It is generally accepted that China will be a major engine of global growth in the 21st century and this growing importance is reflected in the increasing number of funds that focus on the Chinese economy. But there are some fund managers who have been honing their expertise in the Chinese markets for some time, delivering impressive performance numbers.

Philip Ehrmann has been a fund manager since 1984 and has specialised in emerging markets since 1990. He was one of the first managers to focus on China in his role as head of emerging markets at Gartmore, before moving, in October 2006, to Jupiter Asset Management, where he now runs the Jupiter China Fund.

Serious business
He explains that, despite still being very much part of the emerging markets universe, Chinese companies and managements are learning fast about making businesses work, ‘There is a much more positive attitude to management and the corporate base is improving. By getting rid of poorly performing businesses the government is taking inefficient and polluting industrial plants out of commission and replacing them with more modern technologies.’

He insists that ‘Chinese managements are now more willing to talk to you about profit growth, and are moving away from the state micromanaging the economy to it simply providing a social security safety net.’

Ehrmann’s experience tells him that China is following a well-worn path. ‘In the early days in emerging markets, there were very close similarities with what is happening in China now.’

‘Our job is to sit here and think strategically, and then work on the key themes. One of the great things about working at Jupiter is that we can think strategically without paying too much attention to the benchmark, which, in our particular case, isn’t worth very much anyway.’

Not just about commodities
One way in which this manifests itself is a focus on some of the service sectors, rather than the industrial and commodity-based themes more usually associated with the Chinese economic boom.

Ehrmann explains, ‘For example, we can concentrate on the healthcare sector. Most of China’s healthcare stocks are really just bulk chemical manufacturers and they have some serious choices to make about their future direction. Our job is to define which ones are going to do that successfully. You meet the companies and then make your choices. But that is not the end of the process. You have to then stay very close to the companies you are invested in. Get on the telephone and understand exactly what is going on.’

Ehrmann and his team are based in London, but he does not feel this inhibits their ability to understand what is going on in the Chinese market. It may even be an advantage, he explains, ‘We do a lot of groundwork ourselves. I have extended trips across the country three or four times a year, as do Ben Surtees and Carter Liang, who are both on the investment team. But we also see Chinese companies when they are in London. And I would say that when things get volatile, standing apart from that can be very helpful. You don’t get swept up in the market.’

He adds, ‘It’s important to identify companies with an edge, such as management strength or situations where there may be a possible duopoly in play: they’re the ones with the most chance of surprising on the upside.’

Ehrmann points out that ‘In practical terms, we can invest anywhere in the world, so long as the companies have at least 50 per cent of their business in China. That means I’m investing in companies listed in Hong Kong, Singapore, the US and, occasionally, the UK, although I wouldn’t touch most of the things on AIM: if they’re so good, why don’t they list at home?’

Focusing on the mainland
He adds, ‘I can look at Taiwan, but I’m much more interested in the People’s Republic of China, although the prospect of political change in Taiwan makes that more interesting. There’s so much more going on in China that I don’t want to get distracted, so I tend to concentrate on these themes.’

The themes are ones that investors will be familiar with – rapid industrialisation and urbanisation, the size of the infrastructure development programme, insatiable demand
for industrial and agricultural commodities, the sheer size of the population. But which stocks will profit from these developments?

Ehrmann says, ‘I am drawn to mid-cap growth companies. This is in contrast to the very large companies that have, so far, attracted the most attention.’

‘Environmental spending is the flip side of development, as is the development of service industries that most people don’t pay attention to. About nine per
cent of this portfolio is now in healthcare, and spending on these areas will grow dramatically as a proportion of GDP.’

Ehrmann also points out that ‘Another aspect of the Chinese market that is rarely appreciated is the relatively low level of indebtedness in the country. Only around 20 per cent of investment is financed by borrowing. The rest comes from domestic investors and the government. So the credit crunch will have less impact.’

Proving its resilience
It is partly for this reason that Ehrmann feels that the Chinese economy will prove to be surprisingly robust, even if the US continues to have problems. He argues that ‘China’s exposure to the US is only two per cent of its GDP. That is very modest but, at the moment, sentiment is such that the markets are moving around quite a bit. Last year, investors in China saw a sell-off in August and September as a great buying opportunity, whereas now everyone is very bearish. So if we are genuinely going to be contrarian, now is the time that we should be being more positive.’

It is important for investors to remember the long-term attractions of Chinese economic development. Ehrmann reports that ‘We are now in the second year of the Chinese government’s 11th five-year plan. This involves a heavy level of expenditure
on infrastructure.’

He adds, ‘You are also seeing the dramatic growth of cities in China and the infrastructure suppliers are involved in that. You have property companies that are involved in residential and commercial developments, companies involved in the building of railways and road projects. China will see seven million cars sold this year, up from 5.3 million.’

Cutting out the noise
Ehrmann adds, ‘There is a lot of background noise. Our job is to do what we have always done, and that is identify major long-term secular growth themes that won’t be derailed by the US housing crisis. Things like the increasing urbanisation of the Chinese population. Between 25 and 30 million people are moving from the countryside to the cities. That will bring with it a lifestyle change. Their increasing affluence will, in turn, boost consumption.’

The nature of investing in this type of market means that the fund will tend to be actively traded, with a relatively high level of turnover. But as Ehrmann points out, ‘With regard to turnover, ideally I am looking for companies that I can hold onto because their prices just keep going up. But two things are likely to happen, and the past 12 months have seen much more of the former than the latter.’

‘The first is that you see huge price volatility on the upside, so it is crucial that you have price targets. This price volatility means that the value of the fund can move dramatically. The turnover has been about 150 per cent, because of buying and selling around a core number of stocks. However, that figure can be misleading since, because of this price volatility, we may well have sold out of a particular stock and then gone back in two or three times.’

Ehrmann continues, ‘The other situation is where a company doesn’t meet expectations, either because of competition in its sector or because the government places a hurdle in its way. In that situation you have to ask yourself whether this is a mortal wound or a buying opportunity. I get really excited about being able to revisit things that had moved outside my price range.’

The long march
Ehrmann insists that ‘Securing long-term growth is what I am concentrating on, either in an individual stock or a market sector. Stocks can fall dramatically, sometimes for no reason, such as happened with the hedge fund sell-off, which means they fall back into my price range and I can buy them again.’

He concludes that ‘The Chinese problem has been too much growth, not too little. As they raise interest rates, that will attract more cash into the economy, which is exactly what they don’t want. The slowing of the global economy might be a good thing for China – it might enable the Chinese authorities to tighten their monetary policy.’

He adds, ‘China will continue to generate significant economic growth this year. In truth, economically, the Olympics doesn’t mean a great deal, with regard to the overall size of the economy, but politically it is very significant. The key things are that valuations look to be attractive and the economy remains largely on track.’