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.
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