A Measured Approach to China

What makes today’s volatility different is the unprecedented nature of recent leadership changes. President Xi’s historic third term, announced at the 20th Party Congress in late 2022, came with an important re-shuffling of the politburo: Xi is now surrounded by a hand-picked team of loyalists, with no successors in sight, giving him the freedom to roll out Common Prosperity initiatives with virtually no resistance. At its core, the aim of Common Prosperity is a social one: lifting more than 300 million people from the lower-income tier into the middle class by 2035, by taking wealth from the top of the income pyramid and spreading it to the bottom. But this aim is also mirrored in the business world: taking power away from large businesses to ensure that companies of all sizes are capable of competing, and intervening in any activities that do not align with the common good. Xi now has more power than ever to carry these efforts out.

These interventions are happening at a rapid pace, with great consequences for the country’s largest firms. Following the suspension of Ant Financial’s initial public offering (IPO) in 2020, the Chinese government announced a series of reforms aimed at disempowering businesses it deemed too powerful—either through fines, mandatory charitable donations, or both. China’s two largest companies, Tencent and Alibaba, were particularly hard-hit by regulatory crackdowns in 2021 and 2022. And because they represent 12.0% and 8.1% of the MSCI China Index, respectively, the negative impact on their share prices rippled through broader market. As of late 2022, China’s share of the MSCI Emerging Markets Index stood at 30%—roughly 15 percentage points lower than its share in 2021 (Exhibit 2)—and its equity market was experiencing its worst performance since the 2008 global financial crisis, declining approximately 50% from its February 2021 peak (Exhibit 3).

Lenovo Group, a Chinese tech company that trades with attractive valuation multiples relative to its profitability, is a prime example. Though its roots are Chinese, Lenovo has become a truly global company—and while escalating US-China tensions do present a threat to Lenovo, the company continues to execute well. Its core personal computer business generates strong levels of free cash flow, which is reinvested into research and development as well as other business segments. More sensitive business activities, like the production of servers, are largely taking place outside of China. Lenovo also has a large manufacturing footprint and can move production out of China to locations such as Mexico if necessary. Today, China remains the cheaper option for the company, but it remains prepared in case tensions escalate. Finally, Lenovo’s ROE is in the 30%–40% range and it is trading at significantly lower PE multiples than those we associate with big tech in China.

Sinopharm, China’s largest distributor of pharmaceuticals and healthcare products, is similar in its appeal. Its activities are Common Prosperity-aligned, its financial health is strong, and the political environment stands to help (not harm) its core business. Sinopharm is not small—it currently covers over 16,000 hospitals including 2,000 top-tier hospitals—meaning it would not be captured by a blanket avoid-large-companies approach. But its ROEs are stable, ranging from 11%–15% since 2018, and its price is attractive, with PE multiples of roughly 8x–12x over the same period. China Medical Systems, a pharmaceutical services provider serving 57,000 hospitals, is another example from the healthcare space: Its business models are conducive to high ROEs and cash flow generation, its ROEs have remained in the 21%–25% range for several years, and like Sinopharm, it is not likely to be severely impacted by government crackdowns on drug prices since it is a service provider rather than a manufacturer.

In the context of emerging markets investing, we believe China is too large a market to ignore. It is home to the world’s largest population of over 1.4 billion, and to the world’s fastest-growing middle class. The core focus of the Common Prosperity agenda is to sustain this trend, and the changes it is making outside of the business world—doubling its higher education spending from 2012 to 2021, for example, and producing more graduate degrees in science, technology, engineering, and math (STEM) than the US does—reflects its commitment to this effort.

But significant risks remain. The country’s property crisis is still ongoing, and China has decided to move away from its “three red lines” policy of limiting leverage in the property sector following a wave of defaults, a liquidity crisis for developers, and slowing housing sales. Tensions with both Hong Kong and Taiwan do not show any signs of lessening, and we believe that a reunification with Taiwan by military force could have extreme consequences: Taiwanese supply chains would be disrupted; China would likely be subject to severe, coordinated Western sanctions with the potential for a US-led military response; and the global economy would likely then tumble into a deep recession, perhaps even a depression. Global equities—not just Taiwanese and Chinese securities—would come under pressure in a flight-to-safety environment. On the topic of a potential forced delisting of US-listed Chinese companies, encouragingly, US accounting regulators were granted full access to the audit papers at the end of last year, resetting the clock for compliance and reducing the near-term risk of a forced delisting.

Against this backdrop of ongoing political, social, and economic change, we believe investors should proceed with caution and avoid extremes. Following a mass exodus from China due to political risk—as many investors sought to do in 2021—may not be practical, given the country’s size, economic growth, market cap weight in the MSCI EM Index, and number of constituents in the emerging markets universe. At more than 30%, it still represents the lion’s share of the MSCI EM Index, even if that share has gone down. But making a top-down decision to be significantly overweight China now that its zero-COVID policy has been scrapped may not be the best approach either, given the scale of the risks hovering over the market and the fact that economic reopening is still in its very early stages. Instead, we believe the best approach lies somewhere in the middle: being strategic about China’s weight within an emerging markets allocation, reducing exposure when necessary, and understanding how specific businesses may be harmed (or helped) by external events.

In our relative value portfolio, we have found more compelling investment opportunities with attractive risk-adjusted upsides over the past two years in China, particularly in the consumer staples, health care, utilities, information technology, and consumer discretionary sectors. We are excited about the composition of our Chinese securities today. When China peaked at near 45% of the MSCI EM Index, our portfolio was roughly 20% underweight. While we are still less exposed to China, the underweight is closer to 8%, a reflection of both the significant drop in Chinese equities as well as the bottom-up-driven opportunities we have added to the portfolio. The underweight to China could continue to narrow over the coming year, but for now, we remain selective in our exposure, as we see more compelling bottom-up opportunities across other emerging markets countries.