Realising the investment potential of China firms

CHINA'S investment potential since the opening of its economy has enticed many investors. Its rapid economic rise and the emergence of large industrial and service sectors have created a wide range of investment opportunities and instruments. While the potential returns are attractive, there are challenges and pitfalls to overcome. Two experts and I examine the different ways to invest in Chinese companies.

"China's growth must be seen in the context of its expanding role in the world economy. This means that investors shouldn't only focus on growth numbers. They need to look closely at the characteristics of each company or opportunity within overall trends," says Ayaz Ebrahim, CIO Asia ex-Japan equities and deputy chief executive officer of Amundi Hong Kong.

He adds: "Continuation of economic opening and liberalisation is a key trend allowing the entry and expansion of foreign banks. QFII (Qualified Foreign Institutional Investor), RQFII (Renminbi Qualified Foreign Institutional Investor) and Shanghai-Hong Kong Connect are policy commitments towards a controlled opening of China."

Premier Xi Jinping has executed many reforms, the most prominent being anti-corruption drives. He has also raised civil service pay by 60 per cent. This is an effective way to fight corruption. Interest rate liberalisation (in lending, not deposits) is a big step forward towards a free market economy. In a command economy, controlled lending rates are an inefficient way to allocate capital and price risk.

Olivier Carcy, global head of private equity at Credit Agricole Private Banking, says: "The opening of the China market is a controlled and long process." He manages global private equity portfolios, which represent unlisted investments. He believes that "private equity is slowly opening up. In the US, private equity represents 2.5 per cent of GDP and in China 0.35 per cent. Privatisation of state owned companies remains a big opportunity".

Mr Ebrahim highlights one of the biggest problems facing investors in Chinese corporations. "Corporate governance issues continue to be a problem in China. On corporate governance rankings, China is still not on the same level as the US and Europe. One reason is that retail investors, who dominate Chinese markets, have not demanded major regulatory changes. But as more foreign investors participate, this bias will change."

Recent data suggests that China's economic growth is slowing down. After years of high growth, investors need to understand the positive and negative outcomes of moderating expansion. Mr Carcy observes: "For private equity investors, it could be good news. Private equity is a costly and intrusive form of capital. Slower economic growth improves entry valuations for investors. It also encourages companies to venture and expand overseas and improve cost controls. It forces an economic rebalancing by removing excess production capacity. In the past, companies with access to cheap credit created overcapacity, which forced down product prices to irrational levels."

Slower GDP growth and China's integration with the international economy might improve management quality. Mr Ebrahim advises: "If investors focus on companies with the ability to rationally price and operate, they can make superior, long term returns."

However, Mr Carcy believes "there is still a long way to go for Chinese corporations to evolve into world class organisations, especially in terms of middle management quality". However, private equity investors face unique due diligence challenges. Mr Carcy points out: "Basically, we need full access to all of the company's financial statements. If not, we cannot proceed with an investment."

In listed equities, we favour private sector Chinese companies. For the fixed income class, we seek state owned companies for their stable yield. Diversification is the key to building a fixed income portfolio.

Mr Ebrahim recommends investing through H shares rather than A share markets. "In China, mutual fund flows are driven by retail rather than by pension funds and institutional investors. So they are more volatile." He currently favours sectors such as consumer discretionary products, automobile parts, travel, local luxury goods, alcohol, local brands and insurance companies. "China valuations are below their 10-year average so we are optimistic about their growth prospects."

Investors need to think about other risk factors that are unique to China. The overall political risk of the latest anti-corruption drive could impact the rule of law. Mr Ebrahim cites other challenges such as the inability of the Chinese government to rebalance the economy and prevent widespread unemployment due to closure of the RMB capital account. "But, there is upside in 2015 as analysts may not have priced the fall in oil prices into the output of mainland companies."