It is glorious to be rich

It is glorious to be rich

Khiem Do, Baring Asset Management, Hong Kong
Originally published in the January 2005 issue

"History", said Edward Gibbon, "is little more than the register of the crimes, follies and misfortunes of mankind". Historians looking back at the 20th century years from now will no doubt find confirmation of Gibbon's definition in the two most significant economic events of the century.

The first of these was the transition from capitalist market to socialist planned systems in Russia, in China and in the associated satellite states in the early years of the century. This experiment in central planning was not a marked success, and as a consequence we have seen a second widespread transformation but this time in the opposite direction, as the majority of those economies embrace re-capitalism.

The path China has taken is very different from the route followed in Eastern Europe or the former Soviet Union, but it has undeniably been a success. From initial stirrings at the Third Plenum of the Eleventh Chinese Communist Party Congress in 1978, when the party began to shift focus from class struggle towards economic development, through to Deng Xioping's famous maxim that "it is glorious to be rich" and room in today's system for market mechanisms, China has regained much of its old imperial supremacy across Asia, and is emerging as the likeliest challenger to the United States as a global superpower without abandoning communism.

Today, travellers to China can only marvel at the pace of change taking place in the country. The biggest mass migration in the history of the world is underway, creating what is effectively a second industrial revolution. Last year alone, half the world's concrete was poured into China's cities, helping to turn paddyfields into industrial parks in the name of progress. Guangdong province, up the Pearl River from Hong Kong, is China's industrial heartland, contributing 10% of the economy and a third of exports from thousands of factories, although it faces fierce competition from the Yangtze delta centred on Shanghai.
Four years ago, Qingdao, a city on the North-East coast of China did not even exist. Today, it is one of the biggest container ports in the world, where ships unload vast quantities of raw materials such as iron ore and oil to fuel China's factories, and load up with exports from the ever-expanding manufacturing industry.

The World Bank estimates that China's share of the world economy will triple over the next twenty years, to the point where it is contributing the same to world economic output as the US in purchasing power terms. Indeed, China's entry into the World Trade Organisation three years ago could be said to mark the point where the future becomes less involved with how the world is changing China than with how China is starting to change the world. Already, in markets for base metals, shipping, cooking, soy-beans and other agricultural commodities, Chinese demand has become either the dominant price-setter or a big swing factor.
With gross domestic product expanding at an official rate of 9.6% in the first three quarters of the year, the Chinese economy has led the rest of Asia this year, and has become a vital component in Japanese attempts to lift the economy from relative stagnation. In the short term, the measures taken by the authorities to ease the pace of growth to something more sustainable are likely to produce a modest mid-cycle correction, but nothing to be concerned about. We are extremely confident that the economy will experience a "soft" landing and that the fundamen
tal factors driving growth in the economy will remain in place: increasing levels of trade and foreign direct investment, and demand from consumers for goods which reflect their new-found affluence.

In fact, we think that the "Chinese economic miracle" will be the dominant economic agent of change this decade. If events in the 1970s were most strongly influenced by the decisions of OPEC, and the next two decades belonged to Japan and the US respectively, we think that historians will look back on the second industrialisation of China as this decade's global growth driver.

The strength of our conviction on China, and indeed on Asian equity markets generally should not come as much of a surprise. We have long had a tilt towards the faster growing economies of the East and away from the more developed markets of the West at Baring Asset Management, and our country and sector positioning for portfolios invested in the region reflects this. We also have a long history of investing in Asia from a local presence, and our flagship product in the region, the Baring Hong Kong China fund has produced encouraging returns to investors over the course of its twenty-one year history.

Clearly, the secular growth of China has become a very significant theme for investors around the world, who would like to participate in the growth available in this region. The problem, of course, is that the Asian markets, including China, are notoriously volatile. An investor who put money in the original basket of H-shares back in 1993 would, until recently, have seen very little in the way of net gains.

Old Asia hands, who have been investing in the region for years, know this, and have developed a number of techniques to minimise the effect of periodic weakness on performance. The most common ways of doing this are to hide in defensive companies or sectors during downturns, or even to raise cash where this is permissible. However, by definition long-only managers can do little more than try to preserve capital in down markets, and all too often even the most defensive stocks are dragged lower with the rest of the market when there is a bear market.

