Canny investors can make money in Chinese equities if they have the discipline and flexibility to look past the turmoil and negative headlines, the author of this comment says.

The dramatic fall in Chinese mainland stocks recently, coupled with data pointing to weaker growth, has encouraged some investor to quit the market, but according to investment house Brown Advisory, a nimble strategy towards China and its neighbours can bring results. The comments below are from Taylor Graff, asset allocation analyst. The views are not necessarily shared by this publication's editors, but we are grateful for this contribution to a debate about China that is likely to run on for some time, and we welcome other contributions from readers.

Stock prices on the Shanghai exchange more than doubled in the 12 months ending in mid-June. Fueling that surge was not so much improving fundamentals but rather outright speculation stoked by government purchases of equities, a mandatory increase in margin lending from brokerages, new rules easing investment from Hong Kong into mainland stocks and government media including the newspaper People’s Daily extolling equity investment as a way to achieve national prosperity.

A rally driven by hype instead of earnings growth eventually succumbs to gravity. That’s what happened in July and August, with the Shanghai Composite Index, as of 25 August, plunging 44 per cent from its mid-June high.

Behind the change in investor sentiment lies deteriorating economics in China. President Xi Jinping speaks of bringing about prosperity with a vision that he calls the “Chinese Dream”, and annual growth in gross domestic product averaging nearly 10 per cent from 1 January 1979 until 31 December 2014 suggests that his goal is not just fantasy.

But recent turbulence in the world’s second-largest economy indicates that Xi’s dream may be a bit deferred. Chinese exports in July fell 8.3 per cent compared with the previous year, while imports did not perform much better, declining 8.1 per cent. Then, in mid-August, the People’s Bank of China relaxed controls on the yuan—which has been pegged to the dollar—and allowed a 3 per cent decline in a matter of days. Many economists view the devaluation as an attempt to spur exports and revive growth. 

Long-term winners
Still, we believe that attractive opportunities for fundamental, bottom-up investing endure in China and Asia’s other emerging markets, where valuations are more attractive than for equities in the developed world like the US. The economies of India and the ASEAN-5 (Indonesia, Malaysia, the Philippines, Thailand and Vietnam) entered the second half of 2015 with robust growth. They should benefit from an appreciating US dollar and loose domestic monetary policy. 

We are using third-party managers such as Somerset and Macquarie in an effort to position client portfolios to benefit from the rising middle class across the region. We mitigate risk by ensuring that the managers buy shares of Chinese companies outside mainland exchanges, where speculation is rife. 

Here are two companies in our managers’ portfolios that we believe can weather the short-term turbulence and excel long term: 

From media to fashion to tourism, South Korean companies have ridden the rise of middle-income China. Korea Kolmar, one of the country’s top original design manufacturers of cosmetics, generated about $390 million in revenues last year. It researches, designs and manufactures cosmetics for clients ranging from top Asian brands like AmorePacific to multinationals like L’Oreal. China’s annual retail cosmetic sales increased more than 20 per cent from 1 January 2008 until 31 December 2014, quickly making the country the world’s number two market at about $30 billion. 

Established in 1938, China Taiping is one of the oldest insurance companies in China, offering primarily life and property and casualty insurance. Over the next 20 years, the proportion of China’s population over 60 is projected to climb to 30 per cent from about 9 per cent today. Beijing has mandated growth in the insurance industry, aiming to push up insurance penetration to at least 6 per cent by 2020 from about 3 per cent today. It is offering tax incentives for purchasing private insurance and tax deferrals for annuity products and corporate pension plans. While leveraging the policy shifts, China Taiping has restructured its sales force and streamlined its incentive structure. 

We think that by investing in companies like these, clients can benefit from China’s long-term growth while avoiding the froth and macroeconomic downdrafts that currently keep investors awake.