A fter a sizzling rally in 2017, Hong Kong equity started off 2018 with increased volatility, ruffling the feathers of many investors. But not Principal’s. This year’s MPF Investment Manager of the Year in Hong Kong Equity, the firm makes a convincing case for staying invested in the Hong Kong market. Alan Wang, Portfolio Manager – Managing Director, Head of Greater China Equities at Principal Global Investors, explained the details.
BENCHMARK (BM): In 2017, MPF funds posted the best return since 2009, with Hong Kong equity funds gaining close to 40% on average. What fueled the stellar performance? Do you think these catalysts will remain in 2018?
Alan Wang (AW): Without a doubt, 2017 was a year of broad-based earnings growth. The earnings recovery that started in early 2016 climaxed and surpassed market expectations during the year, driving stock markets higher. We believe the strong earnings growth was attributable to four factors: First, capacity reduction in the steel, coal, aluminum, and other industries in China has given a boost to the profitability of these sectors. Second, the stabilizing Chinese economy and Renminbi helped to refuel Asia’s trade and growth. Third, the return of synchronized global growth. Fourth, companies have learned to adopt stricter capital and cost disciplines during the lean years, which translated into improved asset turnover and margins expansion. Riding on these forces, fundamentals improved and caused re-ratings and multiple expansions across various sectors.
Looking ahead, we expect profit expansion to continue, but at a slower pace in 2018, given the high base in earnings results and valuations last year. Since the potential for positive surprises and earnings growth will be more limited this year, some stocks may even come under de-rating pressures if they disappoint on growth expectations. That said, though, we remain positive on the Hong Kong market, but a more selective approach and a greater focus on finding attractive valuations are warranted.
BM: From a sector perspective, financials account for close to half of your portfolio. What potentials do you see in this sector? What sectors do you favor in 2018?
AW: We have turned slightly more positive on the Chinese banking sector, which is starting to benefit from China’s economic recovery. As the debt-servicing ability of corporate borrowers improved on the back of reinvigorated economic activities, we see the potential for Chinese banks to chalk up stronger earnings that the market is underestimating right now.
Besides the economic revival, supply side reform is another catalyst for Chinese banks. The reform, which targets to reduce overcapacity in raw material producers, has unleashed a healthy reflation in upstream and midstream sectors, thereby improving the credit quality of banks. The trend is proving beneficial to the materials and energy sectors, too.
We maintain a relatively constructive view on China. Our biggest overweight positions are in the consumer discretionary, information technology, and energy sectors due to favorable government policies, sustainable growth drivers, and underleveraged consumer segments.
BM: Under China’s ongoing market liberalization, restrictions on foreign ownership in financial firms are set to be further loosened. What are the implications of this on your portfolio and its 20+% exposure to H shares?
AW: We believe this policy move paves the way for more positive developments in China’s financial system. Although more active participation by foreign capital will make the system more competitive and stable, these changes will only take place gradually over the next three to five years. Therefore, in the near term, we don’t expect to see any meaningful impact.
In the H-share space, the government’s focus on deleveraging and clamping down on speculative activities are positive for China’s financial institutions. If continued next year, these measures will likely reduce the risk premia attached to these stocks. As always, we will continue to focus on the profitability, fundamentals, and valuations in our decision-making.
BM: Most MPF schemes and investment platforms in Hong Kong are increasing Hong Kong ETFs offerings. Do you see this as a threat to managed funds?
AW: Good question. Calling the rise of ETFs a threat may be an overstatement because of the fact that passive investing is not yet a long-term winning strategy in many markets. Moreover, the cost advantage of passive strategies over their active peers is not as significant as perceived. Another problem with passive ETFs is the dominance of large-cap stocks in their tracking indices. The highly concentrated passive portfolios are subject to a higher degree of volatility. More importantly, skillful active management also plays a role in risk mitigation, such as detecting governance abuses that could evade the loopholes of passive investing. BM