Instead, we believe an alternative approach is a more efficient way of playing Chinese secular growth, and that is to invest through the medium of a long/short equity hedge fund. Not only does this approach allow the manager to increase or reduce the net exposure to the market to reflect an assessment of the equity risk premium and the prospects for the market, including going short if price rises begin to look stretched against fundamentals, but it allows the manager to short individual stocks, either singly on a fundamental basis or as part of a pairs trade.

The desire to have greater degree of investment flexibility and so be able to generate positive absolute returns for investors without the cyclicality traditionally associated with China-related markets was a key factor in our decision to launch a China long/short equity hedge fund.

When we launched the fund in July, our decision to open with a net short position was a somewhat controversial one, but the limited degree of market participation in the fund was based on the strong conviction that investors had not fully priced in a number of risks in the short term. When equity indices started to move lower, this position enabled us to generate positive investment returns from day one. We have subsequently raised the net long exposure of the fund as our assessment of the equity risk premium and the prospects for the market have become more positive, but we would not hesitate to reduce it again or take a net long position if we thought that prices were too stretched against fundamentals or that the liquidity-driven rally was about to run out of steam.

In the five month period since launch we have taken advantage of a very wide range of net exposure positions, from net short to a net long position. The ability to deliver superior risk-adjusted returns regardless of market conditions while preserving capital is our primary focus. This will not change.

What we have also found is that running a long/short equity China fund is a natural extension of our highly successful long-only business. Both are performance driven rather than index driven, with a focus on adding alpha rather than chasing beta. The advantage with the hedge fund is that it has access to a wider opportunity set of investment instruments to manage money more efficiently.

We feel that it is a distinct benefit for us in Hong Kong to be part of a larger investment business rather thana very small but under-resourced investment house when investing in these markets. We believe our "big boutique" approach facilitates a disciplined investment approach, prudent business management, operational excellence and comprehensive risk management – the essential ingredients of success.

This is particularly evident when analysing stocks for pairs trading, as this is simply a natural extension of the work we are already doing for long only portfolios, where we assign companies a score from 1 (best) through 5 (worst). One recent trade we put in place was a long in Hong Kong China Gas, which has upside potential in the form of its prudent and well-judged expansion in China, plus undervalued property assets in Hong Kong, paired with short positions in Hong Kong Electric and China Light Power, which could well could face earnings difficulties when they renegotiate their scheme of control tariffs.

As well as investing directly in the domestic markets in China and Hong Kong, it is important to remember that it is possible to play the China growth story by investing in companies listed overseas which export raw materials to China. This is a variation of the old story that shopkeepers selling picks and shovels did better than the majority of prospectors during the Californian gold rush, and gives us flexibility to take advantage of developments in China from both sides. In practice, we aim to keep around 70% of the long and short positions in the fund listed in China or in Hong Kong, but from time to time we also participate in other regional markets where companies have sufficiently close business links with China.

There is a common misconception that only a small proportion of the China growth story can be accessed outside the A and B domestic markets. This is wrong, as there are still world-class companies within the core H share market in Hong Kong – companies such as PetroChina, China Telecom and Wu-Mart, as well as some great indirect plays on China and Hong Kong-based beneficiaries of the explosive growth in the tourist trade since border controls with mainland China were relaxed. These include retailers, property investors and developers, as well as banking stocks.

One of the advantages of investing in China-related companies as well as in Chinese equities directly is that it offers greater liquidity. However, contrary to what many investors might expect, liquidity is not a problem. Greater China, comprising China, Hong Kong and Taiwan, is capitalised at more than US$1,600 billion, fairly evenly divided between Hong Kong on the one hand, and China and Taiwan on the other. Daily turnover in both Hong Kong and Taiwan is equal to or greater than that of the Swiss market.

For anything but the very largest funds, there is ample liquidity on the long side without having to look beyond these core markets. What might be surprising is that liquidity is adequate on the short side too without resorting to using ADRs. There are currently two hundred and twenty nine stocks to short in Hong Kong and China, and more if one looks beyond those markets. Borrowing costs are reasonable outside the very smallest companies, with a degree of transparency which is as good as any in the Western world.

Our current investment strategy reflects a more upbeat view on Hong Kong and China markets than at fund launch. Consequently, we have increased our net long equity position, while maintaining short futures positions to hedge against unanticipated events. The main areas we are positive on at the moment include consumer-related companies in China and Hong Kong, and beneficiaries of tourism and closer economic ties with mainland China. We also like a number of attractively-valued Taiwanese technology stocks and resource producers in Australia and Malaysia which are helping to meet the insatiable Chinese demand for raw materials.