China is not fertile ground for bottom-up stock pickers

As fundamentally driven, bottom-up stock pickers, we view the go-anywhere scope of our approach to international equities as a strength.

While we focus on equities in the world's developed markets, we remain open to selective opportunities within emerging markets, especially at a time like now, when the line between developed and emerging is increasingly blurring. It is our conviction that, irrespective of where a company is headquartered, long-term stock performance is driven by characteristics that make up the three critical elements of our stock selection: attractive valuation, strong business fundamentals, and a positive catalyst for change. In several instances in recent years, our disciplined approach led us to initiate positions in companies headquartered in China, among other emerging markets, because these stocks possessed a combination of the key attributes that we believe leads to a greater likelihood of long-term outperformance.

However, we selectively trimmed our modest overall weighting in China through much of 2015 and have recently been reluctant to initiate new positions there. While stock-specific factors have influenced each of these moves, a macro-level consideration has become increasingly influential: Growing intervention by China's government in the nation's financial markets has made it a fool's game for fundamentally driven stock pickers such as ourselves to ascertain which equities present the best opportunities.

China's interventionist trend

China's central government has always strictly managed its economy and exerted tight controls over financial markets and state-owned enterprises. The government's heavy hand has become more visible recently as China has struggled to avert a hard landing from the slowdown in the growth of its economy, which, according to official figures, expanded in 2015 at the slowest rate in a quarter century. Mismanagement of this transition in the world's second-largest economy could prevent the rest of the globe from breaking out of its current slow-growth mode, a prospect that has weighed on commodity prices and global markets in early 2016.

China has failed to instill confidence in recent months, as its increasingly aggressive and unpredictable policy measures appear to have had little positive economic impact and may have fueled market volatility rather than contained it. Much of the rapid appreciation in China's domestic equity market during early 2015 can be attributed to policy-driven asset price inflation that created what was widely viewed as a bubble. Regulators served to boost equity prices by relaxing requirements for margin lending, credit extended by brokerages to investors for making stock purchases. Amid disappointing economic developments, this borrowing reached unsustainable levels, and the bottom fell out of China's market rally in June.

NOCHINA-BLOG-chart2-680x400_3

The government responded by suspending newshare offerings and enabling major brokerage firms to create a fund to buy shares in the largest, most stable companies. In addition, hundreds of large companies suspended trading on China's domestic exchanges, and the People's Bank of China committed to provide liquidity through a state-owned company that lends to brokerages to finance share purchases. As for currency, China surprised global markets in August by devaluing the yuan. Despite these measures, the struggle to achieve a degree of market equilibrium extended into 2016. During the first week of the year, officials twice deployed a new circuit breaker system to temporarily suspend trading during heavy sell-offs. However, the system appeared to encourage last-minute selling in advance of its activation, and further use of circuit breakers was suspended.

Taken together, these developments raise concerns about the ability of Chinese policymakers to prevent a hard landing. As for the economy itself, it is exceedingly difficult to gauge its true health, as few investors ascribe serious weight to China's opaque official GDP figures.

Better opportunities elsewhere

As bottom-up stock pickers, we typically apply our strict stock selection criteria without specific regard to currencies, sectors, or countries. However, macro forces in China today appear to be overwhelming the factors that we focus on as we assess individual securities. We are loath to predict the Chinese government's next attempt to get its economy and financial markets back on track. Instead, we prefer an approach that enables us to sleep at night-sticking with our core competency of fundamental securities analysis in those international markets where the value of bottom-up stock picking appears to remain intact.