June Lui – Well Hong Kong is a very exciting place. It’s so sophisticated. It’s very efficient so you can get where ever you want to in a very easy way, so it’s a very lively city.
Ben Jones – So kind of like the 101 here in LA. No traffic and —
June Lui – Ha ha ha ha! Hong Kong is much better!
Ben Jones – Yeah exactly. So today we’re here to talk about China and emerging markets and in particular as a professional investor who spends your career investing in the Chinese markets we want to get your perspective on the opportunities and challenges that advisors might face when trying to incorporate China into a well-diversified portfolio or China exposures. And then also love to talk to about some current events that are happening now and have captured the news over the course of the summer as well. But let’s start first with what kind of kicked off a lot of discussions that your team and our teams have had about China which is China A-shares are now included in the MSCI and FTSE Russell indices. And can you talk a little bit about how this changes the importance and weighting of China in those indices.
June Lui – Yep. With the inclusion of China A-shares into the MSCI, FTSE Russell and also S&P, that means that for any investors including those passive investors that are going to have a bit more exposure in China, especially in China A. For investor you have to pay attention to the markets that you have more exposure and for active managers and we also — we are very glad that market is getting more open to investors. And we see the flows and also more participation by institutional investors and foreign investors that is going to be helpful in putting some more rationality and order into this very wild market.
Ben Jones – So correct me if I’m wrong because I’m often wrong but there are A-shares and H- shares. Is there another kind?
June Lui – Well, there are actually many types of shares. China A-shares are those listed in the domestic exchanges which are the Shanghai Exchange and Shenzhen Exchange. And there are many Chinese companies listed overseas including Hong Kong. Those listed in Hong Kong, we call them H-shares and we also have some companies called P-shares. They’re also Chinese companies listed in Hong Kong. Then also we have the ADRs listed in the US and Singapore.
Ben Jones – Wonderful. Thanks for that explanation and help me out – just at a real basic level what was the weighting to China before the A-shares were added and what is it now in those indices?
June Lui – Well before that in the MSCI emerging market index China accounts for just less than 30%, and so with a full inclusion which is going to happen in the next few years China in total would account for about 40% of the emerging markets index.
Ben Jones – So big increase in weightings for an indices.
June Lui – Yeah.
Ben Jones – Can you talk a little bit about what the implications of that change in weighting and the benchmark means for active managers like yourself?
June Lui – Doesn’t actually change much for us because we are a manager we always look for alpha and look for ideas, whether it is in the benchmark or not in the benchmark we use the very much bottom up approach to find the best investment ideas. And I think the key difference would be more people would pay more attention to the China markets. And so for us we would continue to see this is a great market for any active managers because of the inefficiency in the market and the volatility and also the fact that the market is still very much dominated by retail investors in China. So there are a lot of opportunities of creating value when the speculative behavior leads to mispricing in the market.
Ben Jones – Now you mentioned this before, that the inclusion now gives a lot more access to Chinese equities in the marketplace. Can you talk a little bit how this access has changed and what that’s done to the liquidity of these stocks?
June Lui – Actually it is more as a result of the increasing assets to the markets, that’s why the MSCI or FTSE and S&P, they decided to include more China A-shares into their benchmarks because with the Stock Connect program that means for foreign investors it’s much easier for them to investment in China A-shares. Before that they have to apply for what we called a QFII quota, and also they are under the capital flow restriction as well so the open up of the equity market in China is a key reason why those major indices include China A-shares.
Ben Jones – So what kind of companies are available in China A-shares. Tell me a little bit about the composition of the companies that make up all the A-shares in China.
June Lui – A-shares –So the two — they have slightly difference in terms of the type of companies that you can find but they are different from the offshore markets, in that you find a lot more variety, in terms of the different type of industry and also like different category in different part of the economy. So for example some of the companies, there are like involved in industrial and also military supply. They are available only in Asia but not in Hong Kong or offshore but on the other hand you find some of the companies there you can only find in offshore markets. Most of them are Internet related companies that are listed offshore.
Ben Jones – Very interesting. I’ve heard that the A share market in China is dominated mostly by retail investors and speculation happens a lot and so will this change now with the flow of outside capital into the marketplace?
June Lui – Well that’s what I think the government and the regulator is hoping to introduce more foreign investor and a long-term capital into the market because of the dominance of retail investors in the China A-shares market. Basically it’s like people come into the market betting on stocks like in the casino. So they have no idea about what they are investing. They’re not actually investing. So this kind of speculative behavior is not helpful for the development of a proper capital market in China. So they have to introduce proper institutional investors into the market and hopefully that will have to develop the discipline in those listed companies and how they improve their corporate governance in response to the shareholders’ request.
