In volatile times, investors may think small cap stocks are most at risk. In China, however, it is a different story.
When President Donald Trump was elected in November 2016, investors wondered about the possible impact of US protectionism on Asia and in particular China. Yet in the absence of substance behind the political rhetoric, investors in China enjoyed robust performance in 2017.
The news turned negative last month, however, and Asian markets fell sharply following President Trump’s plans to introduce tariffs on up to US$60 billion in Chinese imports. The MSCI Asia Pacific Index fell -2.12 per cent in U.S. dollar terms in March, while the MSCI China Index was down -3.29 per cent.
In volatile times, investors may think small cap stocks are most at risk. In China, however, it is a different story. Talk of a trade war pressured China’s larger companies and the U.S. market more than it did Chinese small caps.
There are fundamental and technical reasons for the differing impact.
Fundamentally, our research shows that small caps are inherently companies that rely on self-generated capital. This means they are largely self-sustaining. By not being so dependent on financing, in volatile times—with interest rates rising and a focus on deleveraging—their costs are not impacted as much as they are for large-cap companies.
From a technical standpoint, Chinese small caps have long been overlooked by investors. This underinvestment means their liquidity profile is thinner compared with, for example, US small caps. A knee-jerk reaction to events by small-cap market participants will cause stock prices to react, but it is unlikely to trigger a major sell-off.
This is because by being an underinvested asset class, there are not many exchange-traded fund (ETF) options for Chinese small caps. In the absence of programmed trading, the initial volatility to global events, such as the headlines regarding Trump’s tariffs, usually abates after a day or two. For other global asset classes, a downturn typically lasts much longer.
At the same time, because our focus is on companies that are globally innovative, services-driven and have sustainable pricing power, many proposed protectionist measures will likely not apply. These are companies that are innovating on their home turf and are delivering both products and services to their local middle class.
This is important because what may next spark volatility is unknown. It could be a rise in interest rates or a global slowdown. Many factors can impact a company’s costs or pricing. We believe the way to minimize this uncertainty is to pick shares of companies that have strong pricing power with goods that are seen as a necessity, which people are willing to pay for even if they need to sacrifice elsewhere. As a consequence, we have not made substantial changes to our investment philosophy in relation to the Chinese small caps.
We have been using the volatility as an opportunity to add to existing holdings in the technology sector. Technology was a big driver of market performance in 2017, but the sector has been very volatile in the first quarter of 2018. This has not just been the case in China, but globally with the US and the FAANG (Facebook, Amazon, Apple, Netflix and Alphabet’s Google) stocks also being hit.
One area we are monitoring is the pharmaceutical sector where structural reforms aim to speed up new drug approvals. China now parallels the acceleration of approvals by the US Food and Drug Administration, meaning that drugs or medical devices that have US FDA approval would be fast-tracked through China’s approval process. If the US decides to close off its markets to Chinese pharmaceutical companies, however, it would limit their ability to export to the US.
Tiffany Hsiao is a portfolio manager at Matthews Asia.
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