China: In Earnings We Trust
THE 13TH FIFTH PLENUM – BUILD A SOCIETY OF MODERATE PROSPERITY
The focus of China’s 13th Fifth Plenum that will run through 2020, aims to strike a balance between speed of growth and sustainability. The investment implication is a modest rise in middle class consumption with closer attention paid to quality of life, including environmental qualities, such as water, forest, and farmland, along with a robust social safety net. As a measureable target, the party has pledged to double the size of real gross domestic product (GDP) between 2010 and 2020, which means the economy would have to grow by at least a 6.5% annual rate in the next five consecutive years.
The updated GDP growth targets appear to be a confirmation of what most economists have been saying for some time−that it will still be defended aggressively by the government, which suggests more stimulus is coming, but less so than the government had tried to defend the prior target. However, we have observed that the GDP has a rather indirect relationship with equity market returns. China met and overachieved its official GDP targets from 2007-2013 while the Shanghai Composite Index fell by more than half during the same time frame. When China failed to achieve its GDP target in 2014, the equity markets returned nicely. Companies that strive too aggressively for top-line growth (linked to GDP) can result in poor earnings and stretched balance sheets, which can lead to de-rating. Our investment process focuses on corporate earnings and expectation gaps, which we see as the ultimate drivers of stock performance.
The investment implication of the 13th Fifth Plenum reaffirms some of the themes that have long been prevalent in our Hong Kong and China Equity strategy. We continue to favor the more vibrant areas of the economy such as consumer durables, leisure/ travel, transportation, technology/e-commerce, and utilities focused on cleaner energy sources. Conversely, we intentionally shy away from state-owned enterprises and remain cautious around the commodities and banking sectors. We started to see some progress with the “One Belt One Road” initiative, such as a high-speed railway contract with Indonesia, but we still need to closely watch the progress and profitability before becoming optimistic on projects such as these.
MARKET OUTLOOK AND STRATEGY
Uncertainty will likely remain in Hong Kong’s external environment for the remainder of the year. The recovery of external demand from developed markets may not be enough to offset the slowdown in demand from China. Meanwhile, Hong Kong’s domestic consumption, which was resilient in the first half of 2015, may be impacted by financial market volatility in the second half. Therefore, we expect to see Hong Kong’s economic growth continue to slow down.
Recent weakness in the China stock market is mainly due to investors’ concern over China’s macroeconomic growth prospects and further renminbi depreciation. The uncertainty over China’s economic growth will likely linger for a while; therefore we will remain cautious on China until we can see a clear sign of growth stabilization. We may see a slight technical rebound in the near term as the current valuation is very economical and the government continues to launch policy measures (i.e. first home down payment reduction and the reopening of A-share initial public offerings).
Our strategy is to continue identifying and selecting high-potential investment candidates experiencing positive fundamental change. Our goal is to minimize market, sector, and industry exposures relative to the index in order to isolate superior stock selection as the primary source of outperformance.