Emily Larsen – In order to provide some background, Ben and June expanded the scope of their conversation to understanding China’s economy more broadly. To kick off they discussed China’s reported GDP numbers and the impressive CAGR, the Compound Annual Growth Rate, corresponds with their inclusion in the WTO of 2001. All that said, we heard people in the marketplace question the accuracy of China’s GDP numbers so we wanted to ask June’s perspective.
June Lui – Well if you think about if you have to manage a country as big as China both in terms of the geographic, the land mass the size and also the population of 1.3B, 1.4B of people it is understandable that you have to bear with some of the errors in statistics. So for us I think yeah it can never be accurate. So what we see is you might question whether GDP growth is actually — 8% or 9% or 10%, or even 6% but what we have seen was hundreds of millions of people were lifted out of poverty. If you have been traveling to China and you see the development of most of the cities, and the urbanization of the rural area, the infrastructure, the railway system. And you definitely can tell that there has been tremendous economic growth happened over there. The per capital income growth together with the overall country, the GDP growth has been phenomenal in the last 20 years, and it is almost like a $9,000 US per capita. And a big portion of the population is now getting into the middle class and that will bring along a significant implication on the demand for consumption. And when people have more income they tend to spend the extra money on a lot more variety of services and products. And so these are the opportunities that we see because of the domestic consumption, because the population is able and willing to spend.
Ben Jones – So people have more discretionary dollars to spend, and we’ve had Thomas Vester on the show in the past. And he’s explained that in emerging economies when people get discretionary dollars they do things like buy a Coca-Cola after work or maybe they buy some new shoes or things that may be are luxuries that they weren’t doing before and that drives a lot of growth, and so there’s a lot of interest in consumer staples and things of that.
June Lui – What we have seen is the domestic consumption is taking a bigger role in terms of the drive for the economy in the last few years. And with the trade tension actually it is speeding up the process with using the reliance on exports. But exports are not a big part of the GDP contribution anyways in the last few years. And even before all this trade tension China has been actively trying to get rid of those low end labor intensive polluting manufacturing to outside China, to Southeast Asia. And one because of the tightened environment standards that they want business to improve, especially in the manufacturing factories and also because of the shortage of labor, you know that we have the one child policies and the population growth have been slowing and the younger generation, they’re more educated so the low end low skill level labor in factories is just not available. And so this is a development process for China that we want to move on to the higher value adding manufacturing towards more of the value adding and service industry, rather than the low end manufacturing.
Ben Jones – Wonderful. So you mentioned two things I want to touch on. Demographics and then the environmental standards and so let’s start with the environmental standards. I heard this kind of initiative described as a Blue Sky Initiative. And can you explain what the environmental stewardship changes are and how where you invest might change as a result of these things?
June Lui – So in the last few years we have seen quite a few policies being announced that they have set to have a clear target for example, they have clear targets for water quality improvement also increasing the mix of clean energy and total energy consumption so for us, we see the opportunity in investing in some of the clean energy related business for example in a downstream natural gas distribution and so this business is in line with the national agenda and also generates very decent profit out of that.
Ben Jones – And so how does this change the way that you think about investing or the types of companies you might consider as a result of these policies?
June Lui – It’s a very clear shift of the focus from the speed of growth to the quality of growth in China and a lot more attention being paid in the environmental impact and social impact of the business. So companies, they are under scrutiny if they fail to meet any requirements. So when we did our due diligence for our investment ideas, we have a lot of conversation with the management and key shareholders to understand their approach in environmental protection and also how do they meet the requirements. What is the strategy in bringing or even capturing the change in the requirements that can produce positive impact on this issue?
Ben Jones – China has increased its policy focus for more environmentally conscious Chinese businesses. Now June and LGM take ESG factors into consideration when deciding which Chinese stocks to invest in but I had a lot more questions about how LGM identifies investment opportunities given the sheer size of the universe available to invest in. And of course, how advisors should consider allocating to Chinese equities as part of their clients’ portfolios. Your investment process focuses on a company’s ability to generate free cash flow and their ability to return some of that cash to investors in the form of dividends and so I’m curious how large is the opportunity set with that kind of a screen? And how many companies would qualify for that and then ultimately make it through your screening process and into your portfolios.
June Lui – We look for high quality companies which can generate healthy cash flow and we look for aspects. First of all, sustainability of the business model — we like companies that have built up a strong moat around their business and also they have strong and capable management. Stability of the management and also the alignment of interests with minority shareholders to corporate government structure. So we have to take it into consideration all these factors in our assessment. And actually the China universe is big if you take it into consideration of they’re both on shore, the China A-shares, and also offshore, we have more than 6,000 companies listed. And for us our investment strategy is to have high conviction concentrated portfolio so we are not aiming to have 100 names in our portfolio. But we want to find the best high-conviction idea.
