2017 Best Greater China Equity Fund Winner Q&A - ZEAL Voyage China Fund

M: Morningstar Z: Management Team

M: Could you highlight any major changes you made to the portfolio over the course of 2016? Were there any particular holding that drove the fund’s performance for the year?

Z: In the beginning of the 2016, the Chinese market was hit with a number of negative events including massive capital outflow from China and the A share circuit breaker. Being mindful of these risks, the portfolio manager promptly employed a number of risk management tools to preserve capital, namely raising cash and cash equivalents (from here on referred simply as cash), and using index futures for hedging.  Cash level rose from 19% at the end of 2015 to 56% by the end of January, and futures were added from 0% to -23%. This dropped effective equity exposure to just 20% from 77% at the end of 2015. The result of this is significant as shown from the maximum drawdown of the Hang Seng China Enterprises Index in the period of January and February 2016 of -22.68%, compared to -9.85% for the Fund.

By March, we believed that the market was oversold and we deployed the cash to accumulate stocks with attractive valuation, bringing the equity exposure to 86% by the end of March. Many of our high conviction value stock picks in the Materials, Consumer Discretionary, Information Technology, and Health Care were very rewarding in 2016. Among these names, the highest contributing stock was an A share company that specializes in the research and development of chemicals for use in energy and environmental protection applications, including energy purification in China and desulfurization services in the US. From 2010 to 2015, the company experienced a ten-fold increase in net revenue and net profit from to its leading patented technology. We believed that the stock was attractive as its valuation was around 26x 2016 PE and we projected that the net profit growth would be above 35% in each of the coming 3 years. In 2016, the company achieved and patented several global breakthroughs in technology which has benefitted the company with increased global orders and in turn led to excellent stock performance.

M: What is your outlook for 2017 specific to the markets you cover, and how are you positioned to take advantage of opportunities and/or mitigate potential risks?

Z: We believe that the most difficult time of the Chinese economy is behind us in 2016, and in 2017, we will see a sustained economic recovery. The key to the recovery is the reflation of the Chinese economy as seen by the Producers Price Index (PPI) turning positive after 54 months of negative growth. Negative PPI had been devastating for corporate profitability in China, but the figure had turned positive since September of 2016 which led to the recovery of Chinese corporate earnings. The market may worry whether the recovery is sustainable and whether PPI will remain positive. We believe that the recovery is on firm footing since it is not demand driven, which is fickle and subject to many external factors, but supply driven. The Chinese government took great pains to push through supply-side reforms in 2016, cutting supply of overcapacity sectors like cement, steel, coal, etc. The reduction of supply heralded a recovery in basic materials prices, driving PPI up.  We believe that as long as China does not go back to expanding supply irrationally, PPI can remain positive in 2017. And with corporates enjoying better profitability because of reduced supply, there is no incentive to ramp up supply at this time.

The reflation backdrop in China has kick started a virtuous cycle: Overcapacity Cut>Recovery in Basic Materials Prices>Improving Corporate Profitability>Better Consumer Sentiment>More Demand which Further Reduces Overcapacity. 

The cycle has begun to play out which partly explains why the Materials sector was the largest contributor in 2016. As the cycle continues, we have already positioned the Fund in banks since we expect that as corporate profitability improves, corporate debt servicing ability will also increase.  This will help greatly alleviate the multi-year worry about banks’ non-performing loans’ which was the main reason for keeping the valuation of banks so low. The Fund has avoided banks for the past few years, but with this new development, we believe that selected banks are a bargain.

We have also positioned the Fund in Consumer Discretionary stocks and this follows from consumr’s increased propensity to consume as corporate profitability improves, people feel more secure in their employment, and have a better outlook. Anecdotally, from our numerous on-the-ground visits, we have already witnessed significant increases in discretionary spending like retail sales and Macau gaming.

All in all, with a sustainable recovery in China plus an undemanding valuation in the Hong Kong stock market, we believe that 2017 can be very rewarding for the discerning investor. At the same time, if the market continues to go up on the back of the Chinese economic recovery, we will keep a watchful eye on the valuation. While it is nowhere near expensive yet, if it does become so, we will turn cautious. Another risk in the market is regarding the US, China trade relations. We will certainly monitor this carefully, but it is encouraging to note that the Donald Trump Administration’s tone towards China about labelling it as a currency manipulator has significantly softened from the days during the campaign.

M: Can you comment on the macro risks in the global economy, such as the change in leadership in the US, and the significant headwinds faced by emerging markets? How do these risks affect your investment decisions?

Z: The Trump Administration’s rhetoric toward China has been tough, however, so far in terms of real actions, nothing material has come about. Trump has ‘backed down’ on several key areas of friction including the reiteration of the US’ longtime stance on the One China Policy, and having yet to label China as a currency manipulator which he said he would be on day one of his presidency during the campaign. Concerning trade, we believe that any trade barrier would be lose-lose for China and the US, and the chances of it happening are not high. That being said, we will not make a bet here since there is no way to gain an edge in this respect. Thus, we prefer to avoid export companies unless the company has a very strong fundamental case that renders it relatively immune from potential trade barriers with the US.

China and other emerging markets face the macro backdrop of raising US interest rates and bond yields. We are mindful that this involuntary tightens EM markets’ liquidities. However, we believe that China is in relatively good shape since its economy is also reflating at a moderate pace. And as long as this pace is quicker or in line with the raising of US rates, the effect could be manageable. Also, if we assume that the US raise rates as the economy strengthens, this may be beneficial for China, since history shows that the economic activities of the 2 countries have a high correlation and both tend to do well or poorly together.

M: How is your investment team organized? Have there been any changes to the investment team or structure over the past year? Do you anticipate adding to the team in the near future?

Z: The investment team consists of 8 members – a CIO, Deputy CIO, 2 Assistant Portfolio Managers, and 4 Analysts. Each member of the team has their own sector coverage and they identify the best stock ideas within their realm and place them in a common stock idea pool which benefits all the Zeal funds. The CIO chairs an ongoing discussion with the investment team to formulate an overall portfolio strategy, determining whether to be in a defensive or aggressive mode, and the ranges of net and gross exposures. The Portfolio Manager of each fund would choose stocks from the stock idea pool and position the fund according to the overall portfolio strategy. No major changes were made to the investment team in 2016. We are always on the lookout for investment talent and we may add an analyst to the team in the coming year.

M; Can you highlight any areas where you feel that the investment team or the investment process can be improved upon?

Z: The Chinese name of our firm, 行健, is from the ancient Chinese text Yijin《易經》：天行健，君子以自强不息, which means that as nature keeps evolving, we must never stop improving. This encapsulates the spirit of Zeal.

Going forward, we will continuously improve the depth and breadth of our research, and one of the most interesting areas is the A shares market. We believe that the A shares market has become a vital part of any China investment, and its importance will only keep growing. Already, it contains many unique companies and industries that no offshore Chinese market can match in terms of diversity and opportunities. With the Stock Connect schemes and the eventual inclusion in the family of MSCI Indices, the A shares market will become an indispensable part of any global portfolio. And so, we plan to dedicate more and more resources there going forward.

View all Morningstar Hong Kong Fund Awards 2017 articles here.