Intelli-bytes Episode: Rediscovering Zeal for a New China

In response to LPs’ growing requests for sharing our virtual research meetings, we bring you Intelli-bytes– video-recordings of our interactive dialogues with managers of interesting opportunities. Our live conversations with managers are not scripted but curated from a preliminary research perspective to help our sophisticated LP audiences learn about niche investment opportunities, strategies, relevant manager skills/experiences and personalities, just as they would if they were interviewing the managers themselves. These conversations are neither meant to be product pitches nor staged to allow a manager to give canned presentations that they could perhaps on their own behind a camera or in podcasts behind the scenes.

Intelli-bytes brings you raw, uncut, recordings of just how it happened- with our uhms, ahs, laughs, gaffes, interjections, objections, disagreements, distractions, bloopers and more!

This is as real and personal as it could get for you without you having to attend yet another zoom call or webinar or scan a dense pitchbook or take a manager meeting even when we (ever) get back to old days.

So, be it from your desk, car, shower, treadmill or just about anywhere, transport yourself into the scene, jot down (mental) takeaways (not notes!), make inferences, get a feel for the manager, but don’t draw conclusions just yet till you have vetted it yourself or engaged someone like us to do the due diligence on your behalf!

Intelli-byteslatest conversation is with Daniel Poon, Deputy Chief Investment Officer of Zeal Greater China Long Short Equity Fund (Zeal), that has since its inception almost 12 years ago, invested-long and short- in China-related companies listed in Hong Kong (H Shares, P Chips, Red Chips), Shanghai, Shenzhen ( A and B shares), Taiwan and US ADRs.

Synopsis: Rediscovering Zeal for a New China

Today’s China is by no definition the China that investors flocked to on the promise of simple growth driven by massive consumption by its teeming millions. While that was the original promise, China enjoyed ultra- fast annual growth of ~10% after the GFC, driven by a debt-fueled fixed asset investment boom. The story today is more nuanced than ever. The dials of the economy have been turned consciously and strategically, in favor of a more measured pace of growth (~4-5% annually by most estimates) driven by consumption of “quality and innovative” products and services higher up the value chain now that most people’s basic necessities are met. This is partly attributable to a growing legion of more educated people who are driving such demand as well as supply of value-added goods and services through innovation and enhanced productivity. Also, there is an increased focus on greener and more sustainable practices (i.e. decarbonizing) and on spreading economic gains (i.e. prosperity) equitably across its masses. A shift away from fixed asset growth would inevitably temper the pace of economic growth and calls for more regulation, control and monitoring of various business sectors to drive desired results.

While the economic slowdown has become more pronounced in recent months due to unraveling of China’s property sector (almost a third of the economy, affording an opportunity in Non Performing Loans-please see https://www.emaltsauditor.com/intelli-bytes-episode-opportunity-ever-grand/) and a regulatory crackdown on the tech sector, China has engineered “cycles” of structural changes years in the making. For example, China introduced supply-side reforms in 2015/16 (a key part of Xi Jinping Thought on Socialist Economy with Chinese Characteristics for a New Era), accompanied by a Made in China 2025 announced in 2015 followed by a deleveraging campaign in 2018, introduction of three-red lines in fall of 2020, and dual circulation and common-prosperity more recently. Cumulatively, all these policy reforms are aimed at making China more domestic-oriented as it risks decoupling from the West due to both geopolitical reasons and ideological (i.e. authoritarian vs. democratic principles) differences.

Therefore, as investors, as Daniel points out, it is imperative first and foremost to understand the cycles of change in the “New China” and “not merely extrapolate the past or current policies into the future” that many investors mistakenly do. With a better on-the-ground understanding of policy initiatives, sectors that enjoy policy tailwinds (e.g. EVs, semi-conductors, AI, 5G, medical devices, rare-earth minerals etc.: Source ÊMA) open up vast investable opportunities across the spectrum beyond just “online” businesses. Longer term security selection will matter but getting the sector right is key to identifying the right businesses in the initial phases of any economic change. Equally important is investing in management that on their own (and not necessarily due to oversight from state officials on company Boards as in some cases) recognize policy direction, have the “vision and mentality to embrace the new paradigm” and take necessary actions- key litmus tests of Zeal’s numerous company on-sites.

While bottom-up security selection has led Zeal to invest in securities listed across Greater China (Shanghai, Shenzen, HK, Taiwan), going forward mainland China (A shares) has a long runway as the market matures and grows further affording a meaningful universe of 400-500 securities (representing businesses driving higher value-added innovative products and solutions) from the approx. 4000 listed stocks that Stock Connect investors can access (who currently comprise only ~10% of A share trading volume Source: Bloomberg). Add to those offshore stocks in HK and select accessible (by offshore investors) stocks in NASDAQ-like new markets -STAR (Shanghai) and Chi-Next (Shenzen) and NEEQ (OTC, Beijing), it presents a robust opportunity-set offsetting the loss of delistings from US (e.g. Didi and probably a few others of major significance in the offing). On the latter, Beijing and the HK exchange have probably anticipated these delistings (triggered either by US audit requirements or China’s scrutiny of Variable Interest Entities listed in the US) and have paved the way for secondary and primary listings in HK, the transition to which is still being worked out in coordination with the SEC. Uncertainty till then could continue to spur volatility.

All told, policy changes, increased regulation, geopolitical squabbles, market (over) reactions spell a volatile path ahead. In light of this, a long-short approach like Zeal’s in managing net exposures (~ 50%) by shorting index futures, potentially helps mute volatility in quick order (~14% annualized, two-third’s of MSCI China. Source: Zeal) even during volatility spikes due to reduced market liquidity arising from central bank (PBOC and/or Fed) monetary policy tightening. Also, with likely wider dispersion among winners and losers ahead, shorting single name shorts (typically half of Zeal’s short book) could potentially capture short alpha given the improving climate for borrow pool and cost of borrow, of course with exceptions (e.g. over-crowded hedge fund positions in Macau gaming etc.). Overall, Zeal’s ~30 stock (long and short) portfolio is currently positioned in more liquid, large to mega cap stocks in more real economy sectors (consumer discretionary, industrials, materials) targeting absolute returns, which it has historically annualized at ~9%.

Recent negative headlines and China market selloffs notwithstanding, many investors encouragingly, are contemplating carving out a standalone China strategy across the spectrum of public and private markets (private debt, NPLs, venture, etc.). Skeptics who question: Is China investable? might find it insightful to listen to our recorded one-on-one conversation with Daniel Poon, Deputy CIO of Zeal Greater China Long Short Equity Fund to rediscover their zeal (no pun intended) for investing in a New China. Believers in China’s too big to ignore potential will probably only solidify their convictions by getting additional color on the real mechanics of investing in a New China beyond macro perspectives. As time rolls on, we plan on bringing to you other perspectives and approaches to investing in a New China across both public and private markets.

LPs are welcome to reach out to us at [email protected] with questions, comments, or requests for more information/due diligence on any manager or strategy of interest.

GPs with compelling value propositions who wish to be featured in future episodes of Intelli-bytes, are also welcome to reach out with a profile of their firm, strategy and related fund.

Take a listen and stay tuned.

Here’s wishing you and yours, Happy and SAFE Holidays and our very best for a bright and healthy 2022!

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

December 8, 2021

The above content including the recording of the video-call is for information purposes only and should not be used as a basis to make investment decisions. This content is intended for sophisticated audiences as in institutional investors or family offices to help qualify an opportunity for further due diligence. Any theme or idea discussed above is not an offer to buy or sell any investment. All opinions expressed in the video-recording are the managers’ and not of Emerging Markets Alternatives.