Mark Dampier: After meeting Anthony Bolton and Phillip Ehrmann…


Despite its strong rate of economic growth in recent years, China has been a disappointing place to invest. This can be explained, at least in part, by the dominance of state owned enterprises (SOEs), which account for a large proportion of China’s stockmarket indices.

In recent weeks I have spoken with Anthony Bolton in relation to Fidelity China Special Situations and Phillip Ehrmann, manager of the Jupiter China fund. They agree the days of double-digit GDP growth in China are over. The government is pursuing a more balanced economic growth policy, realising it is quality not quantity that counts.

To achieve more sustainable economic growth the focus is shifting from low value exports, high investment and infrastructure spending to value-added manufacturing, domestic consumption and a services-based economy. As part of this transition SOEs are likely to be a less dominant force. In the new economic order smaller, privately-owned companies should be able to take advantage of deregulation and reform; freer movement of capital; anti-corruption policies; and the evolution of online retailing across China.

Both Mr Bolton and Mr Ehrmann have tended to focus more on higher risk smaller and medium-sized companies. They have been early with their move into this type of company and both managers have had a tough time as a result. These types of company can languish as big, international investors tend to focus on the larger companies in an index, while overlooking smaller counterparts which can be harder to buy and sell quickly in large volumes. This is another area which might improve with China’s ongoing development. As more domestic investors save for the future and participate more in the financial markets, more interest should be paid to smaller and medium-sized companies.

Healthcare is one area in which changes are likely to be seen, according to Mr Bolton and Mr Ehrmann. Sales in the pharmaceutical industry are expected to grow at an annualised rate of about 22 per cent over the next two to three years, driven mainly by rapidly rising income. Currently healthcare and pharmaceutical companies account for only around 1 per cent of the Chinese stockmarket by market capitalisation. If growth hits the kind of levels being predicted it would not be too farfetched to envisage healthcare and pharmaceutical companies accounting for a much bigger proportion of the stockmarket.

The economic reforms currently being enacted are all part of the Chinese government’s five-year plan. There has been some disillusionment over the speed with which the government is achieving its stated aims. It is important to remember the transition from export-driven to consumption-driven economy will not happen overnight, or even in five years. It is a multi-year theme that will have setbacks along the way. The main thing is the transition has begun.

One area Mr Bolton and Mr Ehrmann have avoided is the banking sector, which is getting considerable publicity, particularly the shadow banking sector where there has probably been large misallocation of capital. That said, while non-performing loans are extremely low in the banks, making valuations looks attractive, the underwriting quality of these loans is yet to be tested.

Mr Bolton and Mr Ehrmann tend to look for strong management teams with shareholders’ interests at heart. They also look business with good long-term growth prospects, and strong cash generation, but where these prospects are not recognised by other investors, given them the opportunity to invest at attractive valuations.

While there are similar themes running through the funds and both have a bias towards smaller and medium-sized companies they are different portfolios so will perform differently. Fidelity China Special Situations is also a closed-ended investment trust with a high level of gearing, so will only suit investors prepared to accept the additional risk and volatility this brings. Mr Bolton is also due to step down at the end of March 2014 so this must be taken into account. For investors prepared to accept these risks it could look attractive on a discount of around 7 per cent.

The story in China is one of gradual change in my view. As more people become disillusioned with China, investment valuations have fallen. Both funds have seen an improvement in performance over the past year as small and medium-sized companies have begun to perform better. For investors seeking a single-country Asian fund, drip-feeding into China at the current low valuations could prove more profitable in the coming years than it has over the last few years. Whether investors can be patient enough is another question.

Mark Dampier is head of research at Hargreaves Lansdown