Chin Ping Chia, Head of China A Investments, business strategy and development at Invesco, takes a close look at Capturing A-Share opportunities amid China’s accelerating pace of economic transition. The Chinese economy has undergone several phases of economic transition. It once pursued an investment-led and export-oriented model of growth, and in recent years this has shifted to one that is led by consumption growth and innovation. Recent geopolitical developments are hastening this transition. Trade tensions, rising protectionism, the rapid spread of Covid-19 and the changing nature of international relations are making Beijing realise the increased urgency with which China needs to rely on its own consumers and technological upgrade to drive growth. Beijing also wants to liberalise its capital markets to spur economic growth. As a result, industry dynamics are changing, prompting traditional and new industries alike to rethink their business models. A rapidly changing economy
However, historically, a cap-weighted allocation to China equities has proven to be a volatile bet regardless of the choice of benchmarks. While the observed volatility could be due to investor behaviour, market microstructure and the closed nature of its capital markets, we also think the fast-changing nature of China’s economy is a major factor. We argue that investors should be sensitive to the systematic risks present in China by understanding the major phases of macroeconomic transformation and fundamental drivers in economic sectors. We highlight three major drivers amid China’s economic transformation that will drive companies’ long-run performance. They are:

• Demographic trends: the rise of China’s middle class, increased levels of urbanisation and consumption “upgrade” (the consumer sector’s continued expansion as demand shifts towards higher-quality, higher-priced goods and services);
• Technological disruption and digitisation; and
• Reforms and market opening.

China’s tech sector will be a key beneficiary from the transition. Heavy investment in research and development has already led to China filling more PCT patents in certain sectors than the US, with Beijing wanting to sharpen China’s technological eminence by focusing on high-tech 5G infrastructure that are also crucial growth drivers. China’s healthcare sector will also benefit. Demographic trends – specifically ageing population and higher life expectancy – are a tailwind for the sector, with estimates that the number of people aged 65-plus would more than double to 366 million by 2050. Increased urbanisation alongside higher levels of incomes are another driver, as more urban dwellers translate to higher willingness to pay for better-quality healthcare products and services. Even though China is shifting towards a consumption-led model of growth, the result is a bit more nuanced for the consumer sector. Digitisation, big data, the Internet of Things and artificial intelligence allow companies to explore new ways to engage customers. However, not all consumer companies will benefit equally; traditional retailers, for example, may take a hit from China’s shift towards e-commerce. We believe companies that could successfully tap into the consumption upgrade trend are likely to able to stay ahead of competition. The picture is also mixed for financial institutions. We think their role in China’s economy will change as its capital markets develop. While policy considerations will weigh heavily on the sector’s future – especially for the traditional banks – the consumer sector’s expansion and opportunities in wealth management could provide some upside to Chinese lenders. Elsewhere, there are also bright spots for non-bank financials. Well-positioned insurers could benefit from China’s pension reform as Beijing unlocks China’s trillion-dollar pension monies. Style and sector episodes
How, then, should investors position themselves to unearth and seize these opportunities amidst China’s economic transformation? In analysing the A-share market’s development, we witness episodes of style and sector rotations. A study on how China’s old economy (made up of the materials, telecommunication services, utilities, energy and industrials sectors) measures up to the new one (defined as the consumer discretionary, consumer staples and information technology sectors) also illustrates the same point. New-economy stocks saw their cumulative returns increase by 103% over 2007 to 2017, compared to old-economy ones which fell by 29%. As such, we believe that getting the right China beta means getting the right earnings growth. Sectors and companies that can achieve growth amid economic transformation will get duly rewarded. At the same time, the A-share market remains inefficient, making it one of the best alpha hunting grounds for investors. Even though institutional participation is increasing, the market is still dominated by retail investors. Therefore, we believe that going active will be the right approach for allocating to A-shares. We further stress that bottom-up fundamental analysis remains a key building block in portfolio construction. Paying attention to the “quality”, or robustness of company fundamentals, and “speed”, or competitiveness and growth prospects, are key to assessing any company’s long-term performance. In addition, there will be opportunities even in sectors that are out of favour and where valuation has become cheap. However, we caution a pure value approach on A-shares: Investors should be selective and focus only on companies ready for technological disruption and changing consumer needs. Combining disciplined fundamental analysis with a deep understanding of China economic transformation, industry dynamics and business models should help investors uncover the multitude of opportunities in China’s A-share market. © 2020 funds global asia