Tiffany Hsiao, Portfolio Manager, Matthews Asia
China is preparing to start celebrating the Chinese New Year on February 16. Along with being the year of the dog, 2018 might also be the year that innovative Chinese smaller companies come into their own.
Smaller companies typically do not have much capital to compete with their larger peers. A way to win against bigger companies, therefore, is through sustainable innovation. This could be a technology innovation that results in an intellectual-property moat or a business-model innovation where the smaller company has figured out a better way to do business.
2017 was undoubtedly the year of Chinese technology stocks, thanks to the performance of several large internet companies. There could be many opportunities further down the cap scale in 2018, however, if investors are willing to look. About three years ago, mobile phones featured just one camera lens. Today, new smartphones offer up to four camera lenses to enable users to shoot 3D selfies.
As demand for consumer-driven applications in technology devices continues to grow among millennials, we see opportunity in Chinese small cap companies that manufacture modules for smartphones, as well as those that innovate to make handsets thinner and lighter and with a longer battery life. In addition, semiconductors will be an important structural growth area for China as it tries to become self-sufficient in semiconductor production.
There are many small cap opportunities beyond technology. We believe China will be a powerhouse in global health care, for example, whether in pharmaceuticals drug discovery or diagnostics. In the past, the Chinese have been known to take a copycat approach and this has included Western drugs. The government now is trying to steer companies away from that mentality and has created initiatives to foster innovation.
Authorities in China’s Jiangsu province, for example, have greenlighted a program of genetic sequencing that will see them build a genetic database of Chinese residents. One focus of the program is to identify genes linked to cancer and rare and chronic diseases. In my view, this initiative will change the health care landscape within 10 years because this abundance of data will open up opportunities for innovation in the pharmaceutical industry. We already have seen some Chinese gene synthesis companies develop cancer drugs that offer high cure rates.
In our view, small cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments (such as manufacturing, infrastructure and real estate) and toward innovation, consumption and services. Yet while smaller companies in China are perceived to be a higher risk investment, the historical volatility of Chinese small caps has been lower than the overall Chinese equity universe and even the U.S. small cap universe.
In 2016, according to data from the International Monetary Fund, China accounted for 28% of global GDP growth — a rising trend that we think is likely to continue. We believe a portion of this growth can be captured by investing in smaller Chinese companies.
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Risk Considerations
Investments involve risk. Past performance is no guarantee of future results. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Investing in small-and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than large companies.
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