Martin Lau: ‘UK investors have a Financial Times view of China’

First State Asia Focus manager takes contrarian view on China’s state-owned sector

In the new year, First State Asia Focus was among 50 active funds that made the grade for Hargreaves Lansdown’s influential buy list, the revamped Wealth 50.

Fund manager Martin Lau says his addition to the original Wealth 150 in December 2017 has driven some retail interest but, speaking to Portfolio Adviser at the end of 2018, he admitted inflows have been dampened following a difficult year for the region.

The Investment Association China/Greater China sector was the second worst performer in 2018, after European Smaller Companies, with the average fund losing investors 13.6%.

Against that backdrop, Lau, joined by Chinese equities specialist Quanqiang Xian, visited London in November to promote Asia Focus alongside the Greater China Growth and First State All China funds.

"Whenever markets fall, it enables us to take more risk."

A fund for rocky markets

Working in their favour was the fact the First State Stewart Asia team typically performs much better in falling markets.

Hargreaves Lansdown says in its performance analysis of Asia Focus that it should “hold up relatively well when markets are rocky but might lag behind when they rise strongly”. Last year, when the US trade war and dollar squeeze dragged the MSCI Asia Pacific ex Japan index down by 8.5%, First State Asia Focus fell by just 1.6%.

The technology rally of 2017 was a different story. “It was basically about how much you own in Alibaba, Tencent, and all those companies,” says Lau. “We tend to be much more conservatively positioned.” The £424.6m fund still outperformed in 2017, albeit by a more modest margin, returning 26.3% compared with 25.1% in the index.

A similar pattern applies to the Greater China Fund he co-manages with Sophia Li. “In the Greater China Fund we do not have any Alibaba or but we do have Tencent and Baidu,” Lau says.

Last year, the £440.8m fund delivered a softer blow than its peers in the China/Greater China sector, down 7.8%. But it had trailed both the sector and the index during the tech rally of 2017, delivering 29.6%.

The sector rose by 35.9% over the period while MSCI Golden Dragon delivered 31.3%.

Foreign investment in Chinese tech

First State has held Tencent since 2005, a year after it listed on the Hong Kong stock exchange. Lau says they like its management and company structure.

In China, media and internet companies can not be held by foreign investors so they are instead held via a variable interest entity (VIE), which means investors don’t have direct ownership of these companies.

“You have economic ownership of the company, which means you really need to trust the people who are running the company.” A decade-plus of holding Tencent means First State has built a relationship with management, according to Lau.

In an age of environmental, social and governance investing, an approach First State takes across strategies, Lau admits the VIE structure does not represent the best corporate governance practice.

But he points out that US tech rivals such as Google have A and B shares, which limit voting control. And he likes the fact Tencent is a listed company so the fund benefits from new products like Wechat, the Chinese equivalent to Whatsapp.

In contrast, many innovations at Alibaba occur within its private structure, meaning shareholders in the listed company miss out.

Contrarian take on state-owned sector

Improvements in corporate governance are behind two contrarian calls in the team’s portfolios, according to Xian, co-manager on First State’s offshore China funds. That includes state-owned China Telecom, which is held in the China Focus, All-China and China A-share funds.

Many investors shun the state-owned sector due to concerns they are not shareholder friendly, but Xian says China Telecom has been increasing its dividend. It has also introduced a shadow options scheme for management. “They are trying to make it possible for management to have certain alignments with shareholders,” says Xian.

It is also a defensive holding should anything happen to the macro economy in China, he adds.

Navigating A-shares euphoria

The introduction of China A-shares is also a catalyst for more shareholder-friendly policies in local companies. “Initially there was a euphoria,” Xian says of MSCI Emerging Markets and ACWI adding the 233 large-cap mainland Chinese stocks to its indices beginning June 2018.

“People thought they would buy first and then foreigners would come in and bid up the prices. What happened in the end was the opposite. They bought at a high level and then subsequently the share price declined.”

But ultimately, Xian sees foreign investors as a force for good, encouraging dividends and cashflow generation.

In the meantime, the retail investor base of China A-shares creates opportunities, he says. “Local investors, even though some of them are also quite sophisticated, by and large are still quite sentiment driven.”

Asia Focus has around 5% allocated to the local Chinese shares across three companies: Shanghai International Airport, household appliance business Media Group and air-conditioning company Green Electric.

“We are bottom-up investors, so the more ideas we can identify on the A-shares, the more exposure we have in China,” Lau says.

The Greater China Fund has an 11% allocation while pure China funds hold closer to a fifth in the local stocks. The team launched a dedicated China A-shares fund all the way back in 2009.

Avoiding short-term valuation metrics

When it comes to valuations, Lau seeks metrics that highlight the health of the franchise, with a three to five-year focus more so than short-term earnings volatility.

He considers P/E and P/B multiples to be linked to one or two-year outlooks and prefers longer-term indicators like consistency of cashflow and dividend payout trends. That approach can falter in short-term momentum markets, he admits. Every six months they do fair market price reviews for each portfolio holding.

China Mengniu Dairy Company is an example of a company focused on its brand and quality control while the team is looking at the long-term outlook.

Lau says: “A lot of things are happening in the right direction, and margin at the moment is still quite low because of some of those investments. We are talking about a net margin of 4% and comparable other markets could be talking about teens or a high single-digit margin.”

Financial Times view of China’

UK investors are not immune from a sentiment- driven approach to investing in the region and Lau says they typically have “a Financial Times view” of China. “They overly focus on the top-down numbers.

“For example, if the PMIs or retail sales are not doing well, if GDP has slowed and the renminbi has depreciated then the sentiment on China would probably be to take it to the extreme.

“People tend to look at this slowdown in terms of the economy and penalise our stocks disproportionately.”

The US trade war against China was an opportunity for the investment team to add to exporting names such as Minth Group, Techtronic, ASM Pacific, China Merchants Port, Hongfa Technology, Shandong Himile and Wanhua Chemical. In the immediate term, $50bn in tariffs is already affecting business confidence.

“We’ve seen quite a significant reduction in capex by different Chinese companies, because if you are not sure how much tax you are now going to pay, say, for the exports, you’re not going to invest into another factory in China.”

The trade war is a medium to long-term risk, according to Lau. “I think the reason why there’s a trade war is the emergence of China as an economic and political power. It’s about the conflict between two big nations. I don’t think that’s going to go away anytime soon.”

Wealth manager comment

Justine Fearns, research manager, Chase de Vere

Nine fund selectors on the track record they seek before investing

“Martin Lau delivers First State’s trademark approach with aplomb. The investment style, which focuses on quality and valuation with a long-term absolute return mindset, pairs well with an index tracker and can provide a foil to downward markets. It is worth noting, however, that the pairing works both ways and while the fund may hold up better than markets on the downside, it can also lag behind when momentum drives markets up. Nevertheless, clients have experienced excellent risk-adjusted returns assisted greatly by the manager’s 22 years’ investment experience, the considerable team behind him and the tried-and-tested investment process.”

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