One of the more interesting aspects of our business is the ability to speak with incredibly talented LPs and GPs. The following forum is designed to highlight snapshots of conversations that relate to topics and ideas which might be
insightful and relevant to our broader LP network. To enable a candid unfiltered exchange, these conversations are simply “off-the-record”.
Today we’re speaking “off-the-record” with the Head of Investments of a large Hong Kong based institution regarding his thoughts on investment opportunities in China...
You are a Hong Kong based institution, and yet for years you have been underweight China. I feel it’s somewhat rare not to have a home-court bias. But now you’re starting to look at China more closely. Why is that?
Yes, you’re right. For a while we’ve maintained a substantial underweight to China. But we see interesting opportunities in China now and expect that to be the case going forward. As a result, we’re slowly adding to our China exposure. But to be clear, we’re not looking to become overweight the region at this time despite it being a higher conviction opportunity today. We see a number of reasons that support the case to add China exposure.
First, China offers a huge opportunity set in general. We have all read a lot about valuations being more attractive after this recent sell-off. China stocks are deeply discounted and inexpensive by historical measure and particularly compelling when compared to the rest of the world. This creates an interesting value proposition and catalyst in and of itself to accompany a variety of attributes
that we’ve always liked about China.
Also, China is vast and broad. Many investors tend to paint the whole country with the same brush or discuss “China” as a single opportunity, or an area to avoid. But China is more nuanced and complex than that with a lot of bottom-up opportunities across multiple sectors, and even subsectors. investors can also achieve high diversification. At times, certain sectors are in favor and boosted by tailwinds whereas others are not and prone to experience significant adversity.
And going one layer deeper, China has a lot of individual companies to choose from. Many companies are highly liquid or liquid enough. The market is comprised of state-run companies and private enterprises. These companies all have unique business models and a vast spectrum of quality. Some are very strong, have good corporate governance, tight business models, and tremendous growth prospects. Others are a disaster in all these categories. Very simply, this creates significant opportunities for smart investors.
We agree with your comments and speak with a lot of investors that share a similar view. But one topic keeps coming up and that is the risks of investing in China, especially today. Risks like Covid zero/lockdowns, geopolitical tension, regulatory changes like what we saw in education and some mega companies like BABA. How do you think about these factors?
Are the risks overblown/misunderstood?
I would say that there is definitely some bias in western media toward China, but all of the risks are real, no doubt about it. The regulatory, macro, leverage, and now uncertainties in sectors like property which have historically been large growth drivers for the country are all important factors.
But I strongly believe these risks can be a source of alpha you don’t find in other regions, all adding to the inefficiencies.
However, you need to align with the right managers that understand the region deeply, and as importantly, do their homework and have a robust investment process that uncovers and properly price those risks. These risks can be incorporated into the portfolio construction process and managed. The smartest managers have the experience and do the diligence to understand the regulatory environment, the important players, see patterns that develop over time, and do channel checks.
It’s always a boom/bust cycle in China, and everyone does well in a boom, and then, well, busts in the bust. The best managers emerge and thrive and can find amazing opportunities in a bust cycle, which we are in right now.
You say aligning with the right managers who can capitalize on this market is important. Some investors have suggested that cheap index, ETF, and other passive long only methods could be attractive given low China stock market valuations. What do you think of this type of approach?
I disagree. China is not a passive investment market, despite cheap valuations. There will be a large segment of the market that will stay cheap forever as those companies are not managed for the benefit of shareholders. Investing passively means tying up significant capital to those areas and having exposure by default that you don’t or shouldn’t want.
As mentioned previously, it’s important to be able to navigate the risks. You need active stock pickers who can find alpha opportunities and can take advantage of or exploit massive retail participation. This market is very different from any other. It’s national service oriented, when the government tells you to buy, you buy. SOEs are non-economical. You have massive retail participation in the local markets, as well as Chinese ADRs trading in US, and the US sentiment pendulum swings wildly. Not to mention the higher frequency of frauds. High quality active managers pick up on these and use them to their benefit
Ironically, regulatory risks are easier to analyze in China than the US. Change is not as fluid in China- there are 5-year plans with a regime in full control, generally less changes in policy due to public sentiment and pressure over specific political and social issues that pop up, and no state-by-state decisions to contend with. The best managers can benefit from it, or at least not blow up from it.
As mentioned before, unlike the emerging markets of the old days, where you made a country call or sector call (commodities in Brazil or energy in Russia), China is so broad, and managers can construct a diversified idiosyncratic portfolio. It’s closer to the US market now in terms of depth and breadth. There are huge diversification benefits given there are so many sectors, and investors can
choose the ones that are stronger, avoid the weaker. There are a lot of companies you just don’t want to own, and the markets are very inefficient, which can be exploited by active management.
This creates opportunities for managers that focus on portfolio management, rather than just great stock pickers.
Tell me about how you think about manager selection when it comes to China. What type of managers do you prefer?
There are really 3 different camps of managers to choose from. Global managers with teams on the ground, Hong Kong or Singapore based managers, and domestic mainland China based managers.
I’m not going to comment on the foreign managers with no physical presence in the region. The go-to-choice for many large institutional investors I speak to, both international and domestic, is to invest with global managers with China capabilities. They have the brand names and a certain sense of “safety”. The general assumption is that they can hire top talent and build big local teams.
I have found it is true that they have the advantage in numbers, but I also believe they don’t have right people. The best ones spin out on their own after achieving some success (and capital), so these large global firms are left with people who are at best often second tier. Additionally, I have found that global teams are not integrated. These organizations are run by their international offices and more like tourist investors, open-minded and willing when China is hot, but don’t listen
to local teams when things are tough. Hong Kong and Singapore based teams have historically had the best PM’s and investment talent.
They have local knowledge but understand western capital flow dynamics. However, I feel in general their edge in both areas has diminished a bit as true on the ground locals have better insights and domestic capital flows have become more important. Local mainland managers were not that interesting in the past, as the landscape was dominated by mutual fund managers. But in recent years, you’re seeing smaller local mangers with offshore pedigrees which spun out 5-10 years ago turning into larger institutional platforms. These managers have the research and investment teams on the ground in China and have a deep
understanding of the local know how. They have built businesses that are tailored to international asset owners but set up locally- it’s the best of both worlds. And as a bonus, given the tough environment over the past couple of years and challenges, these specialists aren’t “China Perma- Bulls” anymore. They are more realistic and focus more on risk management than in the past.
One final question for you Do you have any comments on public vs. private market China opportunities? Is one more interesting than the other?
Ah, do I have to choose? I like diversification and having both is good. Public equities are generally large, liquid, cheaper to access. I already discussed why I currently like the public markets, and private equities tap growth areas not available in public market, where the GP can have real hand in operating businesses, and provide value add which is a sustainable source of alpha. So overall there is higher upside potential in the private markets, but clearly capital is locked up so there are liquidity considerations. And there may be sensitive industries that restricts foreign capital, but my conversations with GP’s does not suggest this to be an issue yet. We are currently seeing opportunities across the growth spectrum from venture to late-stage growth, and across sectors,
like tech and health care. We generally stay away from long only or long biased credit in China.
Many of the largest managers have tried and lost money in China, and more keep trying. I would rather take a more diversified approach to credit in the Asia region or even more broadly in EM.
We welcome any comments or feedback! Do you agree, disagree? Please let us know if you’d like to participate in the next iteration of “off-the-record” or if you’d like to connect/share ideas with this LP peer.
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