This is why the Robeco Chinese A-share Equities strategy, which recently celebrated its third anniversary with a 14% annualized outperformance, net of fees, relative to the MSCI China A International Index1, applies a rigorous thematic screening approach in its efforts to find the most attractive stocks, says Jie Lu, Head of China research at Robeco.
Over the past few years, Chinese equities have been swinging to the tune of several – sometimes contradictory – forces influencing fundamentals, including the China-US trade dispute, sweeping regulatory changes, a growth slowdown and a subsequent recovery. Which of these forces have had the most powerful impact, in your view?
“All the forces you mention have had a large impact, only not simultaneously. In 2016 China’s GDP growth fell below 7%, showing the limits of its debt-driven development model. Towards the end of 2017 and in 2018, authorities took important steps, including supply-side reforms and measures to rein in the shadow banking system, to cut down overcapacity and deleverage the economy.”
“Then, of course, came the China-US trade war, which really heated up in 2019 and eventually led to the ‘phase 1’ deal signed earlier this year. The conflict had severe economic consequences in China, in particular for the technology sector. So, in reaction, authorities changed their monetary stance to a more accommodative one, to support and stabilize the economy.”
How do you invest in this context?
“We are essentially bottom-up, fundamental-focused stock pickers, with a long-term investment horizon. We start with an investable universe of around 3,000 to 4,000 stocks, which we narrow down by focusing on several long-term investment themes. We then look for quality companies with strong fundamentals deemed to benefit for these themes.”
“We also integrate sustainability into the investment process from the very beginning. Our ESG profile analysis covers 100% for our portfolio holdings, and for more than 70% of the stocks in our broader investable universe. We draw from Robeco’s global framework, tailored to the specific characteristics of the Chinese stock market.”
“This kind of theme-based investment approach is particularly relevant for the Chinese market, as it helps us focus on the structural drivers of economic growth in a market largely dominated by short-term retail investors, prone to hype and overreaction. Our focus themes have actually been the same for the past four years: consumption upgrade, industrial upgrade, technology and innovation, and structural reform.”
“This does not mean we refrain from more tactical moves. During the trade war, for instance, we shifted the portfolio away from tech companies into more defensive sectors and then gradually started building positions in tech companies that would be less affected, such as the solar panel and new-energy vehicle supply chains.”
A theme-based investment approach is particularly relevant for the Chinese market, as it helps us focus on the structural drivers of economic growth.
More specifically, what were the main drivers behind the strategy’s strong outperformance since inception?
“In hindsight, it is clear that the main driver of alpha, over the past three years, has been stock selection. This really makes a strong argument for a thematic screening, bottom-up-driven and benchmark agnostic investment approach like ours.”
The China-US trade conflict was put on pause earlier this year, but could resume at any point in time. How do you view this risk for long-term investors?
“I think, the ‘phase 1’ deal was already a great achievement. Reaching a ‘phase 2’ deal will be much more challenging, as talks will touch upon very sensitive topics, such as intellectual property rights. So, I am very cautious regarding a potential ‘phase 2’ deal. I think we’re in for a prolonged conflict between two superpowers.”
“That said, the confrontation, in particular the Huawei events, has led China to prepare for a ‘plan B’, to help protect the country from future trade tensions. China is now increasingly developing its own technologies in areas such as semiconductors, artificial intelligence, or new energy vehicles. This ‘plan B’ has positive implications for investors, as many companies will benefit from these investments.”
What are the main long-term catalysts for Chinese equities in your view?
“Clearly, the themes I mentioned earlier: consumption upgrade, industrial upgrade, technology and innovation, and structural reform. But on top of these, there is another game-changing factor: the opening up of the A-shares market to overseas investors. In particular, the inclusion of A-shares in MSCI’s emerging market indices, which started in 2017, really boosted foreign inflows into the A-shares market.”
“These inflows have already had a significant impact on investment styles performance. Since 2017, we’ve seen a rerating of quality stocks with sound fundamentals. These stocks have performed very well over the past couple of years, as their profile corresponds to what foreign, mostly institutional investors, that tend to have a long-term and fundamental-driven approach, typically like.”
“Meanwhile, most domestic investors overlook these stocks, as they usually don’t offer very high growth prospects. Of course, the definition of growth for Chinese domestic investors is somewhat different from what overseas investors usually have in mind. What may be considered high growth in Europe or in the US, is often considered average in China.”
“But beyond the short-term rerating effect, this opening up should also have long-term consequences, as the participation rate of foreign, mostly professional investors gradually moves from its current low levels to levels close to those seen in places such as South Korea and Taiwan, which experienced similar opening up movements in previous decades.”
Actually, one major consequence of the inclusion of Chinese A-shares into MSCI EM indices has been the rise of passively managed money in A-shares. How do you as an active asset manager stand out from the crowd?
“Well, because the A-shares market is so inefficient, going passive is definitely not the best way to invest. The large participation of retail investors – who tend to be short-term oriented and very news-driven – as well as frequent regulation changes, mean that too many participants don’t pay enough attention to fundamentals. Therefore, the alpha opportunity for patient, rigorous active managers is huge. A-shares are probably the best place to be for active investors, as there is no other market of this size and liquidity that offers such a huge alpha opportunity. So, why would you invest in passive ETFs?”
A-shares are probably the best place to be for active investors, as there is no other market of this size and liquidity that offers such a huge alpha opportunity.
We often hear that the inefficiency of the A-shares market has to do with the fact that trading flows are largely dominated by retail investors. Is this still the case?
“Oh, yes. Definitely. And this is very interesting because it illustrates another important reason for investors to invest in A-shares: their low correlation relative to other global equity markets. I think this was demonstrated pretty well recently: when global markets started falling severely, A-shares also suffered, but to a much lesser extent.”
In fact, although the Covid-19 outbreak brought large segments of the Chinese economy to a standstill earlier this year, Chinese A-shares have proved relatively resilient. How do you explain this?
“There are several reasons for that. The first reason is that money flows are different from other large equity markets as the investment base in different. This explains the relatively low correlation of A-shares with other equity markets. In comparison, Hong Kong-listed China stocks appear much more vulnerable to external shocks.”
“A second reason is that China entered the coronavirus storm well before Europe and the US. Chinese A-shares started falling earlier this year, while US stocks were still reaching record highs. So, when panic struck global equity markets in early March, the situation was already improving in China and A-Shares started to outperform US and European markets.”
“The third reason is that Chinese investors remain optimistic regarding the government’s ability to fight the crisis and provide stimulus to the economy. Investors are particularly upbeat concerning Chinese technology companies, as they believe that these firms will suffer less from the outbreak than more traditional ones and that the government will keep investing in technology-driven sectors as part of its ‘plan B’.”
Which aspects should investors focus on for the coming months?
“We are long-term investors, so we obviously stick to the themes we have been focusing on over the past few years. But in the shorter term, we will also pay close attention to the stimulus measures put in place by Chinese authorities. These mainly aim to boost infrastructure spending and to support a consumption recovery.”
“Another short-term focus has to do with finding the best placed survivors. As China overcomes the crisis, significant opportunities for consolidation should arise, which we aim to benefit from. We are particularly interested in potential consolidators, companies with strong balance sheets, resilient cashflows and strong brands.”
“The selection of good quality stocks that are available at a reasonable price is what we expect to continue to help us deliver alpha.”
1 Performance figures in US dollars and net of fees, as of 29 February 2020. Past performance is not indicative of future performance.