The MSCI China index has returned 32 per cent in sterling terms since 28 January 2017, the start of the Year of the Rooster, while the MSCI Asia ex-Japan Index has risen 20 per cent. This compares very favourably with the 6.4 per cent performance of the MSCI World index of developed markets and the 4.9 per cent return from the UK’s FTSE All Share. 
It might have been more fitting for last year to have been the Year of the BAT given the extent to which stock market leadership in China/Asia came from Chinese internet companies.
In the US you have the FANG stocks (Facebook, Amazon, Netflix and Google) – and now the growth of China’s own IT sector has justified the coining of its own acronym: BAT – Baidu, Alibaba and Tencent. The FANG stocks have notched up stellar returns over the last year. These four stocks alone account for 13 per cent of the investment return of the 632-member MSCI USA Index since 28 January 2017 (18 per cent in local currency). It has been an even more emphatic story of IT dominance in China; the three BATs accounted for about half of the rise in the 152-member MSCI China index in the Year of the Rooster (47 per cent in local currency).
Following these gains, shares in the BAT companies sit on lofty valuations and, in our opinion, have got ahead of themselves. We will be looking for market leadership to come from elsewhere in the Year of the Dog.
We run an income fund so struggle to justify investing in expensive stocks with a lack of decent dividend yields. The type of companies we own – those that provide a healthy balance of earnings and income growth – tend to come into their own when investors become less sentiment-driven and more discerning. With the Chinese economy set to continue decelerating in future years, this profile could prove very valuable.
Last year we perceived a growing acknowledgement that China is not teetering on the edge of a crisis. Having stabilised in 2016, fears of rampant capital flight remained absent.
In 2017, attitudes in Asia also suggested that China’s high debt levels were no longer causing significant concern. This possibly reflected investors’ realisation that a lot of loans are from government controlled entities, to government controlled entities, meaning they can be unwound without too many negative side effects.
This allowed investors to focus on a significant recovery in corporate earnings which was supported by a better-than-expected economic backdrop. Growth did not tail off much in the second half of the year and although inflation rose slightly, it did not reach levels that concerned markets.
Despite their strong 2017 performance, Chinese equities still look good value. The Hang Seng China Enterprise Index – which represents ‘H’ shares in Chinese companies that are listed in Hong Kong – trades on a forward price/earnings ratio of 7.4. This compares against the US market (MSCI USA index) on 16.9x and Europe (MSCI Europe index) on 13.9x.
China’s GDP actually rose by 6.9 per cent in 2017, up from 6.7 per cent in 2016 – but this was the first time in seven years that growth had accelerated. The growth rate is expected to revert to close to 6.5 per cent this year, a level which is still very high by global standards and maintains China’s position as the regional growth engine.
Although its economy is decelerating, we believe the investment opportunity is expanding for those who are able to differentiate between the companies that will benefit from the economic transition and those that stand to suffer.
Earlier in the economic growth phase, it was tempting for companies to reinvest all earnings in the hope of compounding more growth.
As China’s economy moves to a less aggressive growth phase, we believe that companies will begin to take more considered capital allocation decisions – investing for growth when appropriate while hopefully showing more inclination to return excess cash to shareholders. On aggregate, we expect free cash flow – cash generated by a company’s operations once capital expenditure needs are accounted for – to increase as past years’ heavy investments begin to mature. This will mean more cash is available to be returned to shareholders, which should provide ample opportunities for income investors given the country’s improving dividend culture.
At the 19th Party Congress last year, China’s Communist Party prioritised ongoing economic rebalancing and more sustainable growth for the next five years. This stance is encouraging as, in our view, China need to rebalance its economy away from inefficient industries.
Importantly there was also a move away from the party’s old habit of announcing GDP targets, which have sometimes led to unhelpful decisions (and dubious data). That it was able to make this change with so little fuss suggests that there has been a shift in investor perceptions regarding the Chinese economy, with deceleration seen as acceptable in order to move to a more sustainable long-term growth path.
So we avoid areas of overcapacity and falling returns, shunning moribund industries that are being propped up for employment rather than profit.
As China weans itself off its pursuit of growth at any cost, the country’s personal consumption continues to grow at a double-digit rate. There are lots of companies generating earnings growth from this expanding middle class.
The Liontrust Asia Income fund’s consumer-related exposure (consumer sector stocks as well as companies in other sectors exposed indirectly to consumer demand) stands at over 50 per cent, and around a quarter of this is invested in China and Hong Kong.
We of course invest with a long-term time horizon and here we find that China’s growth prospects are huge. This potential is widely recognised, but perhaps underappreciated is the extent to which this process is in its infancy. For example, we are already seeing Chinese consumption power have a huge impact globally through the 122 million Chinese who travelled overseas (in 2016), but 90% of China’s population still don’t own a passport. Similarly, China is the world’s largest auto market, with car sales exceeding both Europe and the US, but there are still only around 21 motor vehicles for every 100 people (based on 2017 Ministry of Public Security data), compared to almost 80 in the US.
We shouldn’t make the mistake of thinking that the substantial consumption growth that has already fed through is anything more than the tip of the iceberg.
Mark Williams is a fund manager at Liontrust Asset Management. The views expressed above are his own and should not be taken as investment advice.