Fund Review: In 2021 the Strategic China Panda Fund returned -17.57%, outperforming its benchmark by over 4%. The overweight in Sportswear and Shipping, coupled with the underweight in the Internet sector was the major contributor to the outperformance.
2021 was a year of policy shocks. Regulatory storms in Internet and Education sectors, “common prosperity” advocated by President Xi and excessive tightening of the Property market sparked a stock market retreat. Following a home run in 2020, the MSCI China Total Return Index declined 21.7% in 2021 and erased nearly all the gains made the year before.
Despite the decline, the onshore A-share market fared much better than the offshore China market, with the CSI300 down only 5.2% over the year. The small Internet sector weighting in the CSI300 (versus around 20% in the MSCI China) was the key differentiating factor.
Amidst this down market, the performance of new and old economy stocks was polarised. Old economy sectors such as Shipping, Telecommunications, Oil majors and Banks recorded positive gains, while new economy sectors such as the Internet, Education, Technology and Biotech suffered significant losses. There was a clear reversion to mean, with the winners and losers of 2020 simply switching places last year.
COVID-19 continued to be in play. New waves of infection, such as the Delta and Omicron variants, swept through the world and China was no exception. As China remained persistent in pursuing “zero COVID”, cities were locked down from time to time, and cross-city travel was discouraged. This inevitably hurt domestic consumption (particularly Retail and Travel) and employment.
Although GDP growth had a strong rebound to 8.1% in 2021 from 2.3% in 2020, it deflated from 18.3% in the first quarter to a mere 4.0% in the fourth quarter. The COVID resurgence, reduced private investment under regulatory clampdown, floods and power rationing all contributed to the slowdown.
Export, however, was a bright point. China gained market share in global exports due to undisrupted plant operation in China, despite acute global supply chain and logistics issues.
As much as economic growth was losing momentum, the government had shifted its priority from regulatory tightening in H1 2021 to stabilising growth in H2 2021, and the Reserve Requirement Rate (RRR) was cut twice during the year. The government’s policy stance on the Property market also turned from hawkish to dovish after the fall of China Evergrande (the largest developer in China) stirred big waves of bond defaults across the sector.
To help smooth the liquidity pressures of industry players, the regulator urged banks to speed up mortgage approval, re-opened domestic interbank lending markets to selective property developers and encouraged Mergers and Acquisitions (M&As) by excluding M&A loans from the “three red lines” calculation.
The non-stop regulatory crackdown triggered a massive sell-off in the Internet sector. The Chinese regulator accused Di Di Global of violating the data security law just two days after its debut on the Nasdaq. This was followed by a tightening of overseas IPO listing rules for firms with over 1m users on the back of cybersecurity concerns. Incumbents were investigated or fined for violating anti-trust laws.
Industry leaders such as Tencent and Alibaba felt the most heat, given their market dominance. To appease the government, Tencent even distributed its investment in JD.com as a share dividend to its shareholders. The common theme for Internet companies in the results announcements was to embrace “common prosperity”, either through increasing investment or donations. Earnings guidance was, in general, lacklustre, if not disappointing.
Education was another sector that was hit hard under the new regulations. The government announced a new policy banning after-school tutoring (AST) during school holidays, and required existing AST institutions to register as “not-for-profit”. Under the new policy, the AST business models are no longer viable. The news sent a negative signal to the market as investors extrapolated this to other sectors.
Sportswear stocks were star performers in 2021, thanks to the Xinjiang cotton ban. The US banned cotton products from Xinjiang as a sanction on China for the alleged use of forced labour in the region. Many global brands, such as Nike and Adidas, followed the verdict and banned the use of Xinjiang cotton in their products.
Their actions however faced backlash in China, with Chinese consumers boycotting foreign brands and turning their love to domestic brands. Local brands like Li Ning, Anta and Xtep became major beneficiaries of patriotic buying by Chinese consumers. They all reported accelerating sales momentum on market share gain from foreign brands.
