China Equities 2019: Fundamentals Sound, Sentiment Is Wild Card

Amid macro concerns including trade conflicts and fears of slowing growth, Chinese equities were highly volatile in 2018. The declines in equity prices seem to have been driven largely by sentiment. Two decades of investing in China has taught me to look past sentiment and take a closer look at what's happening on the ground. For example, online shopping reached a record high this year during Singles Day, China's version of the U.S. shopping event Black Friday. On November 11, 2018, online sales in China for Singles Day totaled US$42.4 billion, a 27% increase over 2017. Consumer spending patterns, especially in discretionary areas such as electronics, entertainment and clothing, tend to hint at where China's economy is heading.

To get to the real story, we look at the underlying drivers of growth. We also aim to understand the intrinsic value of the businesses we own, as well as those we are considering buying. Long-term value is created by businesses that can weather market turbulence, grow their market share and compound earnings over time. The view on the ground can begin with simple questions: What goods and services are local consumers buying? What stories are being overlooked or misinterpreted by the global media? What opportunities require local research and language skills to capture? What does earnings growth look like for companies we are researching? What companies are generating actual cash flow and genuine profits? By looking at individual businesses from the bottom up, we seek to identify the companies with the most attractive potential for sustainable, durable growth over the long term. Here are some of the trends we are following for 2019.

Consumption broadens to lower tier cities

China is famous for its megacities. Tier one cities, such as Beijing and Shenzhen, have populations of more than 15 million. Tier two cities can range from 3 million to 15 million inhabitants. Things start to become interesting in tier three cities, which can range from 150,000 to 3 million residents. Tier three cities, often satellites to larger cities, are fueling much of the consumption growth in China. For China's businesses, these cities are providing an entirely new base of consumers. Job creation is growing in tier three cities, incomes are going up and consumption is rising. These cities have traditionally been underserved by businesses and represent pent-up demand for everything from dating apps to Indian food restaurants. Entire ecosystems of basic consumer services don't exist yet in these cities, from golf courses to sports bars. And returning to the travel theme, we're starting to see direct flights to Tokyo originating from tier three cities.

Earnings growth still in early stages

Between 2012 and 2016, corporate earnings in China experienced little or no growth. Earnings then ramped up considerably in 2017 and remained sound throughout 2018. In my view the drivers of that growth still have a long way to run. Even if earnings moderate slightly, they are likely to be supported by a healthy economy. This favors companies that can tap into the growing consumer spending that accompanies rising incomes.

Quality of companies improving

What's interesting about the current market drop is that the quality of companies is much better than it was 10 years ago. Current valuations are near the market lows of 2008, but the quality of the marketplace is much improved, creating a buyer's market for long-term investors. Government micro reforms have fostered a healthier marketplace. For example, policy makers have nurtured the creation of a yield curve, a repo market, a local government bond market, wealth management products and peer-to-peer platforms. Policy makers are serious about cleaning up state-owned enterprises (SOEs), progress is being made to reduce environmental pollution and a recent anti-corruption campaign has been effective. The cumulative effects create a more level playing fields for market pricing. In this environment, developing compelling brands is becoming more important to retaining a competitive edge. We're seeing more sophistication in adapting products to suit different customer segments, from high-end to mass market.