ESG Club


Ian Smith is global emerging markets portfolio manager at Newton Investment Management


CRACKING THE CHINA CONUNDRUM


China remains a conundrum for many investors: a source of dynamism and growth potential, and yet, like many other emerging markets, often somewhat opaque in terms of governance. China remains a compelling investment destination, but getting comfortable with it requires an appreciation of the back- drop one is operating in, and a demand- ing level of due diligence on the compa- nies that one might want to own. It has always been important to have a good understanding of (and alignment with) China’s policy initiatives, and with prevail- ing macro trends. That starting position has not wavered, but what is changing are the policy initiatives and macro trends. We see several fundamental shifts:


China is no longer in a period of exceptional growth


China is now the largest economy in the world on a purchasing power parity- adjusted basis. GDP per capita is now 11 times higher than it was 20 years ago. Debt levels are now bloated, with private- sector debt-to-GDP at more than 200%. China’s


working population is also


expected to decline by about 160 million people during the next 30 years.


China’s economy is experiencing a huge amount of change Certain areas of growth are no longer sec- ular – gross capital formation is bloated at more than $6trn (£4.9trn) per annum, and real estate is too large at around 30% of GDP. Even in e-commerce, China is seeing the highest levels of penetration globally. These industries have broadly served their purpose, so it should be no surprise to see greater regulation and less government support. We believe sustaina- bly higher levels of growth will be easier to find in areas upgrading China’s eco- nomic infrastructure, such as semi-con- ductors, software, industrial automation and healthcare R&D.


China has globally leading companies in strategically important sectors China consumes almost twice as much electricity as the US, and thus it is little surprise that Chinese companies lead the way in the solar-energy supply chain. It has also built around 1.5 million base sta- tions for 5G mobile networks, versus around 100,000 in the US. We see a sim- ilar story in other strategically important areas, such as electric-vehicle batteries, where China dominates.


In terms of due diligence, we understand there are significant issues in China as well as bad corporate actors. For these rea- sons, and given China’s emergence as a superpower, we are set for an era of ten- sions between China and the US, or indeed the West more broadly. Some take an extreme view, and argue either that these things do not matter, or that you cannot invest in China at all. Instead, we believe it makes sense to understand the opportunities and pitfalls that result. As seasoned emerging market investors, we think the answer is to make


PI Partnership – Newton Investment Management


sure you ask the right questions before investing, and to have sufficient expertise and resources at your disposal to do so. Many emerging markets, like China, are undergoing massive changes. There are also large variations in terms of institu- tional strength, the rule of law and prop- erty rights. In that sense, the governance backdrop in emerging markets is more complicated. But what we are looking for in terms of high-quality governance is quite simple: it is important to under- stand who we are aligning ourselves with, their core competency and the company culture they are promoting. Specifically, we seek answers to the fol- lowing criteria: evidence of alignment with minority shareholders; evidence that the business has been built on merit in a healthy, competitive environment, rather than via protectionism or patron- age; and an understanding of the culture of a business, and how this leads it to attract and retain talent, intellectual prop- erty,


customer intangibles.


The final, crucial, step is to understand how good governance then drives fran- chise and financial results. Too often in emerging markets we see people viewing governance as a restrictive, tick-box exer- cise where set rules can be applied. Instead, it can be an immensely important factor in determining franchise quality. Lastly, one of the most common ques- tions we receive on the quality of govern- ance in emerging markets is “how can you know?” Our ambition is to ask our- selves the right questions about the more qualitative risks we are taking on behalf of our clients. By doing so, we believe we have a better chance of compounding durable long-term investment returns in emerging markets.


Important information This is a financial promotion. These opinions should not be construed as investment or other advice and are subject to change. This material is for information purposes only. This material is for professional investors only. Any reference to a spe- cific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors. Compared to more established economies, the value of investments in emerging markets may be subject to greater volatil- ity, owing to differences in generally accepted accounting principles or from economic, political instability or less developed market prac- tices. Issued by Newton Investment Management Limited. In the United Kingdom, NIM is authorised and regulated by the Financial Con- duct Authority (‘FCA’), 12 Endeavour Square, London, E20 1JN, in the conduct of investment business. Registered in England no. 01371973.


28 | portfolio institutional | September 2022 | issue 116 relationships or other


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