From the desk of Jing Ning
Thoughts on the current market environment, the framework it provides for value stocks and the historical context for their performance.
It is a widely held belief that China is a growth market where a growth strategy would consistently outperform, while the reality is quite different. The Chinese stock market rotates between value and growth regularly. Since the Global Financial Crisis in 2008, value meaningfully outperformed growth in 2008, 2009, 2011, 2014 and 2018 while growth largely outperformed value in 2013, 2017 and 2019.
I believe there are three underlying reasons behind the Chinese stock market swings between growth and value:
- There is too much cyclicality in the economy (low visibility, short and sharp cycles, tough macro)
- Fierce competition and constant policy changes make it difficult for growth stocks to sustain their momentum
- Investors’ preference for growth is a double-edged sword. As more and more investors chase growth, it becomes a crowded segment, which leaves little safety margin for investors.
This leads to the next question: In what market environment does growth outperform value? We have seen two scenarios supportive of such outperformance
- A bull market coupled with favourable investor sentiment which spurs a beta rally, such as the one we saw recently in 2017;
- Growth segment re-rating in a mediocre macro environment, where overall the market remains largely flat, and the growth outperforms purely due to multiples expansion, which is what we saw in 2013 and now in 2019.
The first scenario is easy to understand, while the second is a result of a delicate balance between “not so weak growth” and “easing monetary policy”. The difference between the underlying macroeconomic backdrop between the two scenarios, also explains why we saw a much stronger magnitude of growth outperformance vs. value in 2017 than in 2013 and year-to-date 2019.
After a year-to-date growth rally, it's reasonable for investors to ask whether we are close to an inflection point, and when will value start its mean reversion against growth?
This is the million-dollar question from investors in the Fidelity China Fund. Recently, the debate about value as investment style has been red hot, after value experienced a strong bounce back globally in September. It reflects that investors are becoming cautious towards other strategies (growth, Quality, Low Volatility) and asset classes given their expensive valuations.
It is always hard to pin down the exact timing of the inflection point as the market never simply repeats itself. Nonetheless, focusing on 1) the historical trend in valuation premiums between growth vs. value and 2) macro catalysts that terminate a growth rally, can help identify scenarios where value may outperform.
At current levels, the valuation premium between growth and value is already quite hefty.
What may happen to halt a growth rally?
In 2014, the Chinese central bank’s policy easing spurred a reflation trade that put a pause on the growth rally seen in 2013. Subsequently, in the latter half of 2014, value outperformed. led by financials and cyclical stocks. 2017’s growth rally was terminated by recession fears triggered by a US-China trade war.
In the current mediocre macroeconomic environment, it is challenging to expect a sustainable outperformance of growth as it would again demand a very fine balance between economic growth and monetary policy easing. Both scenarios of stronger-than-expected as well as weaker-than-expected economic cycles can end a growth rally.
What do investors own in the China ‘value basket’
The Fidelity China Fund aims to find value opportunities across the length and breadth of Chinese equities. There is a component of typical value themes such as financials and cyclicals in the Fund. One common concern I hear from investors about China is the cyclical nature of earnings and leverage situation. In the past couple of years, we have seen structural improvement in both earnings’ quality and balance sheet strength among Chinese cyclicals. This has led to a narrowing gap in metrics such as return on equity, net margin and interest expense ratio for cyclicals vs consumer sectors. The supply-side reforms over the last few years in many cyclical sectors has improved the supply/demand balance, and their earnings are less correlated with the macro cycle. It’s also interesting to notice that even with a better return profile and stronger balance sheet, Chinese cyclical stocks discounted to consumer stocks have reached historical highs.
The Fidelity China Fund also goes beyond a ‘typical value portfolio’ with its exposure to undervalued stocks in typical growth sectors such as technology and health care. Unlike the developed market, where value basket is dominated by traditional financial/cyclical names, the Chinese value story has an interesting twist as many growth companies tend to rotate in and out of value basket. As at 30 September 2019, the Fund is trading at 9.3x PE vs 12.2x for the MSCI China 10% Capped Index and at 1.1x price to book vs. 1.5x for the index.
I would also like to draw attention to a rare attribute of China value basket, its dividend yield, which is often overlooked. Fidelity China Fund is offering a portfolio dividend yield of 3.7% as at 30 September 2019.
With declining earnings volatility and improved balance sheets, cyclical companies in China can afford to pay higher dividends to reward shareholders - and they are doing it. Chinese financials are also a major source of yield. In a race to zero/negative rates globally, will investors switch their attention back to equity income? If you believe they will, the China value category becomes more attractive to retail and institution investors globally who require income.
I am grateful for our clients’ faith in my value-contrarian strategy, and for their support for the Fidelity China Fund.
Performance as at 30 September, net of fees, AUD (%)
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