After lagging the u.s. market for several years, China’s stock market seems to be perking up lately, and Richard Gao, manager of the Matthews China Fund, believes investors have reason for optimism. While it’s true that China’s 10%-14% GDP growth in the late 1990s and early 2000s appears unlikely to happen again anytime soon, he says, growth in the 7% to 8% range is a “reasonable expectation.” Furthermore, that growth is becoming more diversified and stable thanks to increasing demand for consumer goods by the country’s growing middle class.



“Years ago, the government relied on infrastructure investments and exports to stimulate growth,” he says. “But a couple of years ago, there was an intentional shift by the Chinese government toward supporting more quality, stable growth through consumption and the service sector.” New rules making it easier for foreigners to invest directly in China’s stock market rather than indirectly through “H” shares listed on the Hong Kong exchange are another draw for investors, he adds.

Investors may also be attracted to stock valuations that are cheap both by historic standards and when compared now with other markets. The MSCI China Index trades at about 9 times forward 12-month earnings, compared with 11 times earning for the MSCI Emerging Market Index and 17 times earnings for the S&P 500 index.

In the past, the country’s stock market was like a caboose that followed the dips and surges of China’s GDP growth. In 2006, for example, when the economy grew 12.7% the MSCI China Index shot up 82.7%. But when growth slowed to 9.6% in 2008, the index lost 51%. And in 2012 and 2013, when GDP rose between 7% and 8%, the index lagged other world markets by a substantial margin. The question now is whether investors can accept slower but perhaps more stable growth as the new normal.

Another concern among investors is the rapid expansion of credit in China, which some worry could lead to a credit bubble. The borrowing binge began in 2008, when the government enacted a massive stimulus plan and called on banks to lend aggressively in the wake of the global financial crisis. Over the last five years, credit has grown by 25% to 30% annually, about two to three times the rate of GDP growth. Additionally, many companies previously unable to access credit took out loans through the “shadow banking system” at rates well above those of mainstream banks. This informal system of financial intermediaries—which mimic many of the lending functions of commercial banks—includes hedge funds; broker-dealers; and even informal family, village and social networks that provide capital for individuals and businesses.

Gao doesn’t believe the aggressive lending will spark a credit crisis in which borrowers default on a massive scale. Since early 2013, he says, both the government and banks have been more selective about whom they lend money to. “The expansion is slowing down, banks are lending more prudently, and there has been more of an effort to clean up bad debts,” he says. “The government is not just handing out blank checks.”

But he concedes that non-performing loans resulting from the borrowing binge could have a negative impact on some individual banking stocks. That viewpoint has led him to substantially underweight the financial sector relative to the MSCI China Index, and to fill the financials sleeve of the portfolio with privately owned insurers, financial conglomerates, and well-managed regional banks with better-quality loan portfolios.

He points out that China is also unlike many developing economies that have experienced credit meltdowns in the past. It has a substantial current account surplus and a self-funded, liquid banking system. And though credit has expanded and loans have increased, so have bank deposits. Since much of the credit boom has focused on local governments, real estate and infrastructure projects, corporate balance sheets remain generally healthy by historic standards. In addition, China has recently drafted new rules aimed at containing risks in its shadow banking sector and is apparently trying to regulate these lenders.

Betting On The Chinese Consumer
Gao believes certain sectors, including industrial and infrastructure companies involved in the build-out of roads, railways and other public facilities, will grow more slowly than in the past as China becomes less dependent on exports and economic expansion proceeds at a more measured pace. And while he sees no systemic risk to the banking system, the likely increase in non-performing loans in the coming years makes individual bank securities a risky bet. Weeding out the winners from the losers is particularly difficult among banks, which are owned by the government and do not have transparent financial reporting.

On the other hand, the migration of China’s population from rural to urban areas and the expansion of its middle class provide the opportunity for faster growth among consumer and service sectors such as retail and health care. That transition is well under way, according to an analysis by the McKinsey Global Institute, which predicts that over the next 20 years China’s urban population will expand by 350 million to top 1 billion. Already, the government and private sectors have pulled millions of these rural-to-urban immigrants out of poverty by expanding housing, health care, jobs and education. In 2000, China turned out only 1 million college graduates a year; that’s risen to about 6 million in recent years.

“In the past, industrials accounted for most of China’s GDP growth,” says Gao. “But in 2013, for the first time, the service sector was the biggest contributor to growth. People are generally overly pessimistic about China because they are focusing on concerns about banks and real estate. They’re not seeing reform efforts and the important changes that are going on in the economic structure.”

The positioning of Matthews China reflects the changing face of the Chinese economy. The fund has a low 18% weighting in financial stocks, about half the level of the MSCI China Index. Another 18% of assets are in consumer discretionary stocks, significantly more than the 5% weighting for the index. In addition to having the potential for faster growth, these consumer-driven sectors tend to have a more entrepreneurial bent and more transparent financial reporting than banks.

The fund also puts more emphasis on health-care companies than the index. Stimulated by government aid, the spending on health care in China has increased 15% to 20% a year over the last decade. Life expectancy increased from age 66 to age 76 from 1980 to 2011, creating more demand for health-care services, which rising incomes are giving aging seniors and other people more money to pay for.

In addition to emphasizing different sectors than the index, the fund puts more of its muscle into small and mid-cap stocks. Its expense ratio of 1.08% is significantly lower than that of most actively managed China funds.

With the fund’s unique profile, its performance can differ significantly from that of its peers, which tend to hew more closely to the index. From 2009 through 2011, the fund outperformed the average China-focused fund in Morningstar’s database by a significant margin. But with consumer stocks lagging financials for most of the last couple of years, the fund’s more recent performance has been less impressive. Nonetheless, Morningstar analyst William Samuel Rocco noted in a report that the fund is “one of its category’s standouts. … Rough spells are facts of life for even the most elite offerings, and there are ample grounds to be optimistic about this fund’s long-term potential.”

The turnover ratio is just 6%. Gao is clearly a patient investor who takes a long-term view of the fund’s holdings. One of them, Sino Biopharmaceutical, is a leading maker of hepatitis and cardiovascular drugs. Unlike many pharmaceutical companies in China, which focus on producing generics, Sino has its own research and development capabilities and a number of strong products in its pipeline.

A top fund holding, Tencent Holdings, is a leading technology company that is leveraging its 800-million subscriber instant messaging platform to promote its chat services, e-commerce, social networking and online gaming capabilities. While Tencent’s valuation is fairly high, Gao believes it is capable of 30% to 40% annualized earnings growth.

The fund’s consumer plays include China Mengniu Dairy, China’s largest producer of milk, yogurt, ice cream and other dairy products. With a 25% share of China’s dairy market, the company is well positioned to feed the country’s growing appetite for dairy products.

In the financials sector, Ping An Insurance Group, the country’s second-largest insurance company, is entering new areas of business such as banking and investments. Gao says its management team is capable of turning the company into a successful financial conglomerate that will serve the needs of China’s growing middle class.