Q&A with Henderson Investors Fund Manager: Andrew Mattock

Andrew Mattock, the Singapore-based portfolio manager of the Henderson Horizon Fund - China Fund shares his views on the case for investing in China, which has seen a significant improvement in macroeconomic and market sentiments so far this year.

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Chinese markets have been positive for the year to date. What are the reasons for the strong performance?
The MSCI Golden Dragon Index has returned 14.6% for the year to date (as of 24 April), which is a good performance compared to most global markets. Chinese domestic sentiment has improved over the past three month with hopes of a recovery driving up the local A share markets by over 35% in the first quarter. There was a lag between policy implementation and the real impact on economy but we are now starting to see preliminary signs of the stimulus starting to take effect and as a result of that, confidence is returning to the economy.

The Henderson Horizon Fund – China Fund has returned 36.2% over the same period (as of 24 April). Its overweight positions in Chinese property stocks have contributed strongly to performance, and our short positions in Hong Kong utilities – which we felt were overvalued – have begun yielding good net returns as they underperformed the rally. In the last month in particular, long positions in selective mid caps such as Kingdee Software, New World Department Store, Lonking and Yanzhou Coal generated positive relative returns as risk appetite improved.

So does the recovery indicate government policies have been working?
At the beginning of 2008, the Chinese government introduced a range of measures aimed at slowing down consumption and investment, in an attempt to prevent the economy from overheating. Of course the global financial crisis had a considerable impact on Chinese markets, acting as another, albeit unforeseen, slowdown mechanism. As a result, Chinese markets fell far too far too fast. This year we have seen a reversal of some of those slowdown measures, and attempts to reinvigorate the domestic economy through measures such as aggressive cuts in interest rates, relaxing controls on bank lending and various measures aimed at encouraging home-buying.

Property is a huge part of the Chinese economy, and is starting to show renewed signs of life. Transaction volumes are increasing, week-on-week in the major cities such as Beijing, Shanghai and Shenzhen, with sales in the first quarter of this year exceeding the levels witnessed at the peak of the market boom in late-2007.

The government also announced a RMB 4 trillion domestic stimulus package which over two years would increase spending on public housing and infrastructure projects, as well as health and education programmes. While there is always a lag between policy implementation and the real impact on an economy, there are signs emerging that the Chinese economy may have begun to stabilise at a low level.

We have seen for example, Inventories have risen at a slower pace than new orders. This seems to point to a restocking by Chinese manufacturers in order to meet increasing demand. This is an important departure from the rise in inventories experienced in mid-2008, which given that it outpaced new orders, was due to waning demand.

Lending growth is also looking more positive, with supportive evidence that bank lending is easing the squeeze on the corporate sector. The annual growth in money supply (known as the M2) rose 25% year-on-year in March, up from 18.8% in January.

How will China fare if the global crisis keeps lowering the demand for Chinese exports?
While exports may have fallen considerably, China is making the right efforts of focusing on domestic economic growth rather than trying to get exports to recover. Though we think that growth is unlikely to go back above 10% anytime soon, we believe that China now has good odds of achieving the 8% growth in 2009 that Chinese officials still say they expect. Stimulus policies are also setting the backdrop for sustainable long-term growth around the areas geared towards domestic structural growth.

Can you provide some examples of themes or stocks to watch during 2009?
There has been a sharp pick up in fixed asset investment, driven entirely by the acceleration in government investment projects. The increase in industrial activity is expected to benefit the industrial sector, particularly those mid caps with domestic exposure.

There are also tentative signs that the Chinese residential property market may be bottoming out, with property transaction volumes in major cities continuing to increase. Delays in completion of new projects, combined with a visible pick-up in primary transaction volumes have driven down inventory levels, while affordability has improved as a result of mortgage rate cuts. As a result, we are seeing exceptional value in some of the Chinese property stocks.

On a stock specific basis, we have recently added positions in China Petroleum & Chemical Corp (Sinopec), the largest integrated producer and marketer of oil products in China. The company suffered a significant decline in profits in 2008 due to government controls on refining product prices. The company is now forecasting its first quarter profit to increase by 50% year-on-year, after fuel-price controls were relaxed following the fall in oil prices. The government has also raised domestic gasoline and diesel prices by 3-5% recently in an attempt to link the price of refined products with crude oil. This market-driven pricing mechanism, if implemented consistently, shall give Sinopec a more stable return on investment over the longer term.

We are however still wary of some of the export-driven industries (such as steel, shipbuilding, coal) which in spite of the stimulus measures remain very much reliant on a pick up in global demand. Additionally, defensive sectors such as telecoms and Hong Kong utilities remain pricey from a valuation standpoint and these are likely to suffer from a price correction once risk aversion abates and investors bail out of defensive plays.

What are your expectations for the rest of the year?
The Chinese government has sent a clear message that it will do whatever it takes to maintain growth at close to 8%. It has been extremely proactive, and its aggressive approach should do much to restore business and household confidence, and encourage firms to keep investing.

The global financial turmoil has driven valuation multiples in China down to a level where most stocks are on about 11 times earnings, a result of risk aversion rather than concerns over earnings growth. This mis-pricing of long-term growth has given rise to exceptional opportunities in the massively undervalued Chinese stocks.

The downside risks remain, however. China's growth remains highly intertwined with the global state of affairs, and one of the biggest risks to China's short-term growth prospects are if the fiscal and monetary policies fail to achieve the intended results or if we see a rapid rise in unemployment and a surge in number of bad loans. In the worst-case scenario this could erupt into social unrest, something the Chinese authorities are especially keen to avoid. That said, we think that the likelihood of any of these scenarios happening is quite low and the government will do everything in its position to avoid such a scenario.

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