Ben Jones – When it comes to finding companies that fit your investment theses, how has transparency in governance improved in Chinese companies and is it to kind of, what, traditional Western standards?
June Lui – Most of the Chinese companies, they are still like early stage of developing that improvement in corporate governance and from our experience in communicating with those company and engaging with the management and also the key shareholders we found significant improvement in the last few years. Takes a lot of effort to educate them. They want to know why for us as minority shareholders want to know more about their business vision strategy and I want to have a governance structure to put our interests. And this is far from the Western standard, but we have seen some companies which are more like keen on improving their corporate governance than others.
Ben Jones – Tell me a little bit about how your team because your investors, you have US investors that invest in your strategy. You have European investors that invest in your strategy. I’m sure you have domestic investors that invest in your strategy. How does your team view the difference in currency in China where it doesn’t float in the open market like many other countries’ currencies? How do you think about that, and how do you account for it in your investment strategy?
June Lui – The Chinese currency, the RMB, the kind of like controlled by the government, but in the last few years so there is like the reform to improve the flexibility of the range of the movement of the currency. So the government they aim to improve the markets elements in determination of the currency value so this is part of the capital market reform. Because at the initial stage, in the emerging markets we have seen that for countries that they allow free flow of currency there very often they will see a lot more volatility in the currency and also the impact on the economy. So for the Chinese government this is the way for them to basically protect the stability of the economy by controlling the currency. But there is the flip side of this control that they would have a lot of inefficiency and also of course mispricing in the assets’ price because of the control on the currency so that is something that they have to change over time so with the economy getting more stability and also from the view of the government they need a foreign investor to understand the situation in China. In order to appreciate the economic situation and also have a better reflection on the currency level. So that’s why they are taking steps slowly to open up the currency regime. And that’s something that will happen in the next few years and decades.
Ben Jones – And so as an investor given that that’s an unknown variable does that influence your decision on what companies or how to invest capital or what kind of return on equity you need.
June Lui – We’d take into account the currency impact, more in the context of how those currency movement is going to affect the operation of the companies that we invest in. So we look at it’s probably the revenue or the cost more sensitive to currency. And then we’ll put in place the assumption. But overall the portfolios we don’t match the currency. And at the moment because most of the holdings are still listed offshore so the share price itself is not affected by the RMB.
Ben Jones – Wonderful. We hear a lot about the increased focus on the ESG as it pertains to investing. You’ve touched on this a little bit with the Blue Sky Initiative and the way that you guys talk to management. How do you integrate that into your process? For example, like you talked about your looking for high quality companies. You’re looking for sustainable. Where does ESG fit into that due diligence process or is it across the board?
June Lui – Yeah so ESG is like fully integrated in what we look at for quality because we think that it’s not a separate issue. It’s like the core of how the companies should operate, especially in this environment of how globally people are putting more attention on the environmental and social impact of business operation. So it is both a risk management and also a way to look for opportunities for those companies that they are contributing positively they would see a much better future in the sustainability of their business. And so for us, we have the approach avoiders who are bad at what they do, and we also invest in companies that we see would benefit from this trend in development. And also we like to engage with companies that they might not be doing so well at the moment but they have potential to improve, and so we engage with those companies and provide suggestions and we have a great team of ESG specialists within the group to where we leverage on the knowledge and we work with them together to engage with company for how they can improve. And we definitely see this as an inclusion in what we consider for our investment.
Ben Jones – Now I want to talk a little bit about including the exposure in China inside of a well-diversified portfolio. So a lot of professional allocators historically have allocated to emerging markets through either active or passive vehicles and they’ve allocated say, 3% to 5% of the portfolio depending on risk tolerance and whatnot to emerging markets. Recently given the change in A-shares and the significant weighting that China has in the indices I’ve started to hear a lot of professional allocators talk about the idea of investing in emerging markets, X-China, and China as separate weightings. What have you heard as you’ve been out talking to professional allocators or investors and do you have any thoughts on this?
June Lui – I think given the MSCI Emerging Markets is getting a lot more in China. It makes sense to take China out as a separate asset class and, in fact, I think China’s development is also in a different phase, compared to other emerging markets. So it makes sense to me that if investors want to separate China portion and find a specialist in the China market to manage a China portion, and leave the rest to the emerging market mandate.
Ben Jones – If you currently have a strategic allocation to emerging markets increasingly there is a case to be made for splitting out an allocation to China and the rest of your emerging market exposure. I was keenly interested to get June’s perspective about some of the current events going on in China which have made headlines around the world. Over the summer, we’ve seen a lot of protesting in Hong Kong and it’s made worldwide news. Is there a way for both sides to kind of save face, and what’s your perspective on how this whole thing ends?
June Lui – I think it’s gone beyond everyone’s expectations and surprised everyone including the protestors themselves, the Hong Kong government and also the Chinese government. And when it started three months ago, I think no one expected that it will extend into that kind of duration and also the number or the level of participation from people. What it started with was the extradition bill that people wanted to have a proper consultation, and without that they wanted there to be withdrawal. And then it developed into a bigger problem because of the mishandling of the Hong Kong government. So most of the people in the streets, they are actually mad at the Hong Kong government rather than China.
Ben Jones – That doesn’t get reported on. At least from here, right?
June Lui – Yeah that’s the thing I mean like for us in Hong Kong it’s really interesting that we get to hear what is reported in the Chinese media, obviously they have a very different perspective as well. And also, the Western media is also not quite accurate in what they have to report.
Ben Jones – Yeah.
June Lui – And so it’s not all about protesting against the sovereignty of China in Hong Kong. I mean like after three months there might be some people actually come out also wanting to protest on the back of all this, and they also express this disagreement in this, but I think that’s a minority. hopefully the Hong Kong government would be able to come up with better communication and handling of the people in the streets because what’s happening and the violence and people get hurt from both sides, it is really a big concern for people.
Ben Jones – Yeah, and how close was that to your office?
June Lui – It’s very close to our office! But it’s kind of like getting into different areas in Hong Kong. For most of the people you can actually avoid getting into those protest area but there are inevitably some disruption to the public transports.
Ben Jones – So next kind of current thing: There’s been a lot of discussion about trade differences between China and the US over the last year and there’s tariffs going both directions. What’s the outlook for the tariffs and their impact on Chinese markets?
June Lui – So the tariffs definitely have some impact on the Chinese exports and so from what we have heard so far both from the media and also from the conversation that we have with some of the companies that we invest in and we have talked to, extra tariffs are not just being picked up by the Chinese exporters. American importers or the companies they are also sharing some of the tariffs and I believe that also passed onto the US consumers to some extent. So I think the tariffs is bad for both countries and people in both countries. For China, it is a short-term pain that we have to bear with. In the meantime the government is trying to provide more stimulus for a domestic economy to drive the consumption and also putting in more like easing in the monetary policies and so it hasn’t been causing too much distress so far from what we have seen. Consumption slowed a little bit but not entirely because of the tariff. We also have other issues in the domestic market and so like I mean it would be good that we see some kind of relief or reverse of some of the tariffs. But even though I think if it continues to be in place, I think people are just getting on with it.
Ben Jones – I think both the US markets and Chinese markets seem to want this to be resolved quickly.
June Lui – Well to be honest we think it’s not just about trade or the trade deficits. I think this is an issue about rivalry of the two biggest economies and some people think that the Chinese are playing a strategy to wait until the next president to come and I think well you more about the situation in the US but doesn’t matter who is the next president. He or she has to deal with the fact that China is getting bigger and bigger and getting more powerful in terms of economy and also the geopolitical status. And so this is an issue. I think that is not going to get resolved in the next 10, 20, even 30 years — that we have to live in the world that there are two big voices against each other.
Emily Larsen – As China’s equity markets continue their evolution, new opportunities and new challenges will develop. Making investment allocations to this market may require a specialist who’s on the ground and able to understand the nuances of this vast market and really be able to conduct thorough bottom up analysis in order to implement a successful investment approach. We hope sharing these perspectives has been thought provoking and has generated ideas you can put into practice when making investment decisions for your clients. Thanks so much to June for taking the time to share her perspectives, and we’ll leave you with one last thought of hers on the outlook for China’s equity markets over the next couple years.
June Lui – In the short-term the China equity market would be affected by a few factors — the trade tension, the development of trade tension, if we are going to see any resolution from the next meetings but as we have seen in the last few years things can change on a tweet. So there will be a lot of uncertainty in that sense and also we continue to see the inclusion from the key index providers and that would continue to drive more inflows into China markets. We keep an eye on the development of the macro situation, the GDP growth is going to be slower but how the government is going to respond to this slower economy and if they are have the tools to put in place to provide the support and to encourage domestic consumption. And this would help in terms of the market performance.
Ben Jones – Thank you for listening to Better conversations. Better outcomes. This podcast is presented by BMO Global Asset Management. To access the resources discussed in today’s show, please visit us at www.bmogam.com/betterconversations.
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