Exploiting the Disconnect - Foord’s China Experience

China continues to be in the global investment spotlight with challenges around regulation, property sector concerns and the rapid reversal of its COVID policy.

At peak pessimism, prominent investors were calling China to be “uninvestable”.

While Foord’s positions in China were not unscathed throughout these challenges, we held conviction around our research and even increased weights in some of our holdings. Much of that market-contrarian positioning has panned out well in recent months and we believe there is a feasible runway ahead for additional returns.

Confluence of negative headlines

Revisiting 2021, a series of events started to compound and weighed on investor sentiment.

First, we saw the ANT financial IPO blocked by regulators, who then rolled out a series of new measures including antitrust rules that resulted in fines for the likes of Alibaba. There was also upheaval as the government turned the for-profit tutoring industry into non-profit. Furthermore, regulators paused the approval of new games for the likes of Tencent and NetEase. Heading into 2022, Chinese markets were already battered.

After, came the persistent COVID zero policy that resulted in intermittent and unpredictable lockdowns across different Chinese cities. This created more disruption for both consumers and the industrial economy. At the same time, the United States government was putting more pressure in the form of technology export restriction, adding to delisting threats engulfing US-listed Chinese companies over audit papers.

With each of these events, Chinese stocks experienced steep declines. By the 20th party congress in October 2022, President Xi Jinping secured his third term and consolidated power by appointing six of his allies to the new politburo standing committee. Markets became extremely worried about the concentration of power with Xi; how it could potentially lead to sub-optimal policy making given a leadership team filled with allies and what it would mean for China’s long-term growth.

The markets were at peak fear, but we saw opportunity steeped in fundamental analysis.

Critical research revealed opportunities

Our conviction was anchored first by the quality of businesses and second by valuations. Businesses we owned had mostly high margins, were cash generative and had strong balance sheets and free-cash-flow generation even in the challenging macro environment over the last two years.

From a valuation perspective, businesses we owned were at times trading at levels that implied little or no growth, a scenario that looks very conservative. The structural trends that drive growth could slow in the short-term but were inevitable in the long run. Examples include rising travel demand and increasing e-commerce penetration, continued digitalization that benefits cloud providers and advertising players.

A more specific example would be the online gaming sector. People were worried that online gaming was not aligned to the government’s long-term goal and was detrimental to its youth and thus gaming approval might never come back, negatively impacting businesses like Tencent and NetEase. However, our thought process revealed that if China harboured ambition to become a global leader, it needed soft power. China had to continue to export its culture as Hollywood has done for the United States. Online gaming is one of the sectors where China is a bonafide leader and a potential exporter of uniquely Chinese culture, values, and technology globally over time. China’s global leadership ambition will thus be enhanced by having a strong gaming sector, hence headwinds to gaming companies are likely to be temporary. This was part of the thinking process, in combination with assessment of valuation, that helped us increase positions in certain gaming names through 2022.

At a broader macro level, we were also less negative on new leadership appointments than others in the market. We note that the next premier Li Qiang is actually known to be business friendly having driven the establishment of STAR market (science and tech focused stock exchange) and brought the likes of Tesla to Shanghai. He Li Feng, who is likely to succeed Liu He as the new economic czar, is known to be more pro-growth and is entering the role with more experience than Liu having served in multiple roles across Fujian province before heading up NDRC since 2017. The politburo might be staffed with more of Xi’s men, but not without credentials. We did not necessarily think that with the new appointments, China is set on a path of decline as others have suggested. That bit of critical non-consensus thinking gave us an added layer of conviction that China will still focus on the economy and growth will rebound at some point.

Looking ahead

After the recent Chinese market rally, our expectations remain similar. 2023 is looking to be the first year of an upward cycle. Firstly, China reversed COVID zero policies rapidly and positioned itself to fully open up to the rest of the world in the new year. Secondly, in the recently concluded economic work conference, they are now pushing to support internet platform companies, the same ones they imposed strict regulations on over the last two years.

Chinese officials are emphasizing that 2023 is a year to restore and expand domestic consumption, to which lifting of COVID zero measures will go a long way in supporting the rebound of consumer demand and corporate capital expenditure plans. In support, the central bank is easing liquidity measures to put a floor on the property sector which has been hurt by rules introduced over the last couple of years. More policies will come to support these key objectives for the new year, potentially driving a rebound in the economy in 2023.

In terms of valuation, the Hang Seng index has recovered from the bottom in October 2022, but still trades below its long-run average multiples. Many of the names we own still look attractive on trough earnings. As the earnings start rebounding through 2023, we expect the companies to benefit from both earnings growth and valuation re-rating.

Beyond 2023, it remains to be seen what policy changes are to come and how it will affect our portfolios. Armed with fundamental, out of the box thinking and a long-term view, we remain cautiously optimistic.