Why We Still Like China

 |  Includes: FXI, GXC, MCHI, PGJ, YAO
by: Franklin Templeton Investments

When China, the world's second-largest economy and an engine of global growth, sneezes many other markets catch colds. A spike in the country's short-term lending rate in June gave some investors the sniffles at least temporarily, while others have turned bearish on China amid concerns growth rates this year could be under the weather. However, many investors may be overlooking some powerful macro-economic long-term shifts taking place in the economy that could ultimately improve China's bill of health. And, they may be overlooking equity bargains with good long-term potential there, too. Mutual Series'© Philippe Brugere-Trelat and Andrew Sleeman, portfolio managers of Mutual International Fund, find plenty of reasons for a positive prescription for China.

Philippe Brugere-Trelat
Executive Vice President
Portfolio Manager, Mutual Series©

Andrew Sleeman, CFA
Portfolio Manager, Mutual Series©

China's new leaders have demonstrated a focus on reforms and a tolerance for slower economic growth. Premier Li Keqiang has made it clear that he believes the key to stronger and more sustainable growth lies in reforms, rather than relying on stimulus. This position was bolstered by the government's limited response to a June spike in the interbank lending rate, the Shanghai Interbank Offered Rate or SHIBOR, which we interpreted as a warning to banks that they need to better manage liquidity and risk. The government's actions appear to us to have frightened many investors, who have seemingly shifted their attention to Japanese equities. However, we hold a more positive long-term view of China 1, and remain circumspect about Japan's reform efforts. As a result, we have attempted to take advantage of the market's negative response as an opportunity to invest in Chinese companies, as well as in the stocks of foreign companies with a large presence in China, at more attractive valuations.

Bottom-up, security-by-security fundamental analysis is the foundation of the Mutual Series investment process. However, we believe a secular macroeconomic-oriented theme such as in China can arise as a common and potentially powerful catalyst, particularly among undervalued, overlooked stocks. In our view, the deceleration in China's economic growth is part of the re-adjustment process as the economy transitions from investment- and export-dominated growth toward consumerism. We believe the disintermediation of the banking system and a more balanced capital market, in which the cost of capital is determined by market forces, will be a necessary development to achieve this realignment in the economy. With respect to equities, we believe reforms are important in potentially lifting valuations, but-unlike some frightened investors over the past few weeks-we also understand that it will likely take time before such changes bear fruit in the economy and in the re-rating of stocks.

Most of the new government's initiatives are a continuation or acceleration of existing policies, such as measures to promote urbanization, which could further boost consumer spending. We have identified particularly compelling opportunities based on these reform efforts, as well as the existing trends of stronger wage growth and a growing middle class. One area we like is autos, particularly companies running dealerships. Many investors remain focused on potentially weaker new vehicle sales growth due to the country's slowing economic growth and possible pollution controls. We have been attracted to the large potential of service revenues and the nascent used car market, both of which provide higher margins than new vehicle sales. Another area of interest is advertising, as companies strive to raise brand awareness.

In our view, steps to develop China's capital markets and deregulate interest rates could make insurance products more attractive. In addition, moves to reform pensions and savings as well as health care would likely be positive for insurance product demand. Based on these encouraging growth prospects, we have been looking closely at life insurers.

What About Japan?

While reforms by Japan's government to jumpstart that country's moribund economy have generated a lot of buzz and initially appeared more impactful than China's recent moves, we invest with a long-term perspective. We believe the recent rally in Japan's equity markets has been largely driven by increased liquidity and a weaker Japanese yen. In other words, we have seen a massive re-rating of the market with relatively little fundamental change in the earnings outlook on a company-by-company basis. We should note that in a country like Japan, with few natural resources, increased export potential may be significantly offset by higher import prices for raw materials. In addition, Japanese equities are no longer trading at what we view as compelling valuations in absolute terms or compared to those in China.

Therefore, we remain focused on the opportunities that China's more methodical reform process may provide; valuations there are more interesting to us than they have been for many years.

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What Are the Risks?

All investments involve risk, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors.

Because Mutual International Fund invests its assets primarily in companies in Europe and developed Asia, it is subject to greater risks of adverse developments in those regions and/or the surrounding regions than a fund that is more broadly diversified geographically. Political, social or economic disruptions in the region, even in countries in which the Fund is not invested, may adversely affect the value of securities held by the Fund. The Chinese government's participation in its economy remains high and, therefore, the Fund's investments in China will be subject to larger regulatory risk levels compared to many other countries. Current political uncertainty surrounding the European Union (NYSEARCA:EU) and its membership may increase market volatility. The financial instability of some countries in the EU, including Greece, Italy and Spain, together with the risk of that impacting other more stable countries may increase the economic risk of investing in companies in Europe. The Fund's investments in companies engaged in mergers, reorganizations or liquidations also involve special risks as pending deals may not be completed on time or on favorable terms. These and other risk considerations are discussed in the fund's prospectus.


1. Mutual International Fund geographic breakdown, as of 6/30/13: UK 18.85%, China 12.06%, South Korea 9.41%, France 8.33%, Australia 5.08%, Other 46.27%. Holdings subject to change.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.