Overall, there was clear sector rotation from high flying new economy stocks to old economy stocks. New economy stocks were de-rated on policy risk, whilst old economy stocks were re-rated on earnings recovery due to the economy re-opening. Internet and Education stocks, the winners in 2020, turned into dogs during 2021. Conversely, bombed-out cyclical such as Retail, Commodity and Shipping turned into stars last year.
We have a positive outlook towards Chinese equities for 2022. We believe that policy crackdown risk has been largely discounted in share prices. Valuations of Internet bellwethers such as Alibaba and Tencent are trading at low teens and twenties P/E respectively, levels that have not been seen before.
More policy fine-tuning may continue, but we are of the opinion that the key work has been done. After a year-long de-rating, the valuations of new and old economies have converged a lot. We see balanced investment opportunities this year.
China is back in an easing cycle. The huge pressure exerted on the economy by the COVID resurgence, policy storm and Property tightening have caused the government to shift focus from regulatory overhaul to stabilising growth. The government cut lending prime rates and the RRR in H2 2021.
We expect more monetary and fiscal stimulus to come, thereby supporting a 5% GDP growth this year. The government has also eased its hawkish stance on the Property market since Q4 2021. We are likely to see more supportive measures from the government to revive the Property market and ease the liquidity crunch in the sector.
We also expect more mergers and acquisitions in the Property sector as cash-rich SOEs are encouraged by the regulator to do so. Without a doubt, large players with strong balance sheets or backing from local governments will gain market share and consolidate the market. We see a potential re-rating of these players even if the property market remains in the doldrums.
With increasing herd immunity and more people receiving vaccines in the western world, people are slowly reverting to their normal lives. We expect the pandemic to fade out and economic activities to normalise soon into the second half of this year. This will be particularly positive to service industries such as Travel, Tourism and Catering. Global supply chain and logistics disruption should also improve.
China is another story. There is no sign that the Chinese government will abandon its “zero COVID” policy any time soon. “Zero COVID” is our base case scenario for China’s approach to fighting the virus throughout this year.
The biggest risk to our investment thesis is stronger than expected tapering in the US. So far, the market has priced in four interest rate hikes in the US for 2022. There is a risk that the Fed will need to do more if inflation stays higher for longer. China will not be immune if the US market corrects.
That said, we believe China will outperform the US as they are in a completely opposite policy cycle. China started easing with rate cuts in the fourth quarter last year, while the US is just starting tapering. In addition, China is ahead of the US in market de-rating. China equities may even enjoy a P/E re-rating from a possible asset reallocation from the US to China.
It is time to revisit Internet stocks, now that the sector valuation has been de-rated to a reasonable level and large parts of the regulatory overhaul have been implemented. We will remain on the sidelines for now as we are uncertain of further earnings downside risk. We look to get more colour from management guidance in the coming results season.
We remain overweight in the Property sector. With more Property easing to come, sector fundamentals should improve. We will adhere to state-owned enterprises and quality players with strong balance sheets which are taking market share from the financially distressed ones. We are also still in favour of Property Management stocks for their asset-light and strong cash-generating business models. It remains a young and fragmented industry with strong growth potential. We will focus on market leaders with strong parents that can support their growth.
We are overweight the Sportswear sector but have taken some profit following the strong sector run. We remain convinced of the structural trend for local brands to take market share from international brands by improving product offerings and rising patriotism among Chinese consumers.
Among the Consumer Staples, we prefer the Dairy sector. Rising consumer awareness of nutrition and health, margin expansion from a product mix upgrade and rational promotion should support good earnings growth. We are warming up to Travel-related stocks as we anticipate the pandemic will fade out soon and more countries will re-open their borders.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Please do not hesitate to contact us for further information.
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The views and statements contained herein are those of LBN Advisers Limited in their capacity as Investment Adviser to the Fund as of 07/02/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.