conviction mandate of 20 to 30 equally weighted stocks.
Our directional trend indicator (DTI) has three modes:
“No other asset manager currently delivers a long-only fund in this space; one that is focused on deriving absolute returns over the cycle.”
A methodical, quantitative-based approach allows us to remain detached from emotional attachment to a theme, sector or individual stock. This enables us to run winning positions and cut losing positions dispassionately.
The stock selection model is rerun every month to take into consideration new accounting criteria and share price data. This also acts as a natural stop-loss mechanism. Stocks which maintain their top 20% ranking remain in the portfolio, while those companies that fall out of the top 20% are removed and replaced.
Belt and road
China is undergoing a transformation. President Xi Jinping’s spectacular ‘One Belt and One Road’ vision to link Europe to Asia through land and sea is seen by many as Globalisation 2.0 at a time when United States President Donald Trump is pushing a protectionist agenda throughout the world. For China, a country which has traditionally been very insular, the plan to facilitate trading with more than 54 nations through investing US$40 billion in new infrastructure is a dramatic departure. According to an opinion piece by Jorg Wuttke, carried in the Financial Times newspaper earlier this year, the so-called new Silk Road initiative “will involve major investments in infrastructure in Asia and beyond – expanding trade and investment along a new land route extending as far as Europe and through a maritime route all the way to the Middle East and the Mediterranean”.
While Wuttke, President of the European Union Chamber of Commerce in China, noted that the idea was, currently, “less of a practical plan for investment than a broad political vision”, he wrote that “forging closer links across the region can promote faster growth and economic integration”. Without doubt it is an inspiring vision and, like China, it is grand in its scale and complexity.
We believe that our approach to China is unique and aligned to this dynamic and multifaceted nation. As far as we are aware, no other asset manager currently delivers a long-only fund as per the space that is focused on deriving absolute returns over the cycle.
By taking a different approach to the allocation of capital – derive stock selection and manage aggregate portfolio risk – we have found the optimal way to capture the China equity market opportunity.