How to Generate Uncorrelated Returns in the Chinese Stock Market Adapting to slower and more cyclical economic growth


Ronald Cheung, Partner, Optimas Capital Limited, Hong Kong


Merrill Lynch, UBS and Sculptor (formerly Och-Ziff). Optimas started with an anchor investment from a Hong Kong pension fund. The firm maintains a presence in Hong Kong and Singapore, has a research office in Taipei, and an investment team of 16 people, but there is one investment book ultimately managed by one portfolio manager. The firm has 38 employees in total.


O


Investment objective is capital preservation and compounding at 10% p.a., with low volatility and low market correlation, which has been achieved. There have been no losing full calendar years.


China’s slowing growth Optimas observes how China’s economic growth has slowed from hyper growth to the average for emerging markets so that countries such as India and Indonesia are now growing faster. The Chinese government has ambitions for faster structural growth but in reality the slowdown can be explained by the three factors of production: labour, capital and productivity: and all three have been slowing.


Population growth has slowed even after the one child policy was ended, because it is expensive to raise children. And the ageing population is reducing the size of the labour force: in 20 years China will be one of the oldest nations with one of the largest populations aged over 60. Meanwhile capital’s contribution to growth is constrained by China’s leverage: China has had very high rates of capital investment and credit to GDP, and the high investment ratio has capped the marginal return of new projects.


It is a normal pattern for the labour and capital drivers of growth to drop as economies mature, but usually productivity improvements make up the difference. That is not happening in China where applied R&D spending is low, stripping out product development. R&D matters most for innovation, which is also being hampered by geopolitical factors such as the Huawei-related 5G technology embargo, and the more recent ban on Nvidia exporting AI chips to China. This is challenging because China has historically been better at honing and refining imported technology than inventing it.


ptimas was founded in 2016 by Thomas Wong, who has senior sell- side and buy-side experience at firms such as Credit Suisse, Bank of America


Zero Covid policy and the property crisis Taken together these factors mean that growth is moving from structural to cyclical, and recently there have been cyclical headwinds.


The zero Covid policy has been constraining cyclical growth, with over 50 cities locked down at various times. This has intermittently disrupted at least 15- 20% of the economy and exports. Vaccination rates remain relatively low for older people, which adds risk to reopening.


The property market is now a headwind for growth. Property had been a reliable and well performing investment for many years and is the largest asset for most people in China, but the drivers of house purchases have been slowing. The number of marriages has dropped from 13.5 million in 2013 to 8.1 million in 2020. Urbanisation moves from farmland to city have also been slowing, from 29.5 million per year in 2011 down to 12.1 million per year in 2021. Property sales have dropped 40-50% in a month, which threatens growth.


Nonetheless China does boast leadership in some segments such as solar panels boosted by low costs of capital and subsidies; an ecosystem of e-commerce and mobile payments encouraged by the government; and areas such as AI face recognition or robotic medical treatment where more liberal rules on personal data let companies gather more data points and enable deep learning. These niches tend to feature prominently in many China strategies but not for Optimas.


Bottom-up large cap stock-picking The shift from structural to cyclical growth in China makes it no longer an easy buy and hold, or ‘buy the dip’ market where quality companies are multi- baggers. A basket of quality companies multiplied seven-fold since 2010 but has recently halved in value. In the past decade, during which nominal GDP growth averaged 9% per annum, MSCI China/ SHCOMP merely returned 0%/3% CAGR vs. 10% by US equities as measured by SPX. But picking the right themes/sectors/stocks with the right timing has proven to be profitable, as exemplified by the spectacular alpha from commodities in the early 2000’s, financials in the late 2000’s, and consumer/ TMT stocks in the past decade.


Optimas does deep bottom-up fundamental analysis of companies, balance sheets and management teams, looking for strong earnings growth and


good risk management. The team of 16 analysts includes many country specialists focused on Japan, India and Korea, as well as sector specialists. They follow 400-500 mainly large cap companies very closely and do 250 field trips per year. In addition to the companies listed in their respective exchanges, the investment universe includes multinationals where Asia is a dominant share price driver, which can also feed into pairs trades. The largest exposures are in Greater China & north Asia, but the book is increasingly diversifying into India and ASEAN.


Macro factors such as geopolitics, rate hikes and Covid, are considered but the aim is to hedge country, sector and style in order to isolate stock- specific risk. Net exposure does not normally exceed 10% in either direction. An example was when Covid started in early 2020, Optimas decided to cut gross exposure, informed by their analysis of the pandemic, and helped by their experience of SARS in Hong Kong, but they did not make any strong directional bet.


Some sectors, such as internet and e-commerce, have faced regulatory headwinds as well as slowing growth as government regulation has become stricter. In China, Optimas take the view that private enterprise carries more political risk and SOEs have less political risk.


The book is diversified into 200-250 positions and a high conviction one can reach 3-4%, though probably not immediately; they are more likely to scale into stocks as more data points increase confidence in the investment thesis. Optimas aims to allocate incremental dollars to the best upside and downside ideas, adjusted for risk.


Gross exposure varies with the stability of the market climate. Managing risk and drawdowns through active trading is always a key part of the process.


A unique feature of the fund’s strategy is applying Asian expertise to invest in global stocks. Many global stocks, such as the European luxury, Global Semiconductor, or Japanese consumer, sectors, move with Asian driven factors. These companies tend to have better governance and better investor alignment, and more importantly less regulatory- driven volatility. By having a team of experienced analysts on the ground, Optimas is able to gain an information/timing edge. THFJ


67


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32  |  Page 33  |  Page 34  |  Page 35  |  Page 36  |  Page 37  |  Page 38  |  Page 39  |  Page 40  |  Page 41  |  Page 42  |  Page 43  |  Page 44  |  Page 45  |  Page 46  |  Page 47  |  Page 48  |  Page 49  |  Page 50  |  Page 51  |  Page 52  |  Page 53  |  Page 54  |  Page 55  |  Page 56  |  Page 57  |  Page 58  |  Page 59  |  Page 60  |  Page 61  |  Page 62  |  Page 63  |  Page 64  |  Page 65  |  Page 66  |  Page 67  |  Page 68  |  Page 69  |  Page 70  |  Page 71  |  Page 72