There’s opportunity in China stocks if you know where to look

Renewed negativity about China’s growth is creating opportunities to buy good companies that are focused on delivering for shareholders. SAMIR MEHTA explains where to look

• China’s re-opening disappoints 
• Quality opportunities emerging  
• Find out about Samir Mehta’s Pendal Asian Share Fund

CONTINUING negative sentiment towards China stocks is an opportunity to invest in companies with market-leading positions that offer strong cashflow, argues Pendal’s Samir Mehta. 

Beijing’s lifting of its draconian Covid restrictions late last year raised hopes of a return to growth for the Chinese economy, but investors have been disappointed by the country’s mixed performance. 

Luxury goods makers like Burberry and LVMH Moët Hennessy Louis Vuitton are posting strong sales in China as the wealthy pick up spending, but other important sectors like real estate are still performing weakly. 

“It’s a very mixed bag and there is tremendous choppiness,” says Mehta, who manages Pendal Asian Share Fund. 

“The Chinese stock markets were doing quite well until about January-February but have now handed back almost all of their returns this year.” 

Mehta says the weakness offers opportunities for investors willing to take a stock-by-stock view of the Chinese market. 

“My outlook towards China is that I see shades of similarity in what happened to Japan after their big bubble burst in 1991.

“We’ve enjoyed decades of fantastic growth in China, primarily funded by debt, towards an asset — property — which can be quite unproductive. 

“Over the next few years, maybe even a decade or more, we should expect China’s GDP growth to be significantly lower than in the past. 

“However, the quality of the growth in certain sectors will be significantly better if company manager’s recognise what is ahead of us. 

“And that’s how I position my portfolio — to find companies in sectors with concentrated market share positions, or they possess pricing power and better still, where companies are focused on cutting costs and generating cash flows without affecting growth.” 

Two Chinese stocks that look promising

Mehta says two Chinese companies stand out as meeting those criteria: Tencent Music and Netease. 

Tencent Music

“Tencent Music is one of the bigger holdings in the portfolio. You can think of it like the Spotify of China.” 

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Mehta says Tencent Music’s attractiveness lies in its ability to cut costs without hurting sales. 

In 2020-21, Tencent Music was spending approximately 650 million RMB per quarter in selling and marketing expenses. By the first quarter this year, that spend has been cut to 225 million RMB. 

“That’s a dramatic cut. You would assume that when you cut down on sales and marketing there would be a negative impact on the ability to reach customers and generate revenues.

“ But the net paying customer base is the highest that they’ve ever had at about 95 million, and it’s grown more 15 per cent per annum — that’s a very strong increase.” 

Mehta says the point for investors is not in assuming this growth will continue, but instead in demonstrating the latent capacity in certain companies to create cash flow. 

“This company has adjusted its expenses while growth remains on track and is now generating significant amounts of cash flow. They finished US$1 billion dollars of buyback and they just announced another US$500 million of buyback.” 

Tencent Music has net US$3.5 billion in cash on its balance sheet compared to a market capitalisation of US$12.5 billion, sauys Mehta. 

“That’s an enterprise value of about US$9 billion; by my estimates they will be generate around US$800 million of cash every year.” 

Netease

At gaming giant Netease, a similar story is playing out.

Netease recently posted slowing top line growth of 6 per cent but an improvement in gross margin to close to 60 per cent – an improvement from a past average of 56 per cent. 

Driving the change has been a shift away from lower margin licensed games to higher-margin internally developed games, plus a shift in sales and marketing to use direct channels rather than third party sales. 

“You can see management’s thinking: growth is going to be slow but what can we do to get more profitable net results,” says Mehta. 

“An initial plan to buy back $500 million of stock has gone up to $5 billion. They are one of the few companies in the tech space that has a 30 per cent payout ratio for dividends. 

“They have a market cap of about US$55 billion and US$13 billion in net cash and will generate between US$3.5 and US$4 billion of cash flow every year.” 

Mehta says this new focus on shareholder returns and cashflow is a change for Chinese companies, which have traditionally been focused on growth and market share. 

“This negativity on China continues to present an opportunity for people like us to continue owning and, if possible, adding to these names, because they represent what all investors should be looking for: reasonably cheap valuation, moderate top line growth but very good quality margins and cash flow growth. 

“And the right use of that cash to buy back shares or pay out dividends.” 

About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

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