Despite recent volatility and a longer-term economic transition under way, China still offers growth opportunities. Here are crucial themes to watch and weigh.
After more than nine months of volatility and steep decline, is China’s A-share market worth a closer look now?
Let’s start with some caveats: The outlook for the headline index remains challenging. Nominal GDP growth is weak, and the benchmark Shanghai Composite Index is likely to eke out only low-single-digit earnings-per-share growth this year.
From a fundamental perspective, however, valuations have normalized, relative to both the index’s history and multiples of global peers. “The Shanghai Composite in aggregate is now trading back well below average global equity valuations at the headline index level,” says Jonathan Garner, Morgan Stanley’s Chief Asia and Emerging Market Equity Strategist. Some other indicators:
- The trailing price-to-earnings ratio is 14.5 times, or a 15.2% discount, compared to 17.1 times for the MSCI World index;
- The historical price-to-book ratio is 1.59 times, compared to 1.93 times for MSCI World, or a 17.5% discount;
- The trailing dividend yield of the Shanghai Composite, at 2.24%, has narrowed its discount to that of MSCI World, which stands at 2.85%.
“We suspect that in a similar manner to its performance after previous spikes and retracements, the Shanghai Composite Index will now settle into a broad range, potentially for several years,” Garner says. “For us, the directional index call going forward is likely to be a much less important consideration for investors than stock selection.”
Garner ventures five secular investment themes for China stocks:
- Healthcare: Spending in China is expected to compound at a significantly faster rate than overall GDP growth over the medium term. The key drivers are likely to be: a) the tendency for countries to spend more on healthcare relative to GDP, as per-capita GDP rises, and b) China's own aging demographic—its 60+ population, at 13.3% of the total in 2010, is projected to reach 24% by 2030—and changes in government policy, for example, the relatively new two-child policy and more concrete healthcare reform to cover severe illnesses for all health insurance holders and pay for at least half the cost of treatment for severe illnesses.
- Mass-market Consumer: China's policymakers have been trying to raise the share of consumption in expenditure and the services sector in output. At the same time, the current anti-corruption campaign has visibly curbed spending on big-ticket luxury goods, such as watches and jewelry, etc. These policy trends, as well as the tendency of consumption to increase its share within GDP as per-capita GDP rises, suggest that mass-market consumer spending should grow materially faster than overall GDP growth. In China, this has been the case since 2011, with total household consumption spending growing on average faster than overall GDP by 1.5 percentage points each year. Industries that stand to benefit include travel, food and entertainment, as well as household appliances.
- Environment and Clean Energy: China's well-documented problems with air, water and other forms of environmental pollution represent a major challenge for policymakers and society. Yet, China's per-capita consumption of power and freshwater resources is significantly lower than that of countries such as the US, Japan and Korea. The growth potential represents opportunities in producing clean energy, and providing fresh water and sewage treatment services. For investors, the key is to match the top-down push for clean energy and environmental protection with the bottom-up industry structure. Cautionary tales include solar panels, in which a rapid industry build-out, driven by regulatory mandate or other top-down development initiatives, led to too many participants, which drove profitability lower.
- Technology (Hardware, Internet and eCommerce): China's Internet penetration rate is high, supported by the build-out of infrastructure. As a result, Chinese buying patterns in key tech products, such as smartphones, are key to investors in global majors in these industries. In patent applications, China overtook the US in 2011 as the world’s largest, and accounted for 34% of the global total in 2014. It is the world's largest manufacturer by value-added and has been growing its share faster than any other country over the past two decades. It has also moved up the value-added chain and now incorporates some of the most sophisticated plants and machinery. Indeed, Chinese firms have been able to win contracts worldwide for railway equipment supply and even more recently for nuclear power plant construction.
Automation is another focus for China’s manufacturers, as they upgrade capabilities to offset a shrinking labor supply and growing aging population. China lags behind major developed markets in robotics. This is likely to change as labor costs rise and the working population growth decelerates. China’s demand for robots will nearly double from around 100,000 in 2016 to 190,000 a year by 2020, Morgan Stanley projects. - Defense: China's defense industry spending is likely to increase more rapidly than overall GDP, as the country seeks to modernize its infrastructure. China spends around 2% of GDP on defense, compared to 3.5% of GDP for the US. In general, China's approach is to reduce manpower and upgrade its defense capabilities, in particular, through technology. This modernization will call for significant computer network operations, connecting space, air, ground and undersea facilities, which will require sustained investment (taking up at least 5% of the defense budget) in infrastructure and equipment, says Edward Xu, Morgan Stanley's China transportation and infrastructure analyst.
These themes reflect a consistent focus on China’s “new economy” segments, rather than its traditional industries, many of which are dealing with structural issues and overcapacity. For investors, the opportunities will expand as China continues to further open direct access to its domestic marketplace.
This is adapted from a recent Morgan Stanley Research report, “Asia Insight: Time to Look for Bottom-Up Ideas in China A-Shares” (Feb 18, 2016). Ask your Morgan Stanley representative or a Financial Advisor for the full report. Plus, more Ideas.
