Investing in China

Confucius, who lived in the fifth century B.C., is certainly one of the most influential figures ever to have left their mark on Chinese civilisation. One of his proverbs, "Our greatest glory is not in never falling but in rising every time we fall", is a perfect illustration of the philosophy that investors need to adopt towards Chinese equities if they are aiming for long-term gains.

After all, financing the growth of Chinese businesses is not necessarily very remunerative – and may even incur losses for the inexperienced investor. For instance, since 2003 the stock market capitalisation of the Hang Seng China Enterprises (or H-Share) Index listed in Hong Kong has risen by a factor of 14, whereas the index itself has multiplied by only four.

At first sight, these figures illustrate the significant average dilution of an investment in China. However, given the extreme values observed here, an investment strategy that is simultaneously long and short offers excellent prospects. Furthermore, this kind of total return strategy holds out the possibility of neutralising part of the risk linked exclusively to market fluctuations (systematic risk) while providing the investor with better performance per unit of risk.

Businesses that are capable of generating sufficient liquidity from cash flow to finance themselves and that stand to benefit from the continuing strong growth of the Chinese economy are naturally very attractive candidates for the long part of a portfolio on China. In particular, the rising stars – in other words, companies that appear capable of surprising the markets with higher than expected earnings but which still enjoy low valuations – are among the most appealing. By contrast, companies with high valuations that present the risk of disappointing earnings figures are excellent candidates for short selling.

Apart from purely quantitative considerations, profiting from the Chinese economic situation calls for meticulous analysis of its growth drivers, which are currently undergoing a radical transformation. Private consumption is very interesting in this respect. It is set to rise from around 38% to 45% of GDP in the next ten years or so, mainly because of demographic change but also because of the political desire to become less dependent on exports.

Moreover, by 2015, assuming a conservative economic growth figure of 5%, most of China's provinces should be generating annual per capita GDP of more than 3000 to 4000 dollars: the average threshold above which consumers have scope for discretionary spending.

This phenomenon is already triggering changes in the country's economic fabric. The discovery of the world's next Wal-Mart, Nestlé or eBay is thus only a short step away. Indeed, numerous small Chinese companies currently offer stable profit margins, a balanced product mix and growing brand recognition. Bearing in mind that the 23 provinces of China have an average population of 40 million, they each have many of the characteristics of entirely separate nations, with the resulting range of long-term investment opportunities.

Even though the Chinese are striving to become less dependent on exports, the development of their air, road, rail and port infrastructure will continue apace. At the same time, this will push up demand for energy, while energy intensity – i.e. units of energy consumed per unit of gross domestic product – should fall as stricter environmental standards are implemented. In addition, government programmes to encourage the use of clean energy provide further investment opportunities, both long and short.

Generally speaking, the challenge lies in determining who will become the major player of a given sector, and who will fall by the wayside. This investment approach is necessary in order to generate sustainable performance when investing in China. In addition to familiarity with the regulations in force in that economy, it requires in-depth knowledge of companies and their management teams. As applied to the long part of the portfolio, it could justifiably be called "Buy and Homework" rather than "Buy and Hold".

Our experience of a long/short approach to the Chinese equity market appears to produce particularly good performance when implemented in three sections. The first consists of constructing individual long and short positions on the basis of strong convictions, with a particular eye on the growth and valuations of the companies studied. The second comprises pairs of long/short positions, on winners and losers within the same sector or particular theme. The last involves extracting outperformance from securities compared with their benchmark index by buying them and short-selling the index by means of futures contracts.

China is one of the remaining economies that can offer the investor a chance to participate in industries with very high potential, and that still has companies on which comparatively little financial analysis has been conducted. Whereas a long investment bias would appear to be the most appropriate in view of the very favourable outlook for the Chinese economy, short positions can stabilise the portfolio in the case of market turbulence while at the same time allowing for additional sources of risk to be exploited in order to generate performance. In keeping with the philosophy of Confucius quoted in the introduction, this approach should provide investors with the necessary tools not only to pick themselves up easily after a fall, but also to benefit as far as possible from one of the most extraordinary growth stories ever recorded in the economic history of the world.