The optimistic outlooks for both India and China continues to inspire investor interest but, like all successful long-term investing, gaining exposure to these markets requires adaptability and evolution of style in what is an increasingly fast-changing investment environment.
This is even more apparent when considering the unique flavours inherent in emerging markets. Fidelity’s Anthony Bolton, widely regarded as a doyen of investment management, realised as much after failing to transfer his award-winning multi-decade strategy from UK equities to investing in Chinese entities. A different approach is not only desirable, it is imperative.
Launched in 2006, Ashburton’s Chindia Equity Fund highlights the evolution of process that is required to deliver outstanding investor returns over the long-term. In order to achieve this success, the fund had to adapt.
The first shifts to this award-winning strategy occurred in the aftermath of the global financial crisis, and took a few years to become embedded in the blended strategy that determines the allocation and investments made today. Without going into the finer details of why we chose the combination of China and India (when many other fund managers were opening up global emerging market funds or BRICS funds), it is important to note that we identified the potential for India and China as far outweighing those other nations. However, at inception we believed that our tried and tested fundamental approach to investing in other global markets would be immediately transferable to these two goliath economies and that success would soon follow. Sadly, as our early investors discovered, a more nuanced methodology was required.
Following extensive research and testing, it became increasingly apparent that investing in Chinese and Indian equities required a very different approach in order to deliver success. China’s stock market remains immature when compared to Indian exchanges, which are some of the oldest in Asia and have been bolstered by the rule of law introduced by the British. We found that these differences meant that the more traditional, bottom-up stock-picking style worked in India, but Chinese equities needed a more systematic-based philosophy.
Building in-house proprietary models, and working with one of the world’s leading quant houses, this blended approach was introduced and became fully operational by 2012. Since then the fund has delivered strong outperformance of the benchmark, with both country allocations adding to the returns. As a result, we remain committed to the focused, dual-country allocation and a concentrated portfolio of stocks in each region, rather than diluting the potential outcomes from these two fast-growing nations through a broader investment approach.
Investment style, however, is only part of the mix. It’s the markets themselves that provide the spice. As investors, we operate in a world of probabilities rather than certainties. One exception to this rule is the uncanny ability of capital markets to confound consensus thinking, creating a shift in psychology. Heading into 2018, the mood among financial market practitioners was ebullient, with equities soaring on the back of abundant liquidity, an extended period of ultra-low volatility, a ‘Trump bump’ and FANG (Facebook, Amazon, Netflix and Google) mania. Fast forward a quarter, and stocks are stumbling hard, with nervousness and anxiety prevalent as attention has migrated towards the realities of spiralling debt, inflation, geopolitical instability and the unpredictable behaviour of United States President Donald Trump.
China in the spotlight
China remains firmly in the spotlight given the escalation in trade tensions with the United States. With no clear answer as yet, around whether the conflict remains relatively contained, or will intensify into a genuine and sustained altercation, downside pressure on share prices is the path of least resistance. However, the news is not all bad. Viewed objectively, the argument can be made that corporate China finds itself in its strongest position since the global financial crisis, offering a rare degree of visibility in an increasingly unpredictable global environment.
An exciting development for China watchers has been material evidence that China Inc. has emerged from the earnings slump of the past few years. The pick-up has not just been about internet and e-commerce, but has been broad-based across sectors, from materials to consumer-related to the real-estate companies. This is clearly important, because while the internet sector comprises about 40% of the MSCI China Index by market capitalisation, it represents half that (roughly 20%) when measured by earnings. Earnings growth for 14/24 sub-sectors in 2018 is expected to be greater than 20%, based on current consensus figures, while even banks could register 10%+ growth if the current pace of upgrades continues (based on data from CLSA investment bank).
Margin improvement and free cash-flow generation at the operating level has also historically been lacklustre, particularly when measured in a global context, but even here the trend has been improving. The bulk of cash flow is being generated outside the technology sector, and several companies have delivered positive dividend surprises to the market. Old economy stocks (materials, energy and telecommunications) are producing three times the cash flow of China’s well-flagged ‘new economy’ sectors (internet, healthcare and consumer stocks), offering a yield of around 6.5%.
Turning to valuations, the addition of several internet companies to the market in 2015-16 has significantly altered the composition of the MSCI China Index (comprised of H-shares listed in Hong Kong and United States-listed American Depository Receipts). This makes historical comparisons difficult, even on a short- to medium-term basis. Removing the internet sector, MSCI China remains attractively valued on a price-to-earnings and price-to-book basis measured in a regional and global context at 9.8x and 1.3x respectively. At the same time, investors are witnessing a strong turnaround in both the quantum and quality of earnings for ex-internet sectors.
Nifty moves from India
India too is witnessing an upturn in fortunes for its earnings cycle. Recent past expectations for earnings for the Nifty Index, for example, have been in the high teens, but since 2014 have consistently proved disappointing for investors, with the 50 Nifty Index stocks delivering aggregate earnings in the low single-digits. However, for the period ending 31 March 2018, a mid-teen earnings growth figure is a realistic prospect.
This development comes in the wake of Prime Minister Narendra Modi implementing some rather challenging reform measures over the past couple of years. In November 2016, we had the shock of demonetisation, which led to the cancellation of nearly 87% of India’s cash currency. This was followed, in July 2017, by the much-delayed introduction of a pan-Indian Goods and Services Tax (GST).
Demonetisation has been credited, in part, with shifting idle money into action. Whether that be into one of the nearly 300 million bank accounts opened in the past three years, or investment into a new business enterprise, or being invested in the domestic equity market, India displayed its resilience to this overnight decision. This rebound has been apparent in numerous positive corporate earnings announcements since the beginning of 2018, a condition that we believe will continue to improve.
The arguably hurried introduction of GST resulted in significant teething issues, but the continued refinement of taxes has helped to alleviate the pain suffered in the unsettled opening months. With this fine-tuning now largely behind us, companies are better placed to move forward with greater certainty around the tax regime applicable to them, and customers are also taking advantage of the improvement in transparency around pricing. All of this, supported by a depressed comparative number, has provided a more favourable outlook for earnings.
At the time of writing, India was one of the worst-performing emerging markets on a year-to-date basis. This interim weakness could be attributable to a number of factors, including its recent position as a favourite foreign investor investment destination, a ranking that took a knock when investors began reducing their exposure and booking profits. However, the economy’s underlying strong fundamentals remain intact. The urbanisation shift is well underway and is being supported by the youthful population moving to cities and towns, which is providing a boost for housing- and consumer-related companies. The government is targeting re-election in the next 12 months, thus their focus is on job creation and infrastructure investments are also at record highs. This is boosting employment and earnings potential for industrial and materials companies.
Rosy glow for China + India
The bottom line is that, objectively, the aggregate earnings outlook for corporate China looks reasonably healthy at this juncture, underpinned by an attractive valuation backdrop.
India remains the leading foreign direct investment destination and will see its growth profile increasing in the years to come, with a pick-up evident in the December 2017 data. Ultimately, India’s GDP growth will edge towards the 8%+ GDP growth which China has witnessed over more than the past two decades.
There is, indeed, a new dawn on the horizon for both of these senior emerging markets. Of course, external events will always impact investor sentiment at the margin and depress equity prices in short term, but increasing exposure to both markets remains an attractive opportunity, particularly as their visibility relative to the rest of the world continues to improve.
Balancing the unique flavours of both markets has proved a worthwhile investment approach in recent years. And the requirement for a blended approach to China and India has certainly been borne out in the numbers over the past five years or more. We believe this position will continue to demonstrate the most appropriate way to access and invest in these two great nations.