Market Environment

At the start of the Financial Year, optimism towards Chinese stock markets was high. Facing rising inflation, Western economies were entering a tougher policy environment likely to hamper progress in their stock markets. Meanwhile, China stood out as a potential counter-cyclical recovery play, supported by the country's modest stock market valuations, low inflation rate and expansionary monetary policy.

Unfortunately, this optimism was not matched by the subsequent reality: the Company's Reference Index, the MSCI China All Shares Index, fell 31.5% in sterling terms over the Financial Year. Chinese stock markets endured an arduous period in what also proved to be a turbulent time for global financial markets and the world economy. However, unlike the major Western economies, buffeted by inflation and rising interest rates, China experienced a mixture of specific domestic and external challenges that caused its economy to stumble and its stock markets to fall heavily. These pressures were compounded by the difficult global economic backdrop.

Central to the country's domestic challenges was the Chinese government's zero-Covid policy. This strict approach to containment of the Covid-19 virus proved economically disruptive, as major cities were locked down to stop the spread of the virus. Recent months have seen an easing of restrictions and, crucially, increased efforts to boost vaccination rates and hospital capacity that should allow the country to start to reopen. At the time of writing, they have flocked to major airports, train stations and highways during the Lunar New Year holidays. We expect a multi-stage recovery in China where domestic consumption normalisation has a long runway ahead, supported by excess savings among households and depressed valuations.

Another domestic headwind came in the form of a slowdown in China's large and highly indebted property sector. The Chinese government's plans to reduce debt in the real estate sector should be positive in the long-term, resulting in a sector that is better regulated and less burdened by borrowing. The government is aware of the contagion risk from the real estate sector and has been providing liquidity to the property sector through targeted measures, while still having the overarching objective of reducing the sector's excessive leverage. Nevertheless, the short-term reaction - including the refusal of some citizens to pay their mortgages on properties they feared may never be built - was, at times, dramatic. The real estate crisis had a knock-on effect across sectors during the Financial Year, particularly affecting banks, which have a large proportion of mortgages on their books.

Some of the Company's bank holdings were among the worst detractors over the period. Furthermore, regulatory tightening in the technology and e-commerce sectors also hindered performance during the Financial Year.

Geopolitics also played a role in the country's weak stock market performance. Tensions with the US over key technologies and Taiwan, including a contentious visit by the US Speaker of the House of Representatives that saw China react with high-profile military drills, added to the list of issues facing Chinese investors.

Towards the end of the Financial Year, Chinese stock markets fell further after investors were disappointed by the outcome of October's 20th Communist Party Congress. Markets reacted warily to the strengthening of President Xi's position after his re-election, although they have since responded positively following the weakening of the previously announced continuation of the zero-Covid strategy.

Investment Themes

In constructing and managing the Company's portfolio, we employ a five-pronged thematic approach to identifying companies which we believe will deliver superior returns over the long-term. While this approach will not prevent us from buying into a position where we see fundamental value, we would expect most of the holdings to benefit from one of the themes below:

Aspiration: We expect consumer companies to fare well as China strives for a self-sufficient economic model.

Premiumisation: positioning goods and services as high-quality, in part to gain pricing power - is an ugly word but a powerful consumer trend. We believe urbanisation and rising middle-class wealth will drive demand for premium goods and services in the long-run.

Digital: This theme is aligned with the government's objectives of localisation, improving productivity, lowering costs, increasing innovation and helping to propel economic growth. Our holdings in this segment are primarily software-related names. Chinese companies have historically performed strongly given their knowledge of the domestic market and preference for localisation in areas such as cybersecurity and cloud services.

Green: This theme is set to benefit from government policy on decarbonisation and net-zero emissions by 2060. China dominates global manufacturing capacity for renewable energy and storage, accounting for 90% of solar and 75% of battery capacity and is well positioned to benefit from the huge global investment required in renewable energy and electricity storage. Other industries also need to decarbonise, so we expect greater investment in upgrading machinery and increasing energy efficiency. Our holdings include solar wafer-producers, component-makers, battery and related component-makers and automation-related firms.

Health: This theme aligns with government policy objectives to make healthcare cheaper and more accessible. This is particularly relevant in view of China's rapidly ageing society. We are overweight in healthcare services, including companies providing innovative research and clinical trial services that seek to bring high-quality therapies to market.

Wealth: This theme aligns with the government's objective of China becoming a moderately prosperous society by 2035. The financial services sector plays a key role in creating and protecting wealth. Our holdings contribute to the creation of strong financial and capital markets, and also include software companies that support the development of capital markets, such as trading and portfolio management. The adoption of insurance services remains low in China relative to the rest of the world. We see a large potential market in terms of life and health insurance, especially given China's ageing population.

Portfolio Performance

During the Financial Year, the Company's net asset value ("NAV") total return was -37.0%, underperforming the total return of the Reference Index. The Ordinary share price total return was -35.5%, as the discount to NAV at which the Company's shares trade narrowed to 12.5% from 14.5% at the start of the Financial Year. The Company's shares are trading at an 13.5% discount at the time of writing.

In terms of broad headwinds for the portfolio, it was a year when macroeconomic and geopolitical concerns trumped bottom-up stock fundamentals. The many positive developments at the individual company level within the portfolio were often largely ignored by investors who were more concerned about bigger economic themes or threats. A rotation in investment style factors, which saw value stocks favoured over growth stocks, also posed a challenge.

The Company's NAV underperformance during the Financial Year was largely driven by stock selection. Sector allocation effects were broadly neutral, although the portfolio's lack of exposure to the strong-performing energy sector was a detractor to performance. We find few quality stocks in a sector dominated by state-owned enterprises that we do not view as long-term structural winners. We own many renewable energy-related companies in the portfolio, but these are classified within the industrials sector.

Stock picking within financials accounted for almost half of overall underperformance, with banks being a particular area of weakness. Stock selection was also negative in the healthcare, and materials sectors, although our stock choices in information technology and consumer staples contributed positively to overall returns.

China Merchants Bank (CMB) was the portfolio's worst performing stock which suffered due to its property exposure, soft consumer confidence and an unexpected change in senior management.

In the consumer discretionary sector, China MeiDong Auto, a vehicle dealer, struggled against a backdrop of subdued global demand for high-end cars. Elsewhere, CIFI Ever Sunshine, a property management company, was affected by the broader weakness in the property sector. We exited the stock during the Financial Year.

On a brighter note, Proya Cosmetics (see case study below) was a strong contributor to performance. It grew its business over the Financial Year, navigating lockdown effects and expanding in cities considered to be "lower-tier" in the unofficial hierarchical classification of Chinese cities. Owning medical equipment-maker Shenzhen Mindray was also helpful. China's difficulties in dealing with the Covid-19 pandemic have highlighted the need to invest in domestic healthcare. Shenzhen Mindray also benefited from expectations of easing Covid-19 restrictions. Lastly, China Tourism Group Duty Free, the travel retailer, recovered in line with the easing of the burdensome international travel requirements in China.

Portfolio Activity

Our commitment to rigour in our investment process assumed even greater importance given the volatile market conditions and an uncertain economic environment. We mitigated short-term volatility at the portfolio level by adding to defensive sectors such as consumer staples and lowering active exposure to the healthcare, technology and renewable energy sectors.

We initiated a position in Inner Mongolia Yili, the dairy products producer, for its defensive fundamental characteristics. We also established a holding in Anhui Conch Cement, the largest cement manufacturer in China, to increase the portfolio's exposure to infrastructure. In August, we participated in the Hong Kong IPO of China Tourism Group Duty Free. Its shares were listed at an attractive discount and we believe the company's long-term outlook is positive. Elsewhere, we continued to increase our position in Aier Eye Hospital Group, the provider of ophthalmology medical services, to reflect our preference for medical services companies within the healthcare sector.

We exited China Conch Venture, the construction engineering company, and its spin-off entity, China Conch Environment Protection, companies principally engaged in the provision of environmental protection services due to worsening competition dynamics and concern over the companies' funding capability. In September, we sold out of our position in surgical robot company Shanghai Microport Medbot due to increased regulatory risks that did not align with our original expectations.

We calculate that the average top line revenue growth of the companies in the portfolio during the Financial Year was 18% year-on-year ("yoy"). This growth was mainly driven by our holdings in the "Green" theme, which are expected to register an average of 61% yoy growth due to favourable government policies and accelerated developments throughout the industry. The "Health & Wellness" theme also performed well, with revenue growth of 22% yoy.

Our "Aspiration", "Digital" and "Wealth" themes performed less well, being negatively affected by Covid, delivering 12%, 12% and 2% yoy revenue growth respectively.

Earnings growth for the portfolio is largely in-line with revenue growth.

Looking ahead, we expect top line revenue to recover. Growth of Green investments is predicted to normalise from a high base this year, while growth from companies representing Aspiration, Wealth and Digital themes should gradually pick up as Covid subsides and the Chinese economy recovers post reopening. Earnings growth for the portfolio is expected to rebound to 65% yoy next year. Three Year Earnings Compound Annual Growth Rate ("CAGR") for holdings in the portfolio remains solid at 35% on average.

Outlook

While it is still early for the Chinese economy to show strong signs of recovery, we are positive on the outlook in 2023 for several reasons. Firstly, stimulus measures have been working their way through the system since the start of the second half of 2022. Furthermore, we believe macro policy is likely to remain largely accommodative, with more legroom to support growth due to relatively low levels of inflation pressures that remain well contained. Secondly, recent measures to ease Covid restrictions have come at an accelerated pace that has taken everyone by surprise and this is a positive development for markets. It reflects the Government's concerns over the state of the economy as a result of its zero-Covid strategy. While the pivot may not seem gradual by international standards at the time of writing, there are still restrictions such as the need for a PCR test before entering China and, more importantly, the mandate requiring everyone to continue to wear masks. Like other Asian countries, we think the reopening will be bumpy with infections peaking in different phases, starting with cities before moving to rural areas.

Additionally, the troubled property sector now appears to be well-supported, including a raft of liquidity support measures announced in recent months. This indicates that the central Government is well aware of the economic headwinds facing China and is prepared to intervene and protect the growth trajectory. Chinese companies have thus far demonstrated strong fundamentals, with earnings growth of around 20%, despite an extremely challenging environment in the Chinese equities markets for most of the Financial Year. Valuations also remain undemanding due to investor sentiment. We believe a combination of favourable earnings and supportive policies in 2023 will help improve international investor sentiment towards China.

Given the rapid pace of reopening, inevitably, the number of deaths from Covid will rise, but it is a price the Government judges as not being high enough to offset the benefits of abandoning its zero-Covid strategy. However, the direction of travel for China is still one of reopening and economic recovery. To that end, we believe there is strong long-term potential in our five portfolio themes: aspiration, digital, green, health and wealth. That said, the long-term growth trajectory also faces some headwinds, including supply chain diversification away from China and restricted access to advanced US technologies. This is where we believe our bottom-up stock-picking approach, grounded in fundamental research and local expertise, provides an advantage in finding the best quality companies in which to invest.

Nicholas Yeo and Elizabeth Kwik

Co-managers of abrdn China Investment Company Limited

13 February 2023

 

Discrete performance (%)

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. This may mean your money is at greater risk.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• The Company invests into other funds which themselves invest in assets such as bonds, company shares, cash and currencies. The objectives and risk profiles of these underlying funds may not be fully in line with those of this Company

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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