Earnings growth a key focus in ABN Amro China portfolio
Senior portfolio manager Mandy Chan says she is closely watching China-related companies that could go through earnings revisions and possible downgrades, looking for good value where she can find it.
Mandy Chan is a senior portfolio manager at ABN Amro Asset Management. Based in Hong Kong, she manages the HK$1 billion ABN Amro China Equity Fund and the newly launched ABN Amro Greater China Alpha Advantage Fund. Her China Equity Fund allocates about 6%-7% to the A-share market, a cap mainly dictated by a qualified foreign institutional investor (QFII) limitation. She recently spoke with AsianInvestor about her portfolios and her outlook for the China market.
How is your QFII quota looking now?
Chan: We have applied for an additional tranche of quota. As the QDII (qualified domestic institutional investor) quota has been increased, China is going to increase the QFII quota as well, although it may not be an equal amount.
Will QFII quotas continue to expand?
If the A-share market performs strongly, the government would accelerate the QFII program. It depends on the domestic marketÆs performance and the arbitrage between trading in A-shares and H-shares.
Are H-shares still attractive?
The H-share market is definitely trading at a much deeper discount compared with A-shares right now.
What are your expectations for earnings of Chinese-related companies this year? How are valuations looking?
When we look at earnings growth, we are still looking at around 18% earnings growth this year. The Hong Kong market is trading around 16-17 times expected price/earnings for 2008. ItÆs around less than two times standard deviation above the norm. After the correction of recent weeks, the market as a whole is not excessively priced.
We focus on potential earnings revisions and possible downgrades, however, not the overall market. We pick companies and sectors that we think have better visibility on earnings growth, which for now are companies that are not cyclical or exposed to global risk. And within those sectors, we do see likely earnings downgrades. ThatÆs why we expect earnings growth closer to 18% this year rather than the 25%-30% we enjoyed in 2007.
What about A-share valuations?
In 2007, earnings growth was close to 85%. Almost a third of that came from investment gains as companies reinvested IPO proceeds into the stockmarket. The same thing has happened for H-shares. We calculate about 20% of their earnings growth came from investment gains too.
What does that spell for next year?
We donÆt look at P/E in absolute terms. We now look at the P/E to growth ratio, which if you were very bullish, would trade at about 1.0-1.3 times. That means investors are pricing in a very positive outlook for the overall market. But some sectors wonÆt achieve that, their P/E to growth ratio would be closer to 0.5-0.7 times.
Our job is to watch earnings quality very carefully. When we make our earnings assumptions for 2008, we start off with a very conservative case, in which the A-share market returns are flat, to wipe out any expectations of gains purely derived from investments. Our assumptions try to focus on the actual corporate value. IÆd say overall our portfolio is becoming more defensive.
What sectors look attractive?
It varies. Banks have had very good non-interest income growth û a lot of that was from selling mutual funds. If A-shares donÆt perform, that would affect the entire banking sector stock returns by around 5%. In this case we need to have visibility on quality earnings growth, to understand how a flat stockmarket would impact the performance of insurance companies and banks.
What sectors would you overweight and underweight?
Earnings visibility, potential earnings and prices are the factors we look at. For earnings visibility, the consumers sectors would be good. That would be supported by government policies. If export slows down because of US, consumer earnings would be very visible.
What consumer stories do you favour?
We have been very selective with consumer names. We do not prefer the food processors because they will be squeezed by commodity prices. These are all going up: meat prices, corn prices, etcetera. At certain point in time, it may be more difficult for companies to pass these price increases through to consumers, and that will hurt profits.
We prefer consumer companies with a strong brand premium in China. Companies positioned toward the urban middle class can grow more quickly than the national average. As for cyclicals, we are pretty selective.
What about playing the currency?
We like companies that benefit from the appreciation of the renminbi. We expect this trend to accelerate. Sectors that should benefit include property, banks, airlines and telecommunications because their operating margins rise in line with the currency.
What is your allocation for initial public offerings?
We spend quite a lot of time on IPO investments. If we expect a listed stock to have a lot of upside after the first day, weÆll stay invested. But our allocation to IPOs is not that large. We are active managers in the secondary market. We donÆt generate performance from flipping IPOs.
What is going on with the B-share market?
The liquidity is not that good and the market cap is not big. Investors donÆt pay a lot of attention to B shares, even though the discounts have been good compared to the A-share market. B shares make up less than 1% of our portfolio.
How would the introduction of stock index futures impact your A-share investments?
I donÆt think foreign investors will be allowed to participate, though we are not sure. It depends on the market directions. If we look back to Hong Kong and Taiwan when they first launched futures in the 1960s and 1990s, it didnÆt have a big impact, even though it created an opportunity for short selling.
When do you expect the futures to come to the market?
I think itÆs pretty much ready right now in terms of infrastructure. The market talked about Q4 but now that is postponed to the first quarter of 2008. The timing is quite uncertain. But the main thing that would determine the market direction will be company fundamentals and expectations for future earnings growth.
Is there any way you can hedge your risks prior to the introduction of the futures?
We donÆt go short on this fund. But we do have the capacity to short the A50 A-share tracker fund listed in Hong Kong. It leverages up to 50 companies in the A-share market.
How is your QFII quota looking now?
Chan: We have applied for an additional tranche of quota. As the QDII (qualified domestic institutional investor) quota has been increased, China is going to increase the QFII quota as well, although it may not be an equal amount.
Will QFII quotas continue to expand?
If the A-share market performs strongly, the government would accelerate the QFII program. It depends on the domestic marketÆs performance and the arbitrage between trading in A-shares and H-shares.
Are H-shares still attractive?
The H-share market is definitely trading at a much deeper discount compared with A-shares right now.
What are your expectations for earnings of Chinese-related companies this year? How are valuations looking?
When we look at earnings growth, we are still looking at around 18% earnings growth this year. The Hong Kong market is trading around 16-17 times expected price/earnings for 2008. ItÆs around less than two times standard deviation above the norm. After the correction of recent weeks, the market as a whole is not excessively priced.
We focus on potential earnings revisions and possible downgrades, however, not the overall market. We pick companies and sectors that we think have better visibility on earnings growth, which for now are companies that are not cyclical or exposed to global risk. And within those sectors, we do see likely earnings downgrades. ThatÆs why we expect earnings growth closer to 18% this year rather than the 25%-30% we enjoyed in 2007.
What about A-share valuations?
In 2007, earnings growth was close to 85%. Almost a third of that came from investment gains as companies reinvested IPO proceeds into the stockmarket. The same thing has happened for H-shares. We calculate about 20% of their earnings growth came from investment gains too.
What does that spell for next year?
We donÆt look at P/E in absolute terms. We now look at the P/E to growth ratio, which if you were very bullish, would trade at about 1.0-1.3 times. That means investors are pricing in a very positive outlook for the overall market. But some sectors wonÆt achieve that, their P/E to growth ratio would be closer to 0.5-0.7 times.
Our job is to watch earnings quality very carefully. When we make our earnings assumptions for 2008, we start off with a very conservative case, in which the A-share market returns are flat, to wipe out any expectations of gains purely derived from investments. Our assumptions try to focus on the actual corporate value. IÆd say overall our portfolio is becoming more defensive.
What sectors look attractive?
It varies. Banks have had very good non-interest income growth û a lot of that was from selling mutual funds. If A-shares donÆt perform, that would affect the entire banking sector stock returns by around 5%. In this case we need to have visibility on quality earnings growth, to understand how a flat stockmarket would impact the performance of insurance companies and banks.
What sectors would you overweight and underweight?
Earnings visibility, potential earnings and prices are the factors we look at. For earnings visibility, the consumers sectors would be good. That would be supported by government policies. If export slows down because of US, consumer earnings would be very visible.
What consumer stories do you favour?
We have been very selective with consumer names. We do not prefer the food processors because they will be squeezed by commodity prices. These are all going up: meat prices, corn prices, etcetera. At certain point in time, it may be more difficult for companies to pass these price increases through to consumers, and that will hurt profits.
We prefer consumer companies with a strong brand premium in China. Companies positioned toward the urban middle class can grow more quickly than the national average. As for cyclicals, we are pretty selective.
What about playing the currency?
We like companies that benefit from the appreciation of the renminbi. We expect this trend to accelerate. Sectors that should benefit include property, banks, airlines and telecommunications because their operating margins rise in line with the currency.
What is your allocation for initial public offerings?
We spend quite a lot of time on IPO investments. If we expect a listed stock to have a lot of upside after the first day, weÆll stay invested. But our allocation to IPOs is not that large. We are active managers in the secondary market. We donÆt generate performance from flipping IPOs.
What is going on with the B-share market?
The liquidity is not that good and the market cap is not big. Investors donÆt pay a lot of attention to B shares, even though the discounts have been good compared to the A-share market. B shares make up less than 1% of our portfolio.
How would the introduction of stock index futures impact your A-share investments?
I donÆt think foreign investors will be allowed to participate, though we are not sure. It depends on the market directions. If we look back to Hong Kong and Taiwan when they first launched futures in the 1960s and 1990s, it didnÆt have a big impact, even though it created an opportunity for short selling.
When do you expect the futures to come to the market?
I think itÆs pretty much ready right now in terms of infrastructure. The market talked about Q4 but now that is postponed to the first quarter of 2008. The timing is quite uncertain. But the main thing that would determine the market direction will be company fundamentals and expectations for future earnings growth.
Is there any way you can hedge your risks prior to the introduction of the futures?
We donÆt go short on this fund. But we do have the capacity to short the A50 A-share tracker fund listed in Hong Kong. It leverages up to 50 companies in the A-share market.
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