China’s Reforms Open New Path to Equities by Stuart Rae, AllianceBernstein.
For investors in China equities, there have traditionally been two ways of approaching the market: through expensive growth stocks, or risky contrarian plays. Now, thanks to China’s reforms, there’s a third way which may offer a better balance of risk and return.
Despite the headlines about slower growth, credit tightening and the potential for corporate defaults in China, the country’s medium- and long-term prospects continue to interest investors. One reason for this is that opportunities to gain access to Chinese equities are increasing—helped, for example, by the government’s allocation of licenses and quotas under the Renminbi Qualified Foreign Institutional Investor program, and the impending launch of the Shanghai-Hong Kong Stock Connect program.
Moving Beyond High-Growth Stocks
The range of strategic approaches open to investors is broadening too, enabled by changes in the economic and financial environment. Traditionally, investors in China have focused on either growth or contrarian plays, or a combination of the two. Even now, it’s possible to find stocks in China that offer exciting growth potential—for example, in areas of disruptive progress, such as the media and Internet, or in niche sectors that will continue to benefit from economic development and demographic change, such as the environment and healthcare. The downside is that these stocks typically trade at very high multiples and can be hard to find. Governance can be an issue, too: think of accounting problems in the past at some US-listed Chinese companies.
The contrarian play involves buying very cheap stocks which are high-risk but—if all goes well, and the companies not only survive but prosper—may pay off handsomely. Such risks are not for everyone.
Focus on State-Owned Enterprises
Now—thanks to reforms introduced since the government of President Xi Jinping and Premier Li Keqiang came to power last year—a third approach to investing in China is possible. It may not promise the dazzling returns some hope to achieve from China’s growth stocks, but it may be a less risky proposition than those contrarian plays.
It’s a result of the government’s plan to improve the profitability of state-owned enterprises (SOEs). The plan includes a range of measures, such as better incentives for management, corporate restructuring, spin-offs and mergers—any of which can create opportunities for investors.
Historically, investors have been wary of China’s SOEs because their returns on assets are inferior to those of the private sector, and the gap between the two has been widening in recent years (Display). We believe that the government’s reforms could lead to a narrowing of that gap, suggesting that this could be a good opportunity for investors to position themselves to take advantage of improved profitability among SOEs.
Looking Across Sectors
Examples can be found across diverse sectors. Sinopec, the country’s largest refiner, is spinning off its service stations into a separate entity. This is a huge business that consists of tens of thousands of outlets and associated retail operations. The restructuring is drawing private capital into the business and focusing management on unlocking its inherent value.
In the telecom sector, the government is driving a plan for the three major companies—China Mobile Ltd. (ADR) (NYSE:CHL) (HKG:0941), China Telecom Corporation Limited (ADR) (NYSE:CHA) (HKG:0728) and China Unicom Limited (ADR) (NYSE:CHU) (HKG:0762)—to pool their mobile phone tower assets. The move will lead to the companies sharing costs, and is designed to help improve their profitability. The assets will eventually be housed in a stand-alone entity.
Investors need to bear in mind that the government’s dominance of SOE share registers leaves private shareholders with little control over important matters such as the appointment of boards and key managers. On the plus side, the lines of publicly available stock in SOEs are typically large and liquid; they trade at modest multiples compared with growth stocks and are less risky than contrarian China plays.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio managers.
Stuart Rae is Chief Investment Officer of Asia Pacific ex Japan Value Equities and John Lin is Portfolio Manager—China Equities, both at AllianceBernstein Holding LP (NYSE